Ripple, or Bills of Exchange 2.0

Bill of exchange for £30 for tobacco sales, on April 26th 1769

Here's some interesting news. Ripple is finally being implemented.

What is Ripple? Ripple is an open source P2P credit system dreamt up by Ryan Fugger in 2004. Its mission is to provide a non-banking payments alternative by decentralizing the process of creating and circulating highly liquid IOUs. Put differently, Ripple offers an environment in which individuals can be their own credit-issuing and credit-accepting banks. Ripple has always remained conceptual. But now a team of developers lead by Jed McCaleb, founder of MtGox, the world's largest bitcoin exchange, are implementing a living breathing Ripple network.

Ripple might seem to be unprecedented, but the decentralized credit system it envisions existed centuries ago in the form of the historical bills of exchange system. We tend to assume that all transactions conducted by people living in the 16th, 17th and 18th centuries were naive barter or coin-based transactions. But Adam Smith, Henry Thornton, and Sir James Steuart all provide lucid accounts of what was actually a very complex credit-based economy. Just like modern bankers have been busy dreaming up MBS, CDOs, and CLOs, medieval innovators in their own time spawned a broad variety of credit instruments including bills of exchange, promissory notes, cash credits, deposit accounts, accommodation bills, bank notes, shares, exchequer bills, and more.

Bills of exchange are particularly interesting. I'll bring this all back to Ripple in a bit, but in order to do so I need to explain how a bill of exchange worked. Let's start with a horse-drawn buggy merchant who, having received a shipment of buggies from a buggy distributor, must pay the distributor. The merchant writes an IOU, or bill, indicating that he promises to pay the distributor x pounds of gold three months hence.

In the early days of the bill of exchange, the distributor would hold this bill for three months and take delivery of the gold upon maturity. Later on a new use for the bill of exchange emerged. The distributor, unwilling to hold the bill for so long, might decide to "endorse" it onwards before maturity. Endorsement meant that the distributor would write his name on the back of the original bill, thereby promising to stand as a cosignatory to the carpet merchant's debt. The distributor could then spend the original bill by, say, purchasing more buggies from a buggy manufacturer. The buggy manufacturer might in turn use the very same bill to purchase lumber from a lumber merchant, and the lumber merchant might endorse that bill onward to purchase wood from a forest owner.

By the end of the bill of exchange's three month life, it would be returned to the buggy merchant for payment in gold. On the back of the bill would be a long list of cosignatories who, in the interim, had endorsed the merchant's IOU on as "money". The very fact that this chain of merchants knew each other and were willing to vouch for each other's credit gave these instruments their marketability. Henry Thornton, Henry Dunning Macleod, and Thomas Tooke all described how in the county of Lancashire in northern England (which then included Liverpool and Manchester) almost all transactions were carried out in bills of exchange. Macleod describes bills "which had sometimes 150 indorsements on them before they became due."

Even when the original debtor's bill of exchange came due, it would often be settled with a new bill. Either that, or the debtor might have in his cash box someone else's bill that he might endorse to his creditor to settle the original. Thus, though bills were payable in gold, very few bills were actually settled with the metal. IOUs circulated perpetually. The bills system functioned as one of the earliest decentralized P2P networks. Merchants, acting simultaneously as bankers, both created new credit and verified existing credit by endorsing it onwards.

Ripple is (perhaps unintentionally) replicating the bills of exchange system by allowing individuals to emit their own highly liquid IOUs. Ripple users build a list of contacts whose credit they trust and indicate their degree of trust by stipulating how much of an issuer's IOUs they are willing to accept and in what denominations. Once they receive those IOUs in payment, the IOU might be settled in underlying settlement media (say bitcoin or dollars) and canceled. Alternatively, Ripple users are free to exchange these IOUs on to anyone else who accepts the issuer's credit. Finally, when two people owe each other an equivalent IOU, they can simply net out the transaction and cancel both promises.

Webs of trust allow Ripple transactors with no direct personal contact to transact with each other via the chain of trusted credit-granting intermediaries that stand in between them. Joel knows Sarah who knows Bill, and even though Joel and Bill don't know each other, they both trust and are trusted by Sarah who can serve as a go-between. Rather than using a bank, the transaction can be consummated through a distributed network of friends and acquaintances.

Ripple itself takes on no credit risk. Ripple is simply a process, or a utility. Much like merchants trading in bills of exchange, Ripple users are responsible for choosing who they vouch for and in what amounts. If the Ripple system proves to be as successful as bills of exchange system once were, IOUs may never actually be settled in underlying units like bitcoin or dollars. They'll circulate in perpetuity.

Eventually the distributed bills of exchange system was competed away by specialized bankers. Bills were not always convenient to accept since they were typically issued in non-standard amounts. The buggy merchant might issue a bill to his distributor with an ungainly face value of £1557, for instance, which could not be broken down into smaller amounts, nor could it be easily combined into a round larger amount. Bankers solved this problem by offering to buy, or discount, bills of exchange in return for notes and deposits. Deposits are divisible into tiny amounts and notes printed in convenient denominations, all of which would have encouraged their circulation at the expense of bills of exchange. Bankers also took over the job of monitoring credit quality. Unlike bills, bank notes and deposits were homogeneous in terms of credit quality. This would have freed merchants from having to spend scarce time verifying the quality of bills of exchange and tracking down the issuers of mature bills.

Banks are expensive to run. Whereas merchants circulated bills of exchange by hand, banks must maintain their own complex payments infrastructure. Evaluating credit quality requires hiring credit evaluators. These costs must be recouped through transaction fees. Presumably the first bankers offered enough conveniences relative to trade in bills of exchange to compensate merchants for these fees. What is interesting about Ripple is that in the age of the Internet, management of the payments infrastructure can be cheaply outsourced to cooperating nodes, much like how BitTorrent parcels out tasks to peers. Social networking tools provide individuals with tools for DIY credit analysts. While Ripple IOUs are not homogeneous in terms of credit quality, people may be willing to overlook this inconvenience if these other costs are significantly reduced. It may be that the advantages once favoring centralized banking over distributed banking have been so eroded by the Internet that distributed systems like Ripple will once again be chosen by transactors.

PS. If you like this, send me some XRP at rMpB2AsrDTdbynCB48hg8MwHLD4wtXJfRJ. I don't have any yet. [Update... ok, I've got enough]
PSS. If we're lucky, perhaps Joel Katz will pop up in the comments. He's working on the project and might be able to answer questions.