XRP 101: The Banker’s Crypto

Jonathan Hobbs

7 mins

XRP 101: The Banker’s Crypto
  • Unlike most other crypto projects, Ripple aims to work with financial institutions rather than be their competition. It uses a unique blockchain technology based on the ancient Hawala IOU system.

  • Ripple’s blockchain is made up of gateways that need to trust each other to send IOUs back and forth. The XRP token is used as a link when there are no direct or indirect chains of trust between two gateways.

  • XRP is a top 10 digital asset by market size, but it has risks: the true level of XRP use is unclear and Ripple is in a standoff with the SEC that could impact XRP's growth.

Unlike most other crypto projects, Ripple aims to work with financial institutions rather than be their competition. It uses a unique blockchain technology based on the ancient Hawala IOU system.

Ripple’s blockchain is made up of gateways that need to trust each other to send IOUs back and forth. The XRP token is used as a link when there are no direct or indirect chains of trust between two gateways.

XRP is a top 10 digital asset by market size, but it has risks: the true level of XRP use is unclear and Ripple is in a standoff with the SEC that could impact XRP's growth.

Many crypto projects see themselves as a disruptor of the traditional banking system: why use a bank at all, when you can use a decentralized blockchain? But Ripple doesn’t share that sentiment – it aims to be the go-to blockchain for interbank transfers. Ripple’s XRP token has been a top 10 digital asset by market size since 2013, so let’s find out how Ripple works, and why you might want XRP on your radar.

How did Ripple start out and what problem is it trying to solve?

Ripple had a few name changes before it eventually became the company it is today. Canadian software developer Ryan Fugger first founded Ripplepay in 2004. And although blockchain never existed back then, the company’s goal was pretty much the same as it is now: to provide a faster and cheaper global transaction service than the legacy banking system.

In 2012, Fugger sold Ripplepay to Jed McCaleb, Arthur Britto, and David Schwartz, who renamed the company to OpenCoin and gave the payment system its first dose of blockchain technology. They then renamed the company again to Ripple Labs in 2013, and finally, to Ripple in 2015.

Today, Ripple’s website brands itself as having crypto solutions that are “faster, more transparent, and more cost-effective than traditional financial services.” At its core, Ripple aims to replace the Society for Worldwide Interbank Financial Telecommunications (SWIFT) system used by financial institutions to send payments and other financial instructions to each other. SWIFT can take up to four days to settle an international transaction, often for a 3-5% exchange rate fee. Ripple takes less than five seconds per transaction and costs just fractions of a penny.

So how does Ripple work?

Ripple is a blockchain-based payments network, but it doesn't run like your average blockchain. For starters, it doesn’t use proof of work or proof of stake to process transactions. Instead, it’s all based on IOU’s (I owe you) and works like the Hawala system – a method used in ancient Southeast Asia for transferring value over long distances cheaply and efficiently.

Say you lived in ancient times and wanted to send a bar of gold to a friend in a far off land. Instead of shipping that gold (which would be slow and expensive to do), you’d go visit your local Hawala dealer. The dealer would now send word to your friend’s Hawala dealer, who would ask your friend for a secret password. Assuming your friend knows the password, your friend’s Hawala dealer would give your friend a bar of gold.

Now, your Hawala dealer owes your friend’s Hawala dealer that bar of gold. But that’s ok, because those dealers have been doing business together for years, and they fully trust each other to make good on the payment. And because of that, they never actually “settle” those IOUs at all. Instead, they just keep passing IOUs back and forth between themselves and update their own records accordingly.

The RippleNet blockchain system connects gateways

Ripple’s blockchain system, RippleNet, works like this too. But instead of Hawala dealers it has gateways, which are mostly financial institutions. Problem is, not all gateways have done business together before, and they don’t all have an established link of trust. So when you send funds across Ripple’s blockchain, it might need to go via a less direct route. To send your funds to Gateway B, for example, Gateway A might first need to send them to their trusted Gateway C, which also trusts Gateway B.

Conceptual diagram explaining how Gateways are interconnected on Ripple’s blockchain.
Conceptual diagram explaining how Gateways are interconnected on Ripple’s blockchain.

Gateways transport IOU information to each other in encrypted form. Seconds after each payment, RippleNet triggers the gateways involved in the transaction to update their own ledgers. It also updates its blockchain with a consensus process involving its unique node list (UNL), which is basically just a trusted group of validators within the network who make sure the network runs smoothly.

Validators help the blockchain reach consensus

Anyone can become a Ripple validator, which earns you street credit with the Ripple community and it gives you a say in the evolution of the project. But the buck stops there: unlike with most other blockchains, Ripple validators don’t earn a direct fee.

RippleNet needs an 80% agreement among its UNL for any transaction to go through. And while it may be more centralized than other blockchains, it’s one of the fastest and most energy efficient around.

In theory, you could ping any type of currency or asset across the Ripple network – so long as the gateways are willing to accept it. But sometimes, there just isn't a chain of trust from one gateway to another…

The XRP digital currency gets around the trust issue

XRP is a digital currency that was launched in 2013. You can send XRP to any Ripple wallet address on the network – even if there isn’t a chain of trusted gateways to get it there. That’s because, unlike other assets, Ripple doesn’t treat XRP as an IOU. So any two gateways can link up because there’s no need for that same type of trust.

XRP has a maximum coin supply of 100 billion. Ripple owns more than half of those right now – and that’s been met with a lot of skepticism by the crypto community. But in 2017, Ripple moved 55 billion XRP into escrow (a secured third party account) that prevents Ripple from cashing out their chips all at once at the expense of XRP holders.

Each XRP transaction costs about 10 “drops” (0.00001 XRP) in fees. Those XRP fees are “burned” out of circulation by being sent to an XRP wallet that can never be used again. In other words, as more people use XRP for transactions, the token’s supply will decrease at a faster speed, which could boost its long-term value.

So is XRP a good investment?

Ripple provides a solution to a trillion-dollar problem: how to make transactions faster and cheaper among financial institutions. So far, RippleNet has racked up hundreds of institutional clients, including big banks like SEB and Santander. Ripple’s business solutions also extend beyond payments to include e-invoicing, international supply chain payments, and real-time cashpooling. Ripple has also partnered with the Digital Pound Foundation and Digital Euro Association to help build out Central Bank Digital Currencies (CBDCs) for the UK and Europe.

With all that being said, there are still two major gray areas when it comes to investing in XRP itself.

1. It’s unclear what percentage of Ripple's customers actually use XRP

As mentioned above, RippleNet is based on IOUs and you don’t always have to use XRP. But according to Ripple’s quarterly reports, On-demand Liquidity (ODL) volume has been ramping up steadily. That’s important because ODL involves RippleNet customers using XRP as a bridge between two currencies when sending funds internationally. So for example, let’s say a bank in Japan might trade yen for XRP, which is then traded back into US dollars and received by an American bank. And that all takes around three seconds to do. The fact that ODL is increasing suggests more customers are using XRP, but it's still not clear what percentage of Ripple’s blockchain uses XRP for payment services.

2. Legal issues with the Securities and Exchange Commission (SEC)

It’s no secret that regulators are coming after crypto projects to make sure they comply with their rules. And Ripple’s no exception: in December 2020, the SEC sued Ripple and some of its founders for illegally selling XRP as an “unregistered security.” It matters if Ripple is a security because then it would fall under the same regulation as traditional securities like stocks and bonds.

The SEC uses the “Howey Test” to decide if an investment is a security or not. Under this test, XRP would be considered a security if Ripple’s initial sale of tokens to the public involved an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”.

The SEC is saying that Ripple’s sale of XRP meets this criteria. But Ripple’s ready with a comeback: its lawyers are using the “fair notice defense” as the crux of their case. They’re saying that the SEC never gave Ripple fair notice that what they were doing went against regulations because they sold XRP openly for years without any legal issues. In other words, Ripple thought it was operating within the law as far as possible when it was selling XRP tokens.

It’s hard to say what the outcome of the case will be in the end – but the fact that the case has dragged on for nearly two years suggests Ripple still stands a chance of coming out of it in one piece. And XRP’s future growth will depend a lot on that final outcome.

Now test your knowledge with our XRP 101 quiz.

XRP 101 quiz
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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