RIPPLE PAYMENT SYSTEM

Commonwealth Bank, ANZ and Westpac announced recently that they are testing out payment
technology from the US-based company Ripple Labs. The news comes after CBA made headlines
around the world by presenting itself as the first major bank to go public with its trials of Ripple for
transferring payments between its subsidiaries. CBA's chief information officer David Whiteing
described the payment technology as developed by Ripple as "the way of the future".

What is Ripple?
Ripple is a universal payment system enabling users to transfer funds (including fiat (i.e. paper)
currencies, digital currencies and other forms of value) across national boundaries as seamlessly as
sending an email. Ripple enables peer-to-peer transaction settlement across a decentralised network
of computers. Ripple interconnects all the world’s disparate financial systems to enable the secure
transfer of funds in any currency in real time.

How does Ripple work?

First, let us have a look at the Ripple Protocol. Simply put, protocols are a way for distinct computers
or systems to talk to one another and exchange information. A protocol serves as a system of rules
that allows for a message sent by one system to be decoded by another. A near-ubiquitous protocol
that people use on a daily basis is the communications protocol HTTP (Hypertext Transfer Protocol).
This protocol is a set of rules for building and sharing websites, and allowed for the creation of the
World Wide Web, as users on distinct Internet networks found a common language. SMTP (Simple
Mail Transfer Protocol) is another protocol that did the same thing for email.

Prior to the invention of SMTP, email networks operated as walled gardens:

SMTP, like HTTP for websites, removed those walls for users, creating a robust email ecosystem:
So where does Ripple fit in? Much like HTTP or SMTP, the RTXP (Ripple Transaction Protocol) serves
to establish a series of rules by which disparate financial systems can communicate with one another.
Currently, financial systems look a lot like the early days of email:

By establishing a universal financial protocol, Ripple stands to break down the walls between financial
institutions. Instead of each institution being a silo that works within the confines of its own rules and
regulations, the RTXP serves to create a universal set of rules that each institution can abide by.

The end result of this is that servers all over the world can communicate peer-to-peer financial
transactions to one another, allowing payments to become as fast, cheap, and easy as email. This
means instant payments, with no network fees:

The Ripple protocol is therefore, at its core, a shared public database. This database includes a ledger,
which serves to track accounts and the balances associated with them. The ledger is a distributed
database — a perfect, shared record of accounts, balances, and transactions in the Ripple protocol. It
is continually and automatically updated by the Ripple Transaction Protocol (RTXP) so that an identical
ledger exists on thousands of servers around the world. At any time, anybody can review the ledger
and see a record of all activity on the Ripple protocol. When changes are made to the ledger,
computers connected to the Ripple protocol will mutually agree to the changes via a process called
consensus. The Ripple protocol reaches consensus globally within seconds of a change being made.
The consensus finding process is the engineering breakthrough that allows for fast, secure, and
decentralised transaction settlement on the Ripple protocol.
No one owns or controls the Ripple protocol. It runs on computers around the world, all working
together to continually maintain a perfect, shared record of accounts, balances, and transactions.
Distributed networks offer many efficiencies over centralised networks. Because the network is “self-
clearing”, it eliminates the need for a centralised network operator (and gets rid of the associated
layer of fees). Because there is no single point of failure, distributed networks are more reliable. They
also tend to be more secure, due to their open source nature.

Ripple supports any currency, and gives users complete freedom to transact in any currency. A user
can hold balances in one currency, and send payments in another. In the diagram below, a user who
holds USD balances sends payment to a merchant who only accepts payment in JPY. A market maker
who holds both currencies facilitates the transaction, buying USD and selling JPY:

Ripple’s distributed exchange allows users to trade without the need for a broker or a third party
exchange. Anyone can post bids or offers into aggregated global order books, and the Ripple protocol
finds the most efficient path to match trades. There is no network fee, and there is no minimum
transaction size. This allows every currency to have the smooth transactional qualities of a singular
global currency. You can hold balances in gold or Bitcoin, and easily send payments in Australian
Dollars, US Dollars or Euros. Ripple gives everyone complete freedom over currency choice in
transactions.

Ripple and the Australian Banks

Integrating with Ripple allows financial institutions to send cross-currency payments in real time,
without relying on intermediaries. Today, cross-currency payments sent via intermediaries (which are
commonly correspondent banks) take two to four days to complete and are burdened with
counterparty risk and significant lifting fees from each correspondent bank. With Ripple, financial
institutions can send payments in three to six seconds directly from the sending to the receiving
institution, without intermediaries.

The same applies to domestic payments. Integrating with Ripple can allow financial institutions to
send domestic payments in real time by using Ripple to clear and settle transactions bilaterally. Today,
banks clear transactions through ledgers controlled and operated by a central counterparty, such as a
clearinghouse or central bank, which limits availability and speed of transaction services. With Ripple,
financial institutions can clear transactions bilaterally in real time and settle net positions, lowering
the costs and risks of real-time payments.

Traditional fiat currencies — when in digital form — have counterparty risk associated with them. This
may not seem obvious at first glance, but in order to get your fiat $100 bill onto a digital network, you
would traditionally hand it over to a network operator (your bank, PayPal, etc.), and in return you
would get an IOU showing your account balance. At that point, you no longer hold fiat money.
You have traded fiat dollars for a digital dollar balance, which is effectively an operator’s promise to
pay. It is a promise from the bank that you can redeem your money on demand. Due to the fact that
deposits at Commonwealth Bank are not necessarily equivalent to deposits at Bank of Cyprus, digital
fiat currencies carry a counterparty risk.

The same holds true within the Ripple protocol. Gateway is Ripple’s term for currency entry and exit
points to the protocol. A gateway is the place where fiat money enters and exits the Ripple protocol.
Gateways can be any business that accepts currency deposits from customers and issues them
balances on the Ripple protocol in return. In practice, many Ripple gateways may look very similar to
traditional banks; but a gateway can be any business that provides access to the Ripple protocol.
Gateways can be banks, money service businesses, marketplaces, or any financial institution.
Businesses that become gateways create advanced financial functionality for their customers and
generate new revenue streams.

There are clear benefits to traditional banks in using a decentralised distributed network such as
Ripple. Both cross-currency and domestic payments can be made much quicker and at lower costs.
Banks can also play an important role as gateways. It is encouraging that three of Australia’s major
banks are at the forefront of exploring these opportunities with Commonwealth Bank clearly leading
the way.