A Brief Look Into Ripple (XRP): Banks, Pre-mines, and Lawsuits

tldr; This post is a brief look into the different aspects (good, bad, and ugly) of the XRP token and Ripple Labs, the company. It is important to separate the two while also investigating the indisputable overlap between the token and the company.

This article will shine a high-level light on the crypto industry’s most polarizing asset to hopefully help elucidate some of the more misunderstood aspects of XRP.

This article, in part, is from a longer full report available at CryptoEQ.io. CryptoEQ aims to provide the most trusted and intuitive research in the crypto industry.

Overview

It is important to state that XRP and Ripple (AKA Ripple Labs, Inc.) are not the same things, although they are consistently and erroneously used interchangeably. The Ripple network is a protocol to provide liquidity to global markets for fast, cross-border payments with minimal fees. XRP tokens are the accounting units used within the XRP Ledger open-source database and serve as a bridge currency between banks. The ledger stores and preserves XRP transactions and account balances.

Alternatively, Ripple Labs, Inc. is a private, for-profit company that sells the closed-source banking software RippleNet which was previously split into three separate products called xCurrent, xRapid, and xVia. It is important to note that only the xRapid product utilizes actual XRP. The other products can be used independently of XRP or any cryptocurrency. This optionality or lack of necessity for banks to transact in XRP within the Ripple network is the main point of contention when it comes to ascertaining XRP’s underlying value.

XRP Strengths

• Extremely well-funded
• Impressive team with close ties to U.S. regulators and powerful financial institutions
• Name-brand recognition and often discussed in media behind Bitcoin and Ethereum
• Large and passionate following on social media
• A cheap ticker price that, while fundamentally meaningless, does attract new buyers who believe other assets like bitcoin are “too expensive”

XRP Weaknesses

• XRP is not required (and scarcely adopted) by banks to settle transactions within the Ripple protocol. Banks, in many cases, can settle cross border payments simpler and with less volatility using traditional fiat currencies.
• XRP suffers from points of centralization. Roughly 60% of XRP are controlled by the private, for-profit company Ripple forcing users to trust a large entity (like a bank) with the fate of their money.
• Not censorship-resistant — Ripple has an out-sized influence over the Ripple network and can indirectly have funds frozen.
• Lacks the proper “tokenomics” for price appreciation. Value accrual for pure mediums of exchange (i.e. bridge currencies) remains unclear. Banks do not need to hold onto large amounts of XRP to successfully use the protocol, suggesting low demand-side price pressure.
• Increased competition from private companies like Facebook, central bank digital currencies (CBDCs), actual bank coins like JP Morgan, and the proliferation of private stablecoins.

Use Case

The Ripple network is a protocol to provide liquidity to global markets for fast, cross-border payments with minimal fees. XRP tokens are the accounting units used within the XRP Ledger open-source database and serve as a bridge currency between banks.

Ripple Labs Inc, the company owns and sells RippleNet products, is also responsible for creating the asset XRP in 2013. RippleNet is a suite of closed-source software products that help reduce the friction in bank to bank transfers. They are xRapid (now “On-demand Liquidity”), xVia, and xCurrent individually or RippleNet as a collective.

It is important to recognize that XRP differs significantly from other cryptocurrencies such as bitcoin and ether. Bitcoin and Ethereum are intended for censorship-resistant, digital, peer-to-peer payments and transfers of value.

By contrast, XRP was never intended to be censorship-resistant nor was it intended to be used for peer-to-peer payments. Instead, the goal of the Ripple network is to improve international bank payments. The XRP token can be used to reduce transaction costs for illiquid trading pairs.

Technology

It is important to reiterate that XRP and Ripple are not the same things, although they are consistently used interchangeably. However, this section will discuss the technological benefits of both entities if used in their closed ecosystem as designed and advertised by Ripple.

RippleNet is currency-agnostic, global, real-time gross settlement system that enables banks to message and settle transactions in the currency of their choice. It serves only to find the cheapest route for Currency A to be exchanged for Currency B.

xVia, the other product that does not require the use of XRP, is a messaging application for RippleNet wherein users can send invoices or other information to different parties.

On-demand Liquidity (xRapid), the sole product that requires the use of XRP and ledger, aims to eliminate the need for banks to hold reserves of particular currencies at other banks. Instead, On-demand Liquidity pools liquidity from the open market by exchanging one fiat for XRP at one end of the transaction and then selling it for a different fiat at the other end.

XRP can settle transactions in about 4–5 seconds, with a transaction throughput of around 1500 transactions per second.The Ripple network provides efficiencies over other extant cross-border payment methods such as SWIFT, which take days to settle and require higher transaction fees.

Ripple settles transactions through the Interledger protocol, a protocol for payments across multiple payment systems (e.g., multiple currencies). The protocol uses intermediaries (banks) to coordinate transfers across multiple ledgers. The intermediary receives payment from the sender, which is recorded on one ledger, and then the intermediary pays the receiver, which is recorded on the other ledger.

To enable faster and cheaper transactions compared to its peers, Ripple uses a Federated Byzantine Agreement (FBA) consensus algorithm made up of a closed set of trusted validators called a Unique Node List (UNL).

Each trusted node maintains its own chain of transactions and validates transactions independently. The transaction then gets hashed and shared with the network where other validators compare it to their results. To achieve consensus, the Ripple network makes use of several servers running the Ripple Server Software.

These servers store the UNL and only the votes of the trusted nodes are factored into determining consensus. Transactions having at least a minimum amount (80%) of ‘yes’ nodes remain in the ledger, while transactions that do not receive this threshold of votes get discarded.

Economics

At inception, 100 billion XRP tokens were created in what is called a “pre-mine,” and no new XRP tokens have been created since. As a result, XRP is deflationary by definition, in that all the tokens that will ever be created have been.

However, only a small fraction of the supply is currently openly traded. The majority of the XRP tokens (about 80%) were distributed to Ripple’s creators and the company. ~55% currently sits in escrow under the control of Ripple Labs Inc.

This means the majority of the supply is controlled by a central, for-profit entity that has the ability to dilute current holders' share for their personal gain.

XRP exhibits extreme amounts of wealth centralization. Without even including the >50% stake of XRP held in escrow under the control of the company, the top 100 XRP accounts constitute ~ 75% of the supply.

Furthermore, Ripple Labs Inc holds another 6.5 billion XRP, meaning only 43.67 billion XRP are actually in circulation.

Transaction fees on the network are extremely small (~10 XRP per million transactions). Even though this is hypothetically good for adoption, in that it will encourage adoption among banks, it also means that each bank only a small amount XRP to transact and cover fees.

While XRP is primarily intended to be used by the banks, it has primarily been purchased by individuals for speculation purposes thus far. Retailer speculation is at odds with the bank’s use cases for XRP as a bridge currency because the speculation by retail creates added and unwanted volatility to the asset price.

Additionally, if XRP is used as the bridge currency between banks, the token could theoretically struggle to capture value long-term without banks or customers having to acquire and hold meaningful amounts of XRP in order to transact regularly.

Governance

Ripple was created in November 2012 by Chris Larsen, Arthur Britto, and Jed McCaleb in 2004 but was then called RipplePay. The project eventually rebranded several times until ultimately settling on Ripple Labs Inc. in September 2013.

McCaleb left the company in 2013 after disagreements with the direction of the project while Larsen stayed on as CEO until 2017 when he stepped down and was replaced by Brad Garlinghouse.

XRP is not decentralized, and the trusted nodes have control over the network. There is no on-chain governance system nor is there little in the way of off-chain governance.

Changes to the code are voted on by the trusted nodes and require a majority vote before a new version is adopted. Ripple has had about 80 updates to the protocol, including the introduction of the escrow feature. The trusted nodes control validation, vote on protocol changes, and can modify fees.

Ripple has over-sized decision powers when deciding which entities are trusted nodes in the network; thus, Ripple can determine who gets to vote on changes to the protocol.

If a node fails to upgrade any changes, they run the risk of being removed by their UNL peers. Ripple can implement new features with or without community consensus.

Nodes that disagree with the current state can refuse to upgrade, but because Ripple’s controls so many UNL’s due to default configuration, they would most likely be pruned from the network very quickly.

Vulnerabilities

XRP suffers as a cryptocurrency primarily due to its centralization on several fronts. Roughly 60% of all XRP is owned/controlled by Ripple which can be spent or sold at their discretion, essentially controlling the fate of the project as well as diluting current token holders.

Also, Ripple can and has actively intervened to freeze users' funds, nullifying any illusion of censorship resistance or immutability. Additionally, XRP exhibits extreme amounts of wealth centralization. Without even including the >50% stake of XRP held in escrow under the control of the company, the top 100 XRP accounts constitute ~ 75% of the supply.

Finally, centralization concerns were raised in a Bitmex report in which they discovered that Ripple controlled all the public keys issued when attempting to download the Ripple software. This means all access to the code runs through the company.

The economic issues with XRP center around the fact that there are 100 billion XRP in circulation, and the amount of XRP destroyed per transaction in fees is minuscule (~10 tokens are destroyed per million transactions).

At this burn rate, banks do not need to hold a large amount of XRP to use the protocol if they even choose to do so. Not only do banks need an insignificant amount of XRP to operate, retail investors, the majority of XRP holders outside of Ripple, have no need for XRP.

The biggest obstacle is that XRP is not required for banks to settle transactions within the Ripple protocol. Banks can settle cross-border payments faster and cheaper with traditional currencies (USD, Euro, etc.) using xCurent.

XRP is also seeing increased competition from private companies like Facebook, central bank digital currencies (CBDCs), actual bank coins like JP Morgan, and the proliferation of private stablecoins.

Network effects

XRP is arguably the most popular cryptocurrency outside of bitcoin and ether, and is listed on most of the critical exchanges including Coinbase, Binance, Bitfinex, Huobi, Bittrex, Kraken, Poloniex, and many more. XRP is constantly in the top 5 crypto-assets in 24-hour trading volume led by the Tether (USDT) and Bitcoin (BTC) pairs.

However, partly due to its use case as an inter-bank liquidity coin, XRP active addresses lags well behind its fellow top 5 in terms of active addresses.

Several banks such as Moneygram, American Express, CIBC, UBS, Banco Santander, Bank of America, YES Bank, RBC, National Bank of Australia, and Unicredit have agreed to test Ripple’s distributed ledger.

As of Q1 2020, more than 200 banks are experimenting with RippleNet in various stages of exploration while as of November 2019, 37 institutions utilize On-demand Liquidity or the use of XRP as a bridge currency.

Companies utilizing xRapid have experienced cost savings between 40–70% compared to traditional systems and transaction times of about 2 minutes.

In the social media world, Ripple has a strong Reddit following with ~210,000 subscribers to the r/Ripple subreddit (compared to ~1 million for Bitcoin and ~400,000 for Ethereum).

The official Twitter page has ~950,000 followers and an active presence in which it updates users, markets their products, and educates about FinTech (financial technology). For better or worse, XRP also has an infamous Twitter bot community dubbed the “XRP Army” that is known for bombarding any posts associated with XRP.

Team

Ripple was founded by Jed McCaleb, who later left Ripple to create Stellar. Prior to creating Ripple, McCaleb is known for creating eDonkey and the now infamous Bitcoin exchange Mt. Gox.

Currently, Brad Garlinghouse is the CEO of Ripple. He has amassed a wide variety of experience in the technology industry, previously serving as President of Consumer Applications at AOL and as Senior Vice President at Yahoo!. He is generally the name seen in press releases and articles concerning Ripple, serving as the face of the project.

Chris Larsen is the co-founder and former CEO of Ripple. Today, he serves as the Executive Chairman of Ripple’s Board of Directors. Prior to Ripple, Chris had proven himself in the FinTech world by co-founding Prosper, a peer-to-peer marketplace, and E-LOAN, an online lender.

David Schwartz is Ripple’s CTO and Chief Cryptographer. He previously worked for the NSA and has decades of experience in cryptography. Known as “JoelKatz”, David was Ripple’s main GitHub contributor during the early stages of the project although he rarely has any commits these days.

Other notables include Ethan Beard, Elliot Lee, Evan Schwartz, and Benjamin Lawksy. Overall, this team has amassed years of experience and is very knowledgeable in both cryptocurrency and the broader software technology arena.

User experience

As the third-largest digital asset according to liquid market cap, a large number of wallets and exchanges store, trade, and support XRP tokens. This includes trusted and security-centric hardware wallets such as the Ledger Nano S and Trezor Model T, desktop wallets such as Rippex, GateHub, Exodus Wallet as well as mobile wallets such as Toast Wallet!, edge, and Abra wallets.

All wallets come with trade-offs concerning security, usability, and convenience, and the choice ultimately comes down to user preference.

XRP has built-in rules on minimum balances held in XRP addresses, just like some bank accounts minimum balances. In order to activate and use XRP, you must first deposit no less than 20 XRP into your address.

Transaction speeds, settlement times, and costs are Ripple’s biggest selling points. Because the Ripple network is semi-centralized, it scales much better than competitors like Bitcoin and Ethereum.

While Bitcoin and Ethereum can handle about 5–15 transactions per second, Ripple’s scalability is significantly better and delivers 1500 transactions per second. In addition, the transaction speed of Ripple is also significantly faster as it takes only a few seconds to settle a transaction as opposed to minutes or hours.

Finally, XRP boasts some of the lowest transactional fees of any crypto-asset, remaining orders of magnitude cheaper than either BTC or ETH.

Regulation

While the director of corporate finance at the SEC, William Hinman, appeared to declare on June 14, 2018 that neither bitcoin nor Ether were securities, no direct comments were made about XRP.

The lack of clarity from formal regulators and the SEC leaves XRP in legal limbo. A case can be made for XRP to be deemed a security based on the common definition and interpretation of the Howey Test, the most common legal test applied to securities.

The four-component questions of the test are listed below:

Is there an investment of money?Is there an expectation of future profits?Is the investment of money in a common enterprise?Do any profits come from the efforts of a promoter or third party?

When examined through the lens of the Howey Test, XRP fails or narrowly skirts the line on at least two points. The first failure (for not being classified as a security) is the investment of money and the expectations of profit.

Retail users undoubtedly invested money into XRP and now Ripple is left to defend that they did so for some other reason aside from speculation and profit.

Since XRP is a bridge currency for banks in cross border payments it is difficult to justify the average person’s need to own any.

The second issue with XRP deals with numbers 3 and 4 of the Howey Test questions concerning a common enterprise and Ripple’s control over XRP. Ripple the company has overly centralized control over XRP.

Despite trying to distance the company from XRP as of late, in the early years of Ripple’s development, they appeared to state clearly that Ripple Labs created XRP. This could be interpreted to mean Ripple Labs would be considered the “common enterprise” and retail investors would be seeking “profits from a third party.”

Ripple is currently engaged in a federal lawsuit over this very issue of its relationship with XRP and whether they misled customers to buy XRP. The case is currently ongoing and no decision is expected in 2019.

Roadmap

Ripple, the company, will continue to court and onboard banks onto its RippleNet platform. However, how XRP fits within the network still remains murky with very little in the way of a roadmap or news concerning the token.

This is most likely due to their current lawsuits and the lack of clarity from the US government concerning digital assets.

In 2019, Ripple proposed an upgrade to the current consensus mechanism called Cobalt which could reduce transaction times even further as well as support multiple recommended Unique Node Lists (UNLs). Progress with the update remains scarce and no date has been set for a rollout.

Looming regulation, increased competition from other digital assets and banks, equity alternatives like the Swarm token, and the questionable necessity of the token make for an uphill battle concerning the adoption and utility of the XRP token.

However, even with all these obstacles in its path, XRP has billions in USD reserves and close ties with large institutions and banks which can help it overcome a lot that smaller projects could not.

This report was originally written by C. Pick. It has since been reviewed, edited, and updated by the CryptoEQ Core Analyst team. It solely represents their opinions and is not intended as financial advice.