Tuesday, February 19, 2013

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.


  1. Wow, another top notch post.

    I'm really starting to think that the future of Free Banking really lies in things like Bitcoin and Ripple.

    Mainstream economists will never champion a decentralized banking system (for what would the macroeconomists do?), and central banks aren't going away anytime soon. But even if we can't change the current system, perhaps someday we can escape it.

    1. I think you're right. If anything will move the world towards free banking, it's distributed credit systems like Ripple. I'm still skeptical of bitcoin.

      Economists are way behind the ball on all these developments, kind of like how they only started talking about MBS and CDOs after the crisis.

    2. In many ways (perhaps completely), I think Ripple will supercede Bitcoin.

      You posted before on the intrinsic value (or lack therof) of Bitcoin. My take is: Bitcoin's value now (I realize, not "intrinsic" since it relies on BTC being a medium of exchange) lies in its relative anonymity (facilitating illicit transactions in drugs, bitporn, etc) and speed/low cost for things like int'l transfers.

      No other payment system in the world surpasses BTC on these fronts. And BTC has an infinitely more developed infrastructure (eg Mt. Gox), network effect, and brand-name recognition compared to other virtual currencies/payment systems; these advantages are unlikely to be competed away by current alternatives (Namecoin etc).

      However, Ripple seems to have many of the same advantages of BTC while adding the "killer-app" (as Katz put it) of social credit. If Ripple does take off to the extent that BTC has, this function will put it over the top imo. And if the settlement medium can be dollars or BTC, then where does that leave BTC? Out in the cold?

      I'm sure you've seen this thread. It seems to that, initially, BTC and Ripple can enjoy some synergy, but as Ripple develops BTC will ultimately become superfluous. https://bitcointalk.org/index.php?topic=128413.0

    3. "And if the settlement medium can be dollars or BTC, then where does that leave BTC? Out in the cold?"

      The ideas embedded in BTC will live on, at least. Ripple seems to be taking the best from bitcoin, namely the public ledger, while avoiding the worst of bitcoin, which is its lack of a genuine anchor. Credit is a good anchor, its got a long history.

  2. Neat. I think it is no accident that it is being implemented during a recession. It confirms my view that recessions are due to a shortage of media of exchange, so that we would expect to see increasing use of: home production; barter; and the appearance of new media of exchange.

    1. One of my old posts on the subject: http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/03/greece-barter-and-the-gap-cubed-law-of-new-exchange-systems.html

    2. Interesting. Irving Fisher's Stamp Scrip came out in 1932 wish surely bears out your theory.

      The sudden emergence of crypto alternatives could also have something to do with the fact that young finance-minded geeks can't find an outlet at banks because the jobs aren't there, or they're too disillusioned with banks to bother applying.

  3. Interesting stuff. (BTW great blog and enjoyed learning about Bitcoin through you.)
    But, for Ripple to be successful, what real difference is it bringing vs. the merchants of 1600? True, we may have a wider network of Facebook friends, but our monetary *circle* is probably smaller than in 1600 (modern life = not talking to any of your neighbours!) It seems you need some system that increases the trust circle not just an arbitrary trust network size, i.e. I'm pretty sure Kevin Bacon is not going to lend me $20!

    1. I've read this criticism that lending to family and friends is never going to take off b/c such lending can adversely affect these social bonds (a point with which I largely agree).

      However, it seems that social credit networks don't have to be limited to those in one's personal circle, or even to personal lending. Can't businesses also use Ripple to deal with their distributors, suppliers, and customers for their short term credit arrangements?

      Also, what's to stop someone from starting a specialized Ripple-based "bank"? Starting a real bank now involves a ton of red tape and adherence to all kinds of regulations; Ripple potentially flattens the playing field. To some degree, it seems like Ripple : Financial Industry :: 3D Printing : Manufacturing Industry.

    2. "I'm pretty sure Kevin Bacon is not going to lend me $20!"

      That's actually the way the old bills of exchange system worked. If 150 people countersigned a bill, the final person (#151) to accept the bill before redeeming it would have no idea who the original debtor was. They wouldn't know the first 140 signatories either. What convinced the 151st person to take it was the fact he knew the previous 10 signatories and trusted them.

      In theory, Ripple could work something like that.

      And as John S points out, Ripple-based banks could emerge to simplify the process. The developers seem to be implementing a gateway system which could lead them in that direction.

    3. Social credit will only work well if there are social changes to facilitate. However, social media systems like Facebook and Twitter, and even texting, required significant social changes to work, and those social changes happened.

      Ripple doesn't rely on social credit. It's being promoted primarily as a payment system -- a way to move money around cheaply and quickly. It may be many years before social credit takes off, if it does at all. But I personally believe that social credit has the potential to change the way we think about money.

      (I am an employee of the company developing Ripple, speaking only for myself.)

    4. Thanks for dropping by. It would be neat of the social credit aspect took off.

      Any thoughts on how FINCEN's recent announcement affects gateways and other issuers of Ripple IOUs? I see that Mt-Gox is discontinuing redeemable code.

    5. As the self-described 'Kevin bacon of Ripple', you're on, "jt". What's your address?

    6. Guess I should have clarified, although I'm easy to find online, email me at recursive.genepool@gmail.com to call me on this. I'm going to stop coming back to here to check on you, "jt"

  4. Beware of the current Ripple implementation though, the way it's set up, you have to buy (or be arbitrarily given) the currency for transactions (which self-destructs after being used, making them scarce over time), of which anywhere between 20-50% will be held by the founders. If they ever come to have any monetary value, then it will make the founders very, very rich.

    Other than that though, fantastic post. The Ripple protocol and idea IS the future of monetary exchange.

    1. Good point, if true. Limited supply is the Achilles Heel of BitCoin, which means long term it will not be easy to trade (Keynesian theory!),see http://crypto.stanford.edu/~xb/fc12/bitcoin.pdf (That said, I want to support BitCoin and Ripple, if possible, though at the moment it's a chicken and egg problem).

    2. That's not what the Keynesian theory says. Rather, it is based on debt deflation, and the alleged consequence is the collapse of the economy, not the collapse of the currency. It furthermore requires that the deflationary currency is used in economic calculation, which with respect to Bitcoin would require that the fiat currencies are close to collapse or already collapsed and Bitcoin has replaced them. Just read Krugman's paper, http://web.mit.edu/krugman/www/spiral.html , if you don't believe me. It lists both the requirements: decrease in the money supply and expectations about nominal rate of interest (i.e. used in economic calculation). And it also claims that the consequence is a collapse of the economy, not a collapse of the currency.

      And the keynesian/monetarist argument is wrong anyway, if not for any other reason, then purely logically because debt deflation must end when 100% reserves are established. At least Krugman admits that there might be a bottom even though he does not see the obvious one.

      I always wonder how people come up with this stuff.

  5. How does Ripple lower the transactions costs compared to bitcoin? With Ripple, you expose yourself to multiple forms of counter party risk: 1) The gateways that you must surrender your underlying funds to, 2) The collective ability of people within the system to meet their credit obligations and (when applicable) 3) The underlying fiat currencies themselves. How does Ripple, for example, prevent a credit induced bubble and inevitable mass-default from happening? Bitcoin, on the other hand, has no counter party risk. As a result, it is far better suited as a monetary unit. Ripple does have the potential to be a better payment processor, so I'm curious to see how it plays out.

    1. Actually, according to my opinion, Ripple is one of the two potential candidates for lowering transaction costs over Bitcoin (the other being Open Transactions). The thing is that transaction costs are heterogeneous, and even if Ripple exposes you to counterparty risk, it still could outweigh some aspects of Bitcoin. Even if such a relationship is only temporary, it could permanently shift the market share, because, as JP says, "liquidity is sticky" or to use an even stronger argument, the choice of a medium of exchange is path dependent. Austrians do not typically use these terms, but Rothbard argued in the sense that once a choice is made, it is difficult to revert.

      I must admit I am not a Ripple expert, even though first time I heard about it around 2005, but my guess is that faster clearing, lower infrastructure costs, support for any unit of account, more flexible financial instruments, and greater anonymity give an advantage to Ripple. Whether this advantage persists (Bitcoin can adapt to implement similar features and some of them are already partially implemented) and whether it is sufficient to cause a shift is a separate issue and one that I don't have an answer to (and as it's empirical, it probably can't be predicted anyway). My hunch is that it is difficult to achieve homogeneity of units in Ripple, so even if Ripple is widely used, it probably won't cause a shift of units away from Bitcoin to something else. But I could be wrong and giving too much weigh to homogeneity (Rothbard made a similar error in "The Case for a Genuine Gold Dollar"), or I could be underestimating the capabilities of XRP.

    2. Good response. Don't have much to add. It seems Ripple developers are trying to solve the homogeneity issue by promoting gateways, or trusted bank-like entities. This focus seems to be a major difference from the original Ripple concept. Whether they are successful remains to be seen.

      What is Open Transactions?

    3. Open-Transactions: https://github.com/FellowTraveler/Open-Transactions/wiki

    4. Peter, the Ripple you heard of in 2005 and the Ripple that is being pushed now are very different. Right now, I think it is too closed and opaque to merit serious consideration. Once (if) the full source code is released then it will be vetted and, I believe, improved upon and likely forked.

  6. In this article, you can find a little about seventeenth century credit in Friesland, the Netherlands: http://peemconference2013.worldeconomicsassociation.org/?paper=monies-debt-and-policy-the-concept-of-endogenous-money-as-a-basis-for-household-and-non-financial-companies-instead-of-bank-centered-monetary-statistics

    I'll delve a little deeper into this.

  7. Ryan FUGGER. A medieval banker's last name. Coincidence? Or clever con man signaling? LOL

  8. The more I read, the more turned off I am by the required implementation of XRP. I think this post in the forums sums up how I feel and what will likely happen:


    "Quote from: proff on February 24, 2013, 05:39:29 AM

    Now, I indeed remember the original ripple web-of-trust proposal being as gmaxwell described. The "new" system seems to be something else, and I echo people's concerns expressed in this thread and do not see how they have been resolved to any satisfaction. It may be unintentional on the part of the ripple developers, but something seems fishy or opaque about it (at least at this point in time), and it looks like a commercial rather than a community project.

    +1. Excellent summary of the situation.

    I find it near impossible to discuss this matter transparently with Joel.

    Joel Katz: "I am prohibited from disclosing my opinion about XRP's future value."

    This is not a joke, and while some people love to suck up to power authority, most bitcoiners in this forum are smart enough to recognize a rotten egg.

    Joel, I recommend to you whole wholeheartedly to either expose your commercial intentions, or commit to altering and democratizing the txn solution at hand; otherwise you will be building a ticking time bomb. You won't end up controlling 50%+ market share but you know what they say: "Power tends to corrupt, and absolute power corrupts absolutely." Don't set yourself up for failure.

    From a true open source and decentralized democratized point of view, the idea of centralized txn authority is ridiculous. If this is the "only viable solution" you should either be opening up the platform to multiple fiat currencies so that users can create their own and there is a competitive free market amongst txn fee operators, or define a rock solid democratic distribution plan of all the XRP.

    Yet as I find the idea of an unsustainable self destructive txn fee currency a horrible idea akin to building on sand, the focus should be on disconnecting any value system from this txn fee mechanism, and focusing on proof of work as a security measure; or allow the network node operators to have a choice of what currency they prefer be paid as a txn mechanism.

    I realize this is a technical challenge but my intention is to open the debate and make sure you are open to change, otherwise I and others will fork our efforts towards bitcoin web of trust enhancement and your "ripple + get rich quick scheme" will bite the dust.

    You are clearly smart enough to know that we would realize this "necessary design flaw" as an overly greedy excuse on your part for power and control; therefore your downplaying of the issue leads me to believe your actions are highly strategic and premeditated. If you truly want to succeed with your efforts and with this community your veil of secrecy and prohibited dialog needs to end.

    Joel, please do not take my comments as hostile or personal. I really want ripple to succeed, and I'm simply pointing out the elephant in the room."

    1. I do agree that the new Ripple seems to have a different focus than the old Ripple. The old Ripple was more like a LETS -- it's purpose seemed to be the creation of an entirely separate monetary system from the existing financial network. The new Ripple seems to be focused on building on top, and grafting itself to, the existing network. I'm still reading about this and will hopefully do another Ripple post in the future.

    2. Forks are already in the works. Here is an interesting proposal that would piggyback Ripple onto bitcoin instead of competing directly with it via XRP. If it becomes viable, then it would have the considerable existing bitcoin network effect behind it:


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  10. This post ended a few months ago. I did a Bill of Exchange out of desperation. I did not realise the total ins and outs and was lead to believe it was a way to clear my debt and save my house from repossession. 1 year later my house has been repossed, but the fraud squad are after me for sending a cheque which was a bill of exchange. What is the likelihood of me being done for fraud? Scared and terrified and naive for believing this was a solution to help my situation.

  11. Nice article.Thanks for sharing some inspirational points about ripple exchange. It is very substantial.