How does Ripple work?
First and foremost Ripple is a distributed payment network. However, it also has its own digital currency called XRP. XRP is not primarily meant to serve as a store of value but rather as a 'bridge currency' that does not discriminate between one currency and another and so makes it easy for any currency to be exchanged and sent easily across the globe. Although XRP shares some of the decentralized features of bitcoin, it is different in that it is a pre-mined currency and uses a consensus protocol to ensure validity of the system. Users can gain access to Ripple’s network by creating a Ripple wallet and then register themselves at “Gateways” that facilitate the money transfer in and out of the Ripple network and helps to support trust between two parties. Because the Ripple network is essentially P2P, there are no intermediaries that make international payments and remittances a long and costly endeavour.
The real innovation behind this technology lies in the aforementioned consensus protocol. For distributed payments to function successfully without a central authority, transactions must rely on consensus in order to agree on the validity of past transactions and integrity of the system. With other distributed networks, such as bitcoin, this is currently done through mining, which verifies transaction and then subsequently saves them on the publicly agreed upon ‘blockchain’ ledger. It bypasses the memory-intensive calculations that bitcoin mining currently operates on, allowing for lower-cost and more efficient methods of global payments and money access.
Unlike many other virtual currencies that are, by some, seen as a way to escape the harmful eye of government, Ripple seems to pose clear economic benefits for all parties involved that could put the financial sector on an innovative and efficient path.
Opportunities for Ripple in China?
The financial sector in China is going through a period of reform and change as the sector works to keep up with economic challenges and the government's desire to support the maturing industry. Technology is a key enabler for this change and helps the financial institutions manage risk and customer growth.
One of the key reforms is interest rate liberalization, which is starting to impact banks' margins, margins that had primarily been driven by interest rate spreads on deposits and loans. Competition will continue to be fierce as the reform continues as banks strive to increase their market share. This compressed spread will push banks to rely more on fee-based income, which tradititonally has never been a strong suit of Chinese banks.
Domestic payments in China are cheap. The cost of sending a low-value RMB payment anywhere in China is about half a RMB or about $0.10. Very cheap especially as if the payment is made during business hours, will go through nearly always as at least a 'near-realtime payment' if not real time. Although the ACH system in the US is free, it does take 2-3 days depending on how long the bank sits on the money and also has a reversal risk if funds are not there.
With domestic payments being so cheap and efficient, there is not much of a play for this payments segment, but if we look at international payments, that's where it starts to get interesting.
Small and Medium enterprises are the bread and butter of China's economic growth since the 70s, yet they face incredible challenges. On one side, cost of inputs (including human and otherwise) have been increasing, while on the other, an increasingly cost-sensitive customer base is demanding cheaper goods. For companies that complete hundreds or thousands of transactions a year, often low value, bank fees are an additional headache, taking up to US$50 out of every transaction depending on the arrangement with the bank and the payment source.
China's banks often only receive a small portion of these fees - many are taken up by the source bank, the correspondent bank or the SWIFT network that manages a significant proportion of the world's international payments.
The current under the Ripple
That's with the traditional banking system. With Ripple (or any other similar technology), these costs drop rapidly. The f/x rate and the actual fees for making an international transfer vary, but they rapidly approach single digits. For a SME or even a larger state-owned enterprise, this is a game changer.
In addition, for smaller banks, Ripple in China presents a cost effective way of increasing customer service without a massive technology capex. Rather than building out a potentially expensive international payment and settlements system (SWIFT or otherwise), banks could just connect into a Ripple gateway that would handle most of the 'technology'. This savings could either be kept by the bank through increased fee margin or passed on to the customer.
Despite Ripple Labs not having engaged with Chinese banks yet, Ripple gateways are already present in China, with RippleChina and RippleCN proving themselves as the most popular. Both accept Chinese Yuan, Bitcoin and Litecoin as available currencies to recharge the gateway. They offer additional exchange services and also host their own forums. An interesting feature on these gateways is the way in which you can recharge your gateway. RippleChina uses its own official Taobao shop to allow its users to fund the gateway, while RippleCN uses Alipay. RippleCN does not (yet) charge fees for their service, while RippleChina charges a minimum of two yuan for withdrawals, which increases incrementally until 300 yuan for sums larger than 50,000 yuan.
In theory, if either of these gateways were able to tap directly into a bank, their usability would dramatically increase. But with Chiense regulators already taking a fierce stand against bitcoin, is that realistic? It's our opinion that if Ripple gateways engaged with the government and regulators in China, they could put forward a strong value proposition about how the gateways could help the regulators 1. implement a robust international payments system to 2. provide banks with more revenue opportunities to 3. save customers money while 4. avoid the use of SWIFT, which the Chinese government isn't too much of a fan of...
Bitcoin was a risk of control for Chinese regulators. With no capital controls on the virtual currency, all the work that the Chinese government had done to gradually de-regulate and modernize the financial system would have been for naught as capital could have potentially left the country. What if the Chinese government could control the Ripple gateways? Although it does somewhat 'centralize' control of a de-centralised network, it would also overcome the main issues that we feel the regulators had with bitcoin.
With control, or at least insight into, the ripple gateway, Chinese authorities would be able to see who was sending what and monitor transactions for legality both in terms of capital control limits and sources. Transactions could be monitored much like SAFE and the PBOC monitor banks payments currently.
Ripple’s association with “threatening” virtual currencies has been a barrier for mainstream uptake in the past. However, Ripple is already gaining credibility in the U.S. and the natural step will be to get a grip of the Chinese market if Ripple wants to create richer network effects. The big question is: can it convince Chinese regulators that it’s all for the greater good?