Ripple Protocol - Deep Dive For Financial Professionals PDF
Ripple Protocol - Deep Dive For Financial Professionals PDF
Ripple Protocol - Deep Dive For Financial Professionals PDF
14. Conclusion 45
16. Contact 47
Ripple Protocol: The Internet for Value
Ripple is a universal protocol founded in 2012 to power the cheapest and fastest payment system for value
transfer with a global, post-Internet architecture. Ripples innovative technology enables users to exchange
money (including fiat currencies, digital currencies, gold, and other items of value) across national boundaries
as seamlessly as sending an email.
At its core, Ripple is a physical network of computers running a common open-sourced software (known as
rippled, pronounced: ripple-d), developed and maintained by Ripple Labs (more on Ripple Labs below).
Users plugged into the rippled software transact according to rules set by the Ripple Protocol. Similar to other
Internet protocols e.g. SMTP for email and HTTP for websites Ripple is a set of rules that govern how
Internet-connected computers communicate with each other. As an Internet protocol, no one owns the Ripple
network and the open-sourced software is completely free. Ripple Labs does not operate the network, collect
fees, or limit access.
In addition, as a protocol, Ripple cannot dis-intermediate banks or its financial services users/partners. This is
synonymous with other Internet protocols like HTTP (the protocol for the Internet) or SMTP (the protocol for
email); no company can cut access to these public goods, because no company controls them. On the other
hand, Ripple relies on financial institutions to serve as gateways providing access for funds to enter and exit
Ripple and market makers to provide liquidity within the network.
Another important aspect of a protocol is that users dont have to know how it works- and in fact, users dont
even know there is a protocol to begin with. Consumers dont have to understand how the Automated Clearing
House (ACH) or Society for Worldwide Interbank Financial Telecommunication (SWIFT) work to send payments
or understand how the HTTP or SMTP protocols to use the Internet. Whats important is that the protocols
ultimately enable a seamless and user-friendly experience.
These costs and risks are most pronounced in international transactions. Today, each country has its own
domestic interbank transfer system, such as the ACH system in the U.S. or the Bankers Automated Clearing
Services (BACS) in the UK. These payment systems enable domestic bank-to-bank transfers, usually routing
through the central bank as a clearing agent. These are typically low-cost transactions for banks, but they
could take two to five days to settle.
For international transactions, however, there is no global equivalent of ACH. This is partially because there is
no trusted, supra-national clearing agent to provide the settlement that central banks provide on a national
level. Instead, money moves across borders through a patchwork of correspondent banking relationships,
connecting one regional banking center to another.
Correspondent banks are typically large, multi-national banks that maintain accounts in several regional
banking systems. These correspondent banks act as a domestic agents bank in international markets and
could process transactions, accept deposits or conduct other business activities on behalf of domestic banks.
For example, a small or mid-sized U.S. bank could transact with a European bank through the services of a
correspondent bank with a presence in the U.S. and in Europe. These correspondent relationships are
governed by bilateral agreements between financial institutions. For a more detailed discussion on
correspondent banking, see A closer look at correspondent banking on page 33.
For businesses, consumers, and banks, the costs of correspondent banking could add up over many
transactions. First, each correspondent bank introduces a per-transaction cost known as a lifting fee. Second,
businesses or consumers typically bear the cost of currency conversion (i.e. the FX spread), which is dictated
by the correspondent. Third, small/mid-size banks are typically required to deposit funds as collateral in an
account at their correspondent bank as part of the arrangement. This liquidity cost varies depending on each
bilateral arrangement and the perceived risk of each bank.
International transactions need to go through a series of hops between domestic banks, central banks and
correspondent banks. Each hop represents an additional layer of cost (usually a per transaction fee), risk
(settlement and counterparty risk), and delay. Additionally, international transactions introduce FX conversion
fees (for businesses/consumers) and currency reserve management costs (for banks). The diagram below, for
all its complexity, shows a relatively simply example between two heavily trafficked regions/currencies. The
path between two developing market regions can be significantly more complex and costly, and in some
cases, non-existent.
Sent: Received:
$1000 720
(760) ($940)
$7.5 $25 4% 15
fee fee FX fee
The need for a clearing agent stems from what technologists refer to as the double spending problem. A digital
USD balance is just an entry in a ledger. It is the liability of its issuer a promise to pay the bearer on demand
and it is underpinned by the assets held by a bank or custodian.
Without the Federal Reserve acting as a trusted clearing agent, a bank could conceivably double spend its
assets and simultaneously send payments to multiple counterparties, which presents significant counterparty
risk. Instead, banks deposit funds with the Federal Reserve, and the Fed can move assets between their
accounts with enough visibility to ensure the solvency of payments. Or in the retail example, users deposit
funds with Paypal, and Paypal can ensure that a users assets are not double spent.
However, the Bitcoin protocol - like most other digital currency protocols - requires users to transact in the
protocols native digital currency (i.e. Bitcoin users must transact in bitcoins, or BTC).
The exhibit below illustrates how the same U.S. importer business can transfer funds to the German exporter
business via the Bitcoin protocol. First, the U.S. business converts USD into BTC using a bitcoin service
provider. BTC can then be transferred directly to the beneficiarys bitcoin account. Next, the German
business service provider converts the BTC into Euros, and finally, the bitcoin service provider delivers Euros to
the German business. The German business then deposits the amount into its EU Bank.
Bitcoins technology is a conceptual improvement that removes much of the friction in the current process for
interbank transfers. The protocol enables peer-to-peer transaction settlement and thus circumvents the
complicated and costly correspondent banking framework. This has the potential to provide users with both
cost savings and faster settlement. However, the fact that the Bitcoin protocol requires users to transact in
BTC introduces some new frictions:
Exchanges or bitcoin payment processors impose transaction fees to convert in and out of bitcoin.
Liquidity to convert in and out of BTC may be limited or costly.
Though many users immediately convert out of BTC upon receipt, there is still ten to sixty minutes of
currency volatility that is unavoidable while the bitcoin network confirms transactions. YTD, the
average hourly trading range for BTC/USD has been 1.5% with outlier moves as high as 20% over a
sixty-minute window. This volatility can entirely consume the savings of using bitcoin, and then
some.
Even if the volatility of BTC is significantly reduced, there is no way to guarantee the fiat value that
the beneficiary will receive (without a third party taking the price risk) which presents challenges for
this schema to comply with Consumer Financial Protection Bureau mandates.
However, in contrast to other digital currencies, the Ripple protocol is completely currency agnostic and users
are not required to convert local currency into Ripples native currency (XRP or ripples). Additionally, rather
than attempt to circumvent traditional financial institutions, Ripple relies on financial institutions to function as
(1) gateways into and out of the Ripple network, and (2) market makers to provide liquidity for FX conversion by
posting bids/asks for each currency pair. Ripple routes each transaction to the trader(s) with the best price in
the network.
Thus, in the same transaction discussed above, the U.S. importers bank would directly plug into Ripple and
initiate a USD to EUR transaction. Market makers will compete for the transaction by posting bid/ask for
EUR/USD. Ripple will ensure the market maker posting the cheapest offer fulfills the transaction. This market
maker will thus, buy USD from U.S. Bank and sell Euros to the EU Bank.
The illustrative example points to several potential advantages of using the Ripple Protocol for interbank
transfers.
First, because, users are not required to convert to XRP in order to transact on the Protocol, the
sender of the funds only needs to worry about one fee, which is the FX spread. This spread,
moreover, is minimized given Ripples algorithm to route transactions to the lowest spread on the
network.
Second, because Ripple is not intended to be directly customer interfacing, banks continue to
control their customers experience. Thus, banks could ultimately decide how much of the cost
savings to pass on to their customers.
Third, transactions on the Ripple network typically settle within a few seconds. This enables banks to
grant their customers faster access to their funds, improving their overall customer experience, and
improving working capital for businesses.
1 2
Peak Volume 19mm Messages/Day 600,000 Transactions/Day 86mm Transactions/Day [RL Est.]
Herstatt Risk
Bilateral Settlement Herstatt Bank was a German bank
that went bankrupt in 1974,
Over the past few decades, best practices for funds settlement have
highlighting to the world an example
trended towards tri-party settlement arrangements. In addition to the of settlement risk.
two counterparties who are transacting with one another, a third party
Per Wikipedia: On June 26, 1974,
settlement agent is often involved to mitigate settlement risk.
German regulators forced the
troubled Bank Herstatt into
Staggered hours of operation across different time zones can make it liquidation. That day, a number of
difficult or sometimes impossible to settle both sides of a banks had released payment of
transaction simultaneously. For example, the banking hours of Japan Deutsche Marks to Herstatt in
and the U.S.A do not share any hours of overlap. To avoid Herstatt Frankfurt in exchange for U.S. Dollars
that were to be delivered in New
Risk (see inset) a settlement agent will typically receive payment from
York. Because of time-zone
both counterparties and wait until both sides of the transaction settle differences, Herstatt ceased
before releasing funds. This serves to reduce the counterparty risk operations between the times of the
that arises from mismatched time zones and varying settlement times. respective payments. The
counterparty banks did not receive
their USD payments.
In contrast to the existing system, the Ripple ledger operates 24/7
and provides for real-time, bilateral settlement, eliminating the need This type of foreign exchange
for a third party clearing agent. Two counterparties who are settlement risk is now known as
Herstatt Risk. CLS Bank was founded
integrated into Ripple can exchange funds or assets simultaneously.
in 2002 to mitigate this type of risk.
1
http://www.swift.com/assets/swift_com/documents/about_swift/SIF_2013_01.pdf
2
https://en.bitcoin.it/wiki/Scalability
Ripple servers use public/private key cryptography to verify whether transactions are valid or not. Each
transaction that gets submitted is signed with a unique digital signature, analogous to how people sign paper
checks with a unique signature in traditional banking. Ripple servers mathematically verify that the correct
signature appears the signature of the owner of the funds before including transactions in a new ledger.
Consensus must be reached among a supermajority of connected computers in order to make changes to the
ledger. This is what is known as an atomic process either a transaction is completely verified, or not.
This process is what enables the Ripple Network to offer users real-time settlement (typically between 3 to 6
seconds) and bypass the need of a central operator, which as explained above, circumvents layers of fees that
financial institutions, business and/or consumer bear for traditional payments. In other words, the process of
consensus is what enables fast, secure and decentralized settlement on the Ripple network. This distinguishes
Ripple from other digital currency protocols, such as Bitcoin, which rely on a process called proof of work (i.e.
mining) to validate transactions on the block chain. Unlike Bitcoin, Ripple does not rely on mining to reach
consensus, so it does not consume the large amounts of energy that Bitcoin does, nor is the networks
security related to the amount of processing power devoted to it. For a more detailed explanation of the
consensus mechanics, please refer to the Consensus white paper or the links to additional information in the
appendix.
Unlike other digital currency protocols, however, Ripple provides users complete currency choice and does not
require users to transact in XRP. Instead, XRP is there to provide two key functions: to prevent abuse of the
system and to act as a bridge currency for market makers providing liquidity within the network (more on both
of these features below). Thus, users can hold balances in one currency and transact in another currency
without converting to XRPs in the process.
Ripple has the potential to meaningfully bring down these costs by making payment FX rates competitive on a
per transaction basis.
The Ripple network translates currencies by routing orders through market makers competing to earn bid/ask
spread. These markets makers are important sources of liquidity within the network and are primarily financial
institutions with a business in currency or securities market making (i.e. banks, hedge funds, quantitative
trading shops). Market makers compete for business within the Ripple network, posting orders to buy and sell
different currency pairs to facilitate payments.
The Ripple Protocol is designed to route every transaction to the cheapest price available in the market. Thus,
the only way an order gets filled is if it is posting the best price for a specific currency pair at the particular time
the transaction is executed. As a result, the protocol can lower one of the highest financial and operational
costs for financial services companies moving funds across national boundaries.
4. Pathfinding
Ripples Pathfinding Algorithm further improves on market maker pricing by searching for the cheapest path for
payments to move across the network.
In the example below, the sender of a payment holds EUR, and the recipient wants to be paid in KRW. Since
there may not be a tight market in EUR/KRW, the payment is routed through several order books to improve
the price. Unlike in traditional markets, users are not exposed to legging risk. Ripple executes multi-hop paths
as a single atomic transaction. The entire transaction either completes or it never happens there is no way for
a payment to get stuck en route. Since Ripple transactions are just updates to a distributed ledger, multiple
legs can be executed at the same instant as they are all included in the same ledger update. There is no
counterparty risk to intermediaries.
3
Settlement risk Atomic process Straight-through processing
3
Straight-through processing enables the entire payment lifecycle to be conducted electronically without the need for manual intervention or re-
keying. Current international wires can have a failure rate of 2-10% depending on the institution, requiring human intervention to remedy.
As a second line of defense, with each transaction that is processed, 0.00001 XRP is destroyed (roughly
$0.000000055 at the time of writing). This is not a fee that is collected by anyone the XRP is destroyed and
ceases to exist. This transaction fee is also designed to be negligible for users. But when the network is under
heavy load, such as when it is attacked, this fee rapidly rises.
If the price of XRP were to appreciate significantly to the point where sending transactions becomes a non-
negligible cost for normal users, there is a mechanism in place to lower (or raise) transaction fees by a
supermajority vote of server operators.
On a protocol level, Ripple makes a distinction between both the balance type (USD, EUR, XAU) and the
issuing counterparty (Bank A, Bank B, etc.). This is important because USD balances issued by two different
banks are technically liabilities of different institutions and have different counterparty risk profiles. From the
perspective of the protocol, they are different financial instruments. As the number of assets and the number of
counterparties in the network grows, the number of currency pairs can quickly become unmanageable for a
market maker.
Instead of quoting every possible currency/gateway combination, XRP can serve as a useful bridging tool for
market makers. If every currency is liquid to XRP, it is also liquid to other currencies.
The role of a bridge currency or vehicle currency is traditionally played by USD in financial markets. Within
the Ripple network, there is a functional reason to prefer XRP. Because XRP is a natively digital asset (as
opposed to a balance/liability), it is the only instrument within Ripple that has no counterparty risk, so it can be
universally exchanged between market makers with no friction. Also, because it has no counterparty, XRP
never has third party fees attached to it.
Ripple Labs believes that an increase in the number of counterparties and asset types in the network adds to
the utility of XRP and creates demand for XRP in the long run.
First, as a software developing company, Ripple Labs provides the core technology for transaction settlement,
developing and maintaining the code of the protocol. Second, Ripple Labs builds new tools to allow developers
to build user-friendly applications, whether those end users are consumers, merchants or other institutions.
Ripple Labs helps incubate these ideas but does not typically take a cut of ownership in order to maintain its
neutrality. Third, Ripple Labs pursues partnerships to expand the Ripple network of financial institutions, users
and market makers, providing APIs to access the protocol.
Ripple Labs has raised capital from some of the leading venture capital and technology firms, including Google
Ventures, Andreessen Horowitz, LightSpeed Venture Partners, IDG Capital Partners, and Founders Fund. In
addition, Ripple Labs continues to attract a diverse set of talented individuals with experience in relevant
technology and financial services companies, including Apple, Google, Square, Twitter, e-Loan, Fiserv,
Promontory Financial Group, Goldman Sachs, and the U.S. Federal Reserve.
Historically, information protocols, like HTTP and SMTP, were impossible to monetize directly. Ripple Labs is
not a financial services provider and thus does not charge for using the network. The Ripple protocol, however,
could in fact be monetized through its native currency, XRP. By design, 100 billion units of XRP were created at
Ripples inception, and per the protocol rules, no more XRP can ever be created.
Ripple Labs plans to retain 25% of all XRP issued to fund operations (and hopefully turn a profit) and distribute
the rest to incent the participation of market makers, gateways, and consumers to utilize the protocol. Given
that there is a finite number of XRP, as demand for XRP grows, the value of XRP should appreciate. In this
manner, Ripple Labs believe that its incentives are aligned with those of protocols users both want the
protocol to reach its full potential and scale.
Note: Corporate logos in graphic above are for illustrative purposes only
If widely adopted, Ripples peer-to-peer, decentralized settlement infrastructure would replace the current
settlement system for funds transfers. However, the other layers on the payments stack would be unchanged.
Financial services institutions, developers, and payment processors would continue to focus on their strengths
and directly integrate their services on top of a more efficient transaction settlement system.
Banks and payment processors will continue to acquire and interface with their end-customers (business
and/or consumers). Regulatory bodies like the Federal Reserve will continue to set and enforce regulatory
standards. Messaging standards like SWIFT can be easily integrated into Ripple as well.
Several networks or clubs of financial institutions may ultimately form on top of Ripples common settlement
protocol. For example, NACHA (the North American Clearing House Association that governs the ACH
network in the U.S.) could create standard rules that allow for payment reversibility, compliance, dispute
resolution, etc. between member banks on the Ripple network. The same can be true for SEPA region banks
in Europe.
Intra-Group Transfers
Large, diversified financial services institutions will often operate separate core ledger systems in different
business lines. This is especially common among companies that were formed through multiple acquisitions
over the years, where ledger system integrations can be challenging and costly.
For example, a financial conglomerate that operates a brokerage and a retail bank may never have integrated
the brokerage and checking account ledger properties after an acquisition. In this case, if a banks customer
wanted to transfer cash from her brokerage account to her checking account maintained in the same financial
institution, the financial services company needs to move the cash outside its system via ACH. As described
above, the transfer could take up to 3 days to settle. Not having access to these funds results in a working
capital challenge to the bank and the banks customer. There are additional operating and compliance costs
associated with expatriating and repatriating funds.
Ripple can provide a relatively turnkey solution to integrate ledger-based properties within an institution.
Inter-Bank Transfers
Domestically, inter-bank transfers appear similar to the intra-group transfers described above. In this case, a
domestic financial institution would need to use the ACH system to transfer the cash to another domestic
financial institution. Once again, the receiving bank (and the banks customer) will not have access to the cash
until the transaction settles in up to 3 days.
International inter-bank transfers, however, have many more pain points given the lack of a global payment rail.
Instead, money moves from one regional bank system to another through a series of correspondent banking
relationships. Correspondent banks are financial institutions that can conduct business transactions, such as
process payments, accept deposits and transfer securities on behalf of other institutions. Correspondent banks
help domestic banks conduct these business transactions in foreign jurisdictions.
As explained above, these international transactions need to go through a sequential process, where
transactions take several hops. Each hop adds a layer of fees, counterparty risk and settlement delay. These
fees and risks vary depending on how complex the correspondent network is. Some transactions (particularly
for funds going to certain developing countries) navigating through an extensive correspondent bank network
involving several hops could take up to 15 days to settle.
For Banks
Ripples technology can enable banks to optimize internal payments operations (e.g. back-office) and provide
new and enhanced external payments services to customers (e.g. retail, commercial and institutional clients).
By reducing fees associated with correspondent banking and shortening the cash cycle, Ripples distributed
network eliminates many of the costs and risks involved in the current ecosystem for banks. In addition, banks
can leverage market maker competition to lower their FX cost for international transactions. Importantly, Ripple
also eliminates the need for banks to post reserves/collateral to their correspondent bank, improving working
capital.
While financial service providers could lower wholesale costs of payments with Ripple, the protocol does not
interfere with a banks relationship with its end customers. This includes customer acquisition, service and
pricing. Thus, the financial services business continues to determine retail prices of payment services for
customers. As a result, Ripple allows banks to continue monetizing their most attractive asset their account
holders.
Banks are also best suited to act as gateways given their extensive experience in complying with financial
services regulations, anti-money laundering (AML) and know your customer (KYC) rules. As a result, having well
regulated entities, such as banks as gateways could help enhance the security of the network and increase
confidence for all users, potentially leading to more payment volume.
Given the intensifying competition in payments and money transfer ecosystems, leveraging the Ripple Protocol
could provide payment processors and money transfer networks a competitive advantage. These companies
would benefit from a lower wholesale cost of payments and money transfers. However, the protocol does not
set retail prices. As a result, payment processors and money transfer operators would have flexibility to
compete on price while managing profit margins. For a more detailed discussion on the payments and money
transfer ecosystems, see A closer look at electronic payments and A closer look at international money
transfers on pages 37 and 40, respectively.
For example, it is currently not economically viable to send $200 internationally, because fees would typically
account for such a large percentage of the total payment value. If the marginal cost per payment were lower,
this and other new market segments could emerge.
For Regulators
Regulators could find it easier to monitor and enforce regulatory standards for transactions that occur on the
Ripple network. Under the current interbank funds transfer systems, banks record transactions on separate
ledgers. Thus, it could be difficult to follow the flows of funds, particularly in international transactions, which
require the funds to go through multiple correspondent banking relationships. Flow of funds within Ripple are
easily traced, as all transactions are posted on one giant ledger.
In addition, since regulated banks and other financial institutions integrate in the Ripple Network and provide
liquidity, these financial services institutions will continue to comply with their existing regulations, such as anti-
money laundering (AML) and know your customer (KYC) rules.
Ripple provides law enforcement and regulators with a single consolidated global ledger with which to monitor
economic activity.
The foreign exchange market is known to be among the most liquid markets in the world, yet retail and B2B
payments have had persistently wide margins. This provides a strong incentive for market makers to
participate in a space where many market making firms historically have not had a seat at the table.
For Merchants
Ripple allows merchants to conduct business in several countries without exposing the merchant to foreign
exchange risk. For example, a EU-based machinery exporter can sell to customers in the U.S., EU, and Japan.
All of the customers can continue to pay for products in their local currencies, leveraging Ripples foreign
exchange network to ensure that the merchant seamlessly receives payment in EUR. In effect, Ripple allows
for continuous rebalancing of foreign exchange, instead of waiting to accumulate blocks of foreign currency
and converting at the end of the quarter or reporting period. Additionally, real-time settlement on Ripple
means that funds are immediately available, improving working capital for the merchant.
The same logic can be applied to convert loyalty points or any other store of value into USD, as long as market
makers can quote the price effectively. This requires no hardware upgrades or modification at the point of
sale. From the merchants perspective, it looks like a traditional debit transaction.
In order for there to be long term organic demand (as opposed to purely speculative demand), XRP must
provide some utility to its holders. XRP provides utility by fulfilling two functions: 1) security and 2) bridge
currency.
hold a small amount of XRP to meet network reserve requirements and to pay > No more XRP can ever
be created, per the
transaction fees. The table below breaks down reserve and transaction fee
protocol rules
amounts. In each of these cases, the economic value is negligible for normal use
> XRP is currently
less than $1 worth of XRP is enough to send tens of thousands of payments across subdivisible to 6 figures
Ripple. The reserves exist to create an economic cost to sending an abusively high (0.000001)
number of transactions.
Trust Line Reserve 5 XRP This amount is frozen as margin for each trust line that is in place.
This amount is frozen for each working order that is in the order book.
Working Order Reserve 5 XRP
When an order is filled or cancelled, the reserve amount is released.
As the number of accounts, the number of live orders, the number of trustlines, and the number of transactions
on the network increase, there should be a very small increase in demand for XRP.
The diagram below shows the network evolving from a few gateways to several hundred thousand gateways.
Rather than quoting every possible currency/gateway combination, XRP can serve as a useful bridging tool for
market makers. If every currency is liquid to XRP, it is also liquid to other currencies.
As the number of gateways grows, it becomes increasingly complex to find paths to resolve transactions.
Long paths are inherently fragile. It takes long periods of time to scan for long paths, and since order books
are subject to constant change, the longer it takes to calculate a path, the more likely it is that the path will
have changed or disappeared by the time a transaction is attempted to be sent.
If XRP is increasingly used as an intermediary currency, users who are unsure of what currency they will need
may choose to hold XRP, since it readily translates into all other assets on the network. Market makers are one
type of user for which this could be the case, but one can easily think of others as well.
If the Ripple protocol becomes the backbone for global value transfer, Ripple Labs expects the demand for
XRP to be considerable.
In some cases, counterparties essentially replicate a real-time payments system via the extension of credit. For
example, the receiving bank in an international bank-to-bank funds transfer can access funds in real-time if
large financial institutions extend credit to the receiving bank. Receiving banks can make those funds readily
available to their end customers before the funds actually settle (in 5-7days). This is sometimes known as a
risk funds model.
However, this introduces another layer of counterparty risk and cost into the system, which may not be the
most efficient way of enabling real-time payments. With Ripples technology, funds are fully settled in real-time
without the need to extend credit. In this case, the funds are known as good funds and are not based on credit
(i.e. a goods funds model). Receiving banks can then loan those funds back out to consumers or businesses,
which then spend the money in the economy. This can greatly increase the velocity of money and have a
positive impact in the overall economy, without increasing counterparty risk.
4
http://fedpaymentsimprovement.org/
Another example might be loyalty points or gift cards, which represent a huge amount of stored value.
According to a study by loyalty marketing information company Colloquy and SWIFT Exchange, approximately
$16 billion in rewards points and miles go unredeemed each year (out of $48 billion total rewards miles and
points issued annually). In addition, CEB TowerGroup estimates that more than $1 billion in gift cards go
unredeemed each year.
Ripple can very easily provide loyalty program managers with tools to enable out of network spending of
loyalty points by converting value into USD or other currencies. This increases utility for customers while giving
points issuers granular control over how and where points can be spent.
The following diagram depicts an account ledger (i.e. the banks core system), and each square represents an
account within the banks ledger (e.g. the checking account of U.S. Sender).
Account Ledger
Account
Each bank plugs into Ripple by downloading the open-source software and communicates balances to the
network via an application-programming interface (API). In the illustrations below, the Ripple network is
depicted by a blue oval. As the diagram shows, U.S. Banks account ledger is integrated into the Ripple
Network.
Integration involves synchronizing the two ledgers, so that the issuance of a balance in Ripple results in a debit
in the core system, and vice versa, so that there is never a duplication of balances.
Multiple banks that are connected to Ripple then establish correspondent agreements either bilaterally or
through clusters in order to transact on a peer-to-peer basis. The diagram on the following page shows that
both U.S. Bank and European Bank are now integrated into Ripple and communicate balances into the
network.
A bilateral or group agreement is typically necessary to provide for KYC information sharing to comply with
funds Travel regulations and to provide for things like reversibility in the event of an erroneous payment.
A market maker (typically a hedge fund or FX trading desk) sets up an account with both banks to provide
liquidity in the system. Banks can vet, authorize, and in some cases, contract with the market maker directly.
Ripple is a pre-funded network. As shown in the diagram below, the market maker pre-funds his account by
sending euros to the receiving bank (European Bank). This is done through the domestic payments systems
(i.e. ACH, SEPA, etc)
European Bank then immobilizes the cash and issues EUR to the market makers account in Ripple. European
Bank now has posted a liability (i.e. a balance) onto the Ripple ledger. This is depicted by the partially yellow
shaded box within the Ripple Network below. This liability is backed by the EUR assets that the market maker
pre-funded, which are now held by the bank in an immobilized account.
The market maker can now post an offer to Ripples order book, signaling to the market the rate where he is
willing to sell his claim on Euros in order to buy U.S. Dollars.
Now we introduce two customers who wish to transact. As illustrated below, the U.S. Sender and European
Receiver are customers of U.S. Bank and Europe Bank, respectively. Each customer is subject to their banks
know-your-customer (KYC) rules, transaction rules, etc.
Each bank, further, has a single house account within Ripple which its customers access by proxy. This is
analogous to how a customer would access ACH/SWIFT by proxy through his bank.
In the diagram below, U.S. Bank immobilizes the USD funds by transferring them to a house account and
issues a USD balance into its Ripple account. This is illustrated in the diagram below by the green-shaded
square interaction.
U.S. Bank can then query Ripple for the best rate to perform the transaction. Ripple automatically calculates
the best execution path to trade between U.S. dollars and euros. The transaction is ultimately routed to the
market maker with the most competitive offer in EUR/USD.
When the payment is sent, the market maker purchases USD from U.S. Bank, and Ripple simultaneously
transfers EUR into Europe Banks Ripple account. It is important to emphasize that neither bank has any
counterparty risk to the market maker at any point in time, since both legs of the transaction are fulfilled
simultaneously.
The European Bank debits this Ripple Balance to gain access to the funds. This is depicted by the yellow arrow
and square in the diagram below.
Finally, European Bank transfers EUR from the immobilized holding account into European Receivers
beneficiary account (i.e. the receivers checking account) held in the institution.
All told, the process essentially boils down to two in-house transfers: 1) a transfer of USD from the sender to
the market maker at U.S. Bank and 2) an offsetting transfer of EUR from the market maker to the recipient at
Europe Bank.
These correspondent banking relationships are bilateral agreements between financial institutions.
Correspondent banking networks could become quite extensive, with larger financial institutions managing
hundreds of bilateral arrangements. Correspondent banks act as a domestic agents bank in international
markets and could process transactions, accept deposits or conduct other business activities on behalf of
domestic banks. For example, a small or mid-sized U.S. bank could transact with a European bank through a
bilateral relationship with a large U.S. bank, which in turn could have a bilateral relationship with a large
European bank.
Correspondent banks typically have correspondent accounts (also known as nostro accounts) with foreign
banks that have the ability to pay and receive in the domestic currency. For example, a large U.S. Bank might
have a correspondent account with a large UK Bank, which can transact in British pounds. The correspondent
account allows the U.S. bank to offer various services to domestic customers, including foreign exchange or
foreign denominated deposits without a bank license in the foreign country.
These correspondent banks, moreover, decide on how and when to settle transactions between them using
their correspondent accounts. For example, two correspondent banks with correspondent accounts could
decide to settle transactions daily on a net basis. The banks simply deposit and withdraw funds from their
correspondent accounts.
The exhibit on the next page walks through how a typical international transaction may look when funds need
to move from a U.S.-based Bank (i.e. Alpha Bank in the illustration) to an India-based Bank (i.e. Beta Bank). In
this example, Alpha Bank is a mid-size bank with no presence in international markets. However, the company
sends the funds to HSBC, its domestic correspondent bank. The exhibit below assumes that HSBC, moreover,
does not have a banking license in India and thus cannot operate in the market. Instead, HSBC transfers the
funds to its correspondent bank in India, Citi. Citi withdraws funds from HSBCs correspondent account and
routes the funds to Beta Bank, the India based bank.
Yet another bank hypothetically Deutsche Bank then handles the FX conversion between USD and INR as
the examples assumes the bank is a big provider of liquidity in both currencies. Finally, banks send international
interbank messages about the transaction (including settlement notification) using SWIFT codes (the Society for
Worldwide Interbank Financial Telecommunication).
The exhibit below is a helpful illustrative example of how these costs could add up (developed by Glenbrook).
The exhibit walks through how a U.S.-based business (Kool Industry) pays its Brazil-based supplier (Supra-
Hidraulica) via a network of correspondent banks. As depicted on the diagram, this transaction could impose
significant transaction fees and FX conversion fees (in this case the 2% FX spread) for business. This funds
transfer system imposes significant costs over the billions of cross-border transactions. In 2013, for example,
over 5 bn financial messages were sent over the SWIFT network (the leading provider of international interbank
financial messages), with 50% of the messages representing cross-border payments.
Source: Glenbrook
Source: SWIFT
The costs of correspondent banking, moreover, are likely to rise given increased regulatory requirements.
According to SWIFT, while correspondent banking and payments processing remains an attractive business,
increased regulation and increased competition are putting pressure on industry profits. In a May 11, 2014
article, moreover, the Wall Street Journal (WSJ) reported that JP Morgan was reviewing many of its domestic
correspondent-banking relationships. According to the WSJ, JP Morgans review was prompted by heighted
regulatory scrutiny, which has encouraged the bank to shore up its risk controls. While this review appeared
specific to domestic correspondent bank relationships, the intense regulatory scrutiny could have important
implications for riskier international correspondent banking networks.
When such payment delays occur, banks need to redirect staff and resources to solve these issues. As a
result, financial institutions seek to minimize the rate of intervention and rate the efficiency of a payments
system by a measure known as the straight through rate (i.e. the percentage of transactions that go through
without intervention).
And of course, counterparty risk exists while transactions are in flight. While it is a remote possibility, it can be
a big problem if a correspondent bank were to fail to make a payment. This is referred to as Herstatt Risk,
coined after the German bank that failed in 1974 after it was unable to cover its liabilities.
Ripple addresses the inefficiencies in the interbank funds transfers as its decentralized network offers a low-
cost, instant settlement system. There are several reasons driving financial institutions to use correspondent
banking networks but one key factor is the difficulty in communicating between banks directly. Each bank has
its own core account ledger, which cannot easily communicate with another banks ledger.
In the Ripple Protocol, there is one shared ledger that other systems can plug into in order to communicate
with each other. By handling transaction clearing and settlement through its decentralized network, Ripples
technology eliminates the need for multiple hops between regional bank systems. This enables settlement of
transactions within 6 seconds.
In the current payments ecosystem, merchants pay a fee for accepting electronic payments called the
merchant discount rate (MDR). This MDR is typically expressed as a percentage of purchase volume and a per
transaction fee. These fees vary widely depending on factors such as merchant size, type of merchant and risk
of transaction (i.e. card not present are higher than card present transactions). However, in the U.S., merchants
pay an average of 2.5% for physical retail payment and 3.0% or higher for online retail payments.
In an open-loop payment system, the MDR is composed of three major components: interchange (revenue for
banks), network fees (revenue for payment networks) and merchant acquiring fees (revenue for payment
processing intermediaries known as merchant acquirers). Merchant acquirers are responsible for charging
merchants the MDR, routing the interchange component to issuing banks and paying some of network fees to
payment networks (typically 60%-70% of network fees). Banks also pay network fees out of their interchange
revenue (typically 30%-40% of network fees). The interchange fees and network fees are typically set by the
payment networks, while the merchant acquiring fees are competitively set.
The following exhibit is a simplistic representation of how the payments economics of a typical credit card
transaction are divided among key payments participants.
The payments ecosystem could theoretically continue to work with current payment network rules and existing
pricing, though this would require payment networks, banks and merchant acquirers to integrate into the
Ripple network.
Conversely, banks and payment processors could leverage Ripples technology to lower their direct cost of
payments (i.e. reducing 0.25% paid to network fees). This could add up to meaningful costs savings for banks
and payment processors handling millions or billions of purchase volume. Companies would then have the
option to hold onto the higher margins or pass on the cost savings to customers.
Payment processors, such as merchant acquirers, could gain an edge on pricing over the competition with
Ripple. The merchant acquiring industry remains highly competitive, particularly in the mature and fragmented
U.S. market. The industrys pricing outlook has turned increasingly as new entrants have introduced a wide
range of new mobile payments/loyalty applications tied to simple pricing. The chart below looks at the
normalized merchant acquiring revenue per transaction growth for First Data, the largest global merchant
acquirer.
The benefits of Ripples clearing and settlement system are more pronounced for international transactions.
Banks and payment processors would benefit from Ripples competitive FX rates and real-time settlement.
These benefits could also be passed down to end customers who often have to pay extra cross-border fees for
international transactions. For example, merchants get charged an extra 40bps to 50bps on average for
accepting cards issued by a foreign bank (i.e. an international transaction) and cardholders get hit with a
currency conversion fee as well.
Cross-border fees are a lucrative business for payment networks. The exhibit below shows how cross-border
revenues have been growing at a rapid clip since the downturn (at about a 14% CAGR5 from 2010-2013) and
account for nearly 25% of Visa and MasterCards combined revenue. Given the high incremental margins of
these transactions, moreover (likely in the 80%-90% range), cross-border volume likely makes up over 30% of
combined profits for the payment networks. While this is already a significant cost for merchants, it likely will
continue to grow as a function of international travel.
By reducing FX conversion fees and cross-border network fees, Ripple could deliver significant cost savings for
banks, payment processors and merchants, while enabling real-time transaction settlement.
5
Compound Annual Growth Rate: The year-over-year growth rate of an investment over a specified period of time.
Money transfer systems thus bear similar costs, risks and settlement delays that exist in international bank fund
transfers. As a result, the family receiving remittances have to wait several days to have access to the cash
unless the sender is willing to pay a premium for faster settlement. In contrast to electronic payments
(discussed above) where merchants bear the cost of payment acceptance, however, consumers are charged
money transfer fees directly.
Nearly all money transfer systems could be broken out to six major components: payment gateways (i.e. cash-
in and cash-out agents), Transaction Clearing and Settlement, FX Services (for international transactions),
Transaction Communication, Messaging, and Dispute Resolution and Standards. As shown by the exhibit
below, money transfer network operators bundle these services and charge a fee to consumers for facilitating
money transfers. These fees incorporate the cost of interbank funds transfers.
The Ripple network unbundles these money transfer components and allows each function to compete on
price. As discussed above, Ripple powers a quicker back-end settlement system than that offered by
correspondent banking and allows FX traders (i.e. market makers) to compete for transactions (as shown in the
exhibit below). This means that Ripple could lower some of the operational costs and FX spreads for money
transfer networks as well as improve their consumers experience by providing them with real-time settlement.
As a result, Ripple could drive down the wholesale cost of remittances for money transfer operators. Since
Ripple does not govern retail prices, moreover, money transfer operators could have the flexibility to choose
We Buy We Sell
1.370 1.380
We Buy We Sell
1.365 1.375
We Buy We Sell
1.372 1.382
In the current money transfer ecosystem, consumers pay MTOs a fee that varies widely by a number of factors
including type of remittance, amount of face value and speed of settlement. Based on World Bank data,
consumers pay roughly 8% of total amount transferred, on average. These fees are used to cover agent
commissions, FX conversion fees, fees related to their correspondent banking relationships and other
operational costs.
However, this fee has contracted significantly in the last five years, particularly for traditional MTOs. The exhibit
below illustrates how the premium pricing charged by MTOs over the global average price of remittances has
virtually eroded. In fact, the average price charged by MTOs reached the lowest level on record and finished
slightly lower than the global average price in 1Q14.
While competition has been steadily intensifying between traditional MTOs, banks and non-traditional
participants (such as retailers and telcos), the biggest change in the competitive landscape is the emergence of
online and mobile money transfer companies.
These new providers leverage the Internet and have formed relationships with banks to enable bank-to-bank
transfers and circumvent some of the fees involved in mobile money transfers, such as agent commissions.
As a result of this cost advantage, online and mobile money transmitters generally charge consumers a more
competitive rate. In addition, rising regulatory requirements have increased operating costs for MTOs. Thus far,
competitive pressure has prompted the leading MTO, Western Union, to lower prices significantly in select
corridors. However, competition is likely to intensify and MTOs will continue to balance the need to offer more
competitive pricing while maintaining healthy margins.
Ripples technology could help lower the cost of money transfer networks by removing the need to maintain an
extensive correspondent banking network and offering competitive FX rates. As noted above, the Ripple
protocol does not govern retail prices and thus money transmitters can choose how much of the potential cost
savings to pass onto their end consumers. At the very least, however, the lower cost could provide MTOs with
the flexibility to lower prices to compete with new entrants.
Though the Ripple protocol is very different from other digital currency protocols, it is unclear whether
regulation will distinguish between protocols or regulate all digital currencies under one broad brush. On a
similar note, Ripple could suffer from reputational damage if other digital currencies are used for illicit activities
or operators/exchanges for other digital currency protocols are engaged in unlawful behavior.
Additionally, while Ripple makes it easier to track the flow of funds within the network, it is hard to identify
individual account holders in isolation. While Ripple Labs is continuing to innovate and add features that could
make it easier to identify account holders to help law enforcement, it will need to balance this with ensuring
user privacy protection.
Finally, while incumbents may not opt to either adopt other digital currencies or create their own, influential
incumbents may enact policies that make it difficult for others in the ecosystem to use Ripple.
However, the Federal Reserve, in a series of recent Payments Town Halls, has indicated that it would prefer a
more comprehensive solution to modernize the payments system. And any upgrade to ACH can be expected
to take many years to implement, giving Ripple some time to gain traction.
It is difficult/impossible to definitely prove that something is fully secure. The absence of security breaches over
a long period of time is usually the best evidence that a system is trustworthy. In this sense, trust in the Ripple
protocol may partially be a function of time.
Because the Ripple protocol relies on integration with gateways and financial institutions, it is more complicated
to effectively clone Ripple than it is to clone Bitcoin. Copying the code is easier than convincing third parties to
integrate and support it.
Likewise, though Bitcoin has been extensively copied and rebranded, the original implementation continues to
enjoy the most adoption and positive network effects.
Partnership Inquiries
Email: partners@ripple.com
Phone: +1.415.967.1836
Address:
Ripple Labs
300 Montgomery Street, 12th Floor
San Francisco, CA 94104
U.S.A