Unfortunately these bridges which make up the exchange market are concentrated and often broken.  This leads to concerns over reliability and security, which can cause market panic and extreme volatility. As Bitcoin enters the mainstream a wave of new businesses, services and software developers have recently dedicated their efforts to solving this problem. Their task will not be easy, and the while the exchange rate has seen some recent stability, there is a long way to go before obtaining bitcoins can be called user friendly and reliable.

This is an especially big problem for the expansion of Bitcoin. Attempting to purchase bitcoins is a frustratingly slow, nervous and difficult process for a consumer who is used to the convenience of internet shopping.  The usual reversible and/or disputable payment methods of credit cards, PayPal, etc. are rarely available in the purchase of non-reversible bitcoins. Generally consumers are required to use slow and expensive bank wires. This situation is an example of the difficult task facing exchanges as they attempt to integrate two very different systems.

Bitcoin was not designed for compatibility with traditional banking.  There is no Bitcoin protocol for ID verification. There are no accounts to freeze or confiscate.  As such exchanges have the unenviable task of attempting to shove Bitcoin transactions into the current banking regulatory mould.  While Bitcoin’s recent gains in popularity have brought about new entrants to the exchange market, it has also brought the scrutiny of regulators. Compliance with financial regulation, particularly in the states, is costly, time consuming and no small barrier to entry.

The Bitcoin exchange market is in the midst of a rapid evolution which will be critical for Bitcoin’s continued adoption. Here we will attempt to provide an overview of the current market and developments on the horizon. This is a tricky task as it is an attempt to take a snap shot of a rapidly moving target.

What are the current options in the Bitcoin exchange market?

While there are a number of different ways to obtain bitcoin, however, the large online exchanges are currently the dominant players in the exchange world.

Online Exchange Markets

By far the most popular option is a large online exchange such as the market leader Mt.Gox. Exchanges such as these operate entirely online. Customers must first open an account which now usually requires sending in copies of ID and waiting for verification in accordance with anti-money laundering polices. Once an account is set up a money wire or another form of irreversible payment is sent in to fund the account. After those steps, which are likely to take days if not weeks, bitcoins can be purchased. While this method requires some patience, the advantage is that it can be done entirely online.

At some exchanges there are faster funding options such as Dwolla or cash deposits, however, these options are often suspended or shut down due to banking and regulatory issues.

Over the Counter Alternatives

For those looking to avoid common delays from online exchanges, or perhaps looking for greater privacy, a common option is a local Bitcoin exchanger.  Services such as LocalBitcoins.com match local Bitcoin traders with those looking to buy or sell. Exchanges can be arranged entirely online using options such as bank wires and the site offers an escrow service. However, many transactions that originate via the site happen in person and with cash. Another OTC option is services such as Bitcoin-OTC.com which helps to match buyers and sellers via an IRC channel.

New Software Options

On the horizon are projects that aim to provide peer-to-peer exchange solutions. MetaLair is an open-source project designed to create a decentralized exchange network. The network created would allow for both crypto-currency to crypto-currency via an automated escrow service with plans for fiat to crypto capabilities. While still very much in development, a solution such as this technology would provide a quick, peer-to-peer exchange solution.

The Expanding Market

Earlier this year Bitcoin’s USD exchange rate hit all-time highs at near $260. This happened as Europe was experiencing a new round of financial trouble in Cyprus and Bitcoin hit the mainstream press.

What was once considered to be only the play thing of computer nerds or conspiracy theorists was now seen by the mainstream press as a possible opportunity. Perhaps still a very risky and out-there opportunity, but Bitcoin got quite of lot of attention.  And it sparked a rush to invest in the new currency and related businesses.

Many Bitcoin start-ups went from being small operations run by one programmer in his/her spare time, to potential big businesses being courted by major venture capitalists. This is especially true for the exchange market as many realize that Mt.Gox’s huge market share can be chipped away at, and the race to do so is on. As Bitcoin exchange support service Bex.io’s co-founder Yurii Rashkovskii put it, the current situation “is a land grab.”

The many new exchanges entering the market is exciting news for the Bitcoin economy which has suffered from extreme market concentration.  The oldest and by far the largest Bitcoin exchange is the Japan based Mt.Gox. While its market share is starting to slip, for years the exchange enjoyed an over 80% market share for USD/BTC exchange.

This extreme concentration has been an ironic problem for the brilliantly decentralized Bitcoin as it leaves one very large point of failure in the exchange market. The trouble this can cause was shown earlier this year during Bitcoin’s run up in price. Mt.Gox is such a dominant force in the market that it’s posted BTC/USD exchange rate is the defacto ‘Bitcoin price’.

In April, as Bitcoin’s price was soaring over $200, Mt.Gox was hit by a series of DDoS attacks that delayed and briefly blocked access to the site. Market speculators panicked and the price plummeted to near $60.

This exchange volatility makes accepting Bitcoin payments a risky business for merchants, often undermines the currencies legitimacy and holds back those considering investing in the Bitcoin world.

However, as the Bitcoin economy continues to expand, new entrants in the exchange market not only stand a chance of making quite a lot of money, but also will wind up solving some of the currencies biggest problems in the process; exchange market concentration and price volatility.

The Race is on

The new businesses entering the market are numerous and varied and any list or figure given here would likely be out-dated by the time it reached the reader. However, some idea of the activity in the area can be gained by looking at new investments in Bitcoin exchanges and exchange related businesses.

Many investors go about their business quietly and solid numbers are unavailable, however, there have been a number of well publicized investments in the Bitcoin exchange space in the past few months.

In April Coinsetter, a Bitcoin trading platform offering margin trading, raised $500k from a number of investors including the Bitcoin Opportunity Fund run by SecondMarket founder Barry Silbert.

Coinbase, a Bitcoin wallet service that can be used to purchase BTC, announced in May this year that they had raised $6 million from a number of big investors including Fred Wilson, Ribbit Capital, SV Angel, and Fundersclub.

Also in May BitInstant, a Bitcoin exchange funding service, raised $1.5 million in a seed funding round led by Winklevoss Capital.

There has also been a number of venture capital funds created for investing in startup Bitcoin businesses. These include Liberty City Venture’s Digital Currency Fund and BitAngels.

The race for market share is such that new businesses providing support to exchanges are springing up; specifically BTCGlobal and Bex.io.  These new businesses provide technical support for new exchanges. “We do the tech. You do the rest” reads the Bex.io website. Or as co-founder Yurii puts it they are “Mt.Gox in a box”.

“Looking at the eco system as a whole there is definitely a need for more access points into and out of the Bitcoin economy and it makes no sense for everyone to be reinventing the same wheel” explains Bex co-founder Jessie Heaslip. ”We are inventing one wheel that we are going to license out.”

The start-up has the goal of making opening an exchange a less capital intensive and technically challenging endeavour.  Bex will focus on developing “the most repeatable parts of this business” and then link together the exchanges using their platform in a “global liquidity pool.” This liquidity pool would allow small exchanges in various locations to operate reliably without a large amount of start-up capital. Instead they would be able to access liquidity from other Bex based exchanges.

Support businesses such as Bex could dramatically lower technical and capital barriers to entry for new exchanges. But Bex is not aiming to capture any of the very large US market share, that would be too resource intensive and risky.

Also looking to create an exchange network is the new Ripple system. Operated by OpenCoin Inc., which received a round of venture capital funding in April, Ripple is looking to create a network of small and large exchanges which are ‘Gateways’ to the Ripple network. With Gateways in many locations Ripple users will be able to exchange a wide variety of currencies. Leading Bitcoin exchange BitStamp is already setup as a Ripple Gateway.

What is the online exchange market doing?

For years Mt. Gox has been the undisputed market leader with a USD exchange market share of 80%+. Mt. Gox came to be in this position largely by getting in first and managing to be the last man standing as the Bitcoin economy grew and became the subject of many theft attempts.  Mt. Gox simply survived the growing pains that killed many others.

Since April, Mt. Gox has slowly been losing its market dominance.  And now sits at just below 50% of the USD exchange market.

*Via BitcoinCharts.com

 *Compiled from data obtained via BitcoinCharts.com. Shows total BTC volume including trades in USD and other currencies, using 7day averages.

Mt. Gox’s decline in market share, as can be seen from the above chart, is due largely to a loss in its own volume rather than being over taken by a competitor.

With all of the issues Mt. Gox has expirenced this year, law suites, bank account closures and issues with USD withdrawals,  it’s not terribly surprising that it has lost volume. But where has the volume gone? Perhaps there has been a reduction in speculator trading. Perhaps Bitcoin users are moving to exchange alternatives.

Unfortunately there are not easily available numbers on the use of exchange alternatives, but as all Bitcoin transactions are public, we can have a look at the Bitcoin transaction numbers in general.

*Chart taken from BlockChain.info 180 day USD major exchange volume using 7 day averages.

The above chart shows USD volume on the major exchanges. It is clear that USD exchange volume in general has been on the decline, particularly in the last month.

However, USD transaction volume on the Bitcoin network has seen a rise in the last few months. This shows that while exchanges have been losing some volume, the Bitcoin network has not.

*Chart taken from BlockChain.info 180 day USD transaction volume using 7 day averages.

It would be very interesting to look at a comparison of trade volume of various exchanges vs. total transactions on the Bitcoin, however, due to a number of technical factors this is quite difficult. However, BlockChain.info provides an estimate of Bitcoin transaction volume and produces a Trade vs. Transaction ratio chart.

The chart was created to examine speculation in the Bitcoin economy. It compares Bitcoin ‘Trade’ volume, volume of exchange between BTC and fiat, to Bitcoin ‘Transaction’ volume, number of transactions which likely represent transactions between users or for purchases of goods and services.  The charts tracks the ratio of transactions to trades; transactions/trades. A higher ratio means less speculation. 

*Via BitcoinCharts.com

The US Dollar remains the dominant national currency in the Bitcoin economy.

Regulation

While Bitcoin’s recent explosion in value and mainstream attention has brought many new entrants to the exchange business, it also brought about the attention of regulators and the scrutiny of banking partners.  Just as the Bitcoin economy is moving into the mainstream regulators and bankers are applying the brakes.

Serious regulation entered the Bitcoin economy earlier this year with US financial regulator, FinCEN, releasing a guidance paper on ‘virtual currencies’.  The guidance made it clear that any entity which buys and sells virtual currencies, such as an exchange, is considered to be a money transmitter.  This is a heavy burden to bear. Not only does it require strict adherence to anti-money laundering policies but also lengthy and costly licensing hurdles. To legally operate as a money transmitter in the States, a business needs to obtain money transmitter licenses from 48 different states. Estimates vary on the time and cost of this compliance but it is certainly a significant hurdle for a start-up business to clear.

One US based exchange start-up, Vaurum, has experienced interest from investors and has raised a seed round, but also faces an uphill battle with compliance. Avish Bhama, Vaurum founder, sees compliance as being a barrier to entry and one which has been very costly for his business. “Complying will cost us ~100k+ / year.  It is expensive and time consuming and is a big barrier to entry. … It’s hard to put a number on it, but lately more than half of my time has been spent on regulatory stuff.”

CampBX, an established US based exchange, also puts a significant amount of resources into staying compliant. “Bitcoin regulation is evolving at a fast clip, and we actively revise our compliance program every quarter to remain fully compliant.”

One could assume that friction with US regulators would simply move Bitcoin businesses off shore. However, this did not save Japanese based Mt. Gox from a run-in with US authorities. Shortly after the release of their guidance regulators seized the Dwolla account of Mt.Gox’s  US subsidiary, Mutum Sigillum LLC. The subsidiary also had its Wells Fargo bank account closed as regulators accused the business of operating in the US as an unlicensed money transmitter. Nearly two years prior while opening the Well Fargo account the businesses CEO, Mark Karpeles, signed a form declaring that the business was not a money transmitter.

While they have now registered with FinCEN, Mt.Gox had failed to register immediately after FinCEN’s guidance which categorized exchanges as money transmitters.

US regulators willingness to enforce their rules on any digital currency based service with US customers was demonstrated in their dealing with Mt. Gox and in the recent shut down of Costa Rican based digital currency provider Liberty Reserve. Statements after the May shutdown of the business make it clear that US regulators intend to enforce their anti-money laundering standards on foreign companies. Under Secretary for Terrorism and Financial Intelligence, David S. Cohen, clarified that the US would pursue illicit financial actors wherever they may be, in the US or overseas.

“We are prepared to target and disrupt illicit financial activity wherever it occurs – domestically, at the far reaches of the globe or across the internet.” 

Any exchange which hopes to share in the very large US market will have to keep US financial regulators in mind. However, the ever resilient Bitcoin economy is developing services designed to ease compliance issues for exchanges.  BTCGlobal, a Uruguayan based support service for Bitcoin businesses, has launched a “Massive Parallel Licensing” program which aims to create a network which will allow members to leverage each other’s regulatory infrastructure and resources.

Via the BTCGlobal Site: “The highest hurdle for entrepreneurs interested in launching a Bitcoin exchange business is the significant international and local regulatory requirements. It is estimated that an investment of over $10 million would be required to reach total legal compliance in all the U.S. 50 states alone. The BTC Global Massive Parallel Licensing program addresses this hurdle with a package that includes comprehensive regulatory support and a full suite of Bitcoin products and services.”

However, increasingly Bitcoin businesses are simply choosing to block US customers as they see entering the US market as too risky and/or costly and focus on other jurisdictions which have been comparably much friendlier.

Regulation outside the US

Many countries have not directly addressed digital currency regulatory issues, however, some countries have stated that they are not requiring any regulatory compliance at this time. Both British and Canadian regulators have issued letters to exchanges stating that they are not required to register with financial authorities.

In Canada a letter from regulator FINTRAC was sent to a number of exchanges confirming that the exchanges were not money service businesses and were therefore exempt from laws governing those businesses.

The UK’s financial regulator HM Revenue & Customs (HMRC) sent a letter to at least one exchange start up making it clear that the business was not required to register with HMRC under money laundering regulations.

In Europe ‘e-money’ is regulated, however, for the moment the European central bank does not view Bitcoin as money or e-money and does not require compliance for Bitcoin businesses.

While regulators may change their policies, it’s clear that some locations are far more lenient than others. However, lenient regulation does not necessarily translate to co-operative banking partners.

Nervous Banks

Recent moves by regulators, particularly in the States, have scared many banks out of the Bitcoin arena and their caution is understandable. Commercial banks cannot exist in their current form without accounting rules and national currencies that are created and supported by national legal structures. They cannot afford to be on the wrong side of these legalities.  Bitcoin should be a concern for them; it was not built to fit the regulatory mould and it seems that banks are frightened of inadvertently enabling violations of financial regulations via the Bitcoin network.

There have been numerous examples of banks, often abruptly, ending their relationships with Bitcoin exchange businesses. Earlier this year US based exchange BitFloor ceased trading after CapitalOne closed their bank account, and this is just one of many examples from the US.

In Germany Bitcoin exchange Bitcoin-24 had its bank account closed by authorities in April who were concerned that the site was being used for fraudulent transactions. More recently, LibertyBit, a Canadian based exchange, halted operations as a result of bank account closures and alleged fraudulent account activity.

While start-up Vaurum has managed to build banking relationships, it took some convincing. “The hard part is that banks won’t even talk to Bitcoin exchanges because their compliance teams are scared of the regulatory issues that come along with banking a Bitcoin exchange. …  The mechanics of the partnership are pretty straight forward – it’s just that banks don’t want to get in trouble with regulators and are quite conservative by nature. … It took some time to educate banks on our business.”

The Other Options

While some are putting their effort into making the Bitcoin/banking partnership work, others are busy finding ways around it. For the moment it would seem that there is only a small percentage of Bitcoin trade happening outside the large exchanges and most exchanges do not view these options as competitors. However, the alternative exchange market is experiencing rapid growth of its own.

As Fiat currencies in their digital form exist only on the servers of banking institutions, Bitcoin to fiat exchange cannot take place without the co-operation of a banking institution.  Many who are looking to bypass the regulatory and banking relationship hurdles are attempting to fly under bank’s radar with small transactions.  This means peer-to-peer transactions rather than a large intermediary such as an exchange.

There are a number of options that aim to connect individual Bitcoin users for trades. Two examples are LocalBitcoins.com and MetaLair.

MetaLair is an open source software project that aims to create a decentralised exchange mechanism which would facilitate peer-to-peer exchanges between crypto-currencies and in the future fiat to crypto exchanges.

The project will begin by building a network to enable peer-to-peer, crypto-currency to crypto-currency exchanges. In this scenario the MetaLair software acts as an automated escrow agent which makes for a very low trust system; but of course fiat to crypto exchanges would be more complicated.

Due to the nature of the banking system, the project’s crypto to fiat exchange plans would necessarily involve fiat funds being held by a third party escrow service. MetaLair plans to provide an open protocol to allow anyone to set up as an escrow service and to build a reputation via a rating system. As lead architect Johnathan Turrall explains, “what we are creating is an open system. The details of how the fiat to fiat transactions occur between the entities are effectively between them, we are just providing an interface by which they can do that.”

While MetaLair aims to create online exchange, LocalBitcoins.com has been in operation for years offering primarily in person exchanges.  The service matches local Bitcoin traders with those looking to buy or sell. The site is known for finding exchange agents for in-person trades, however, exchanges can be arranged entirely online. These trades use options such as bank wires and the site offers an escrow service for added user security. Via a local trader it is possible to purchase bitcoins quickly, privately, in person, and with cash in over 2,200 cities worldwide.

Earlier this month the sites founder Jeremias Kangas said his site has been gaining roughly 300 new users each day and has over 50k users overall. The site currently employs 4 people and is looking to hire more as they continue to improve their service.

New local Bitcoin markets calling themselves Buttonwood have sprung up in a number of US cities. The name is a reference to the 1792 Buttonwood agreement that created the New York Stock Exchange and which took place at 68 Wall Street under a buttonwood tree.

Conclusion

While the exchange market is changing, things are still largely the same. Mt. Gox is currently the largest exchange and USD/BTC exchange is the largest market.

Venture capital backed start-ups are determined to capture the US market and they seem likely to succeed. Only those start-ups who can attract large investment funds will be able to calm nervous banks and clear the regulatory hurdles.  As such the exchange options in the States will become much more serious and will require verification from all clients, likely above the current law. Privacy will not survive in the US online exchange market.

As compliance in the States is a large and expensive hurdle to clear, many innovators who’s projects do not fit the regulatory mould will avoid the US and likely actively block US users. Bitcoin innovation may be driven out of the States.

The large online exchanges are the dominant exchange options and it is difficult to guess the percentage of the market for exchange alternatives such as local markets or OTC trades. These options would seem to be much more appealing to Bitcoin veterans, however there is no doubt that alternative exchange options are experiencing a boom of their own.

As the world of traditional banking collides with the new world of crypto-currencies there will continue to be friction. New exchanges will appear, bank accounts will be closed, regulators will take action, businesses will be shut, some will get rich, some will face prosecution and how the exchange rate reacts is anyone’s guess. But this weak point in the evolving Bitcoin economy is where the action will be. Watch this space!

Ripple was created by Ryan Fugger in 2006 as a trust network where people can grant each other credit, and anyone can ‘be their own bank’. The project has since been acquired by a team of developers including Mt. Gox creator Jed McCaleb. Ryan’s trust network is still there, but it is now one feature of a much expanded system.

The new features of the soon to be open source software include the possibility for a decentralized currency exchange, a p2p transaction network, “Gateways” for bringing other currencies into the system, and Ripples (XRP), a new digital currency.

Passing around IOU’s

To understand the system, let’s start with Ryan’s original vision, the trust network. Ripple allows users to extend credit to their friends, or to anyone whom they trust. The new version of Ripple expands upon this idea with a very sophisticated system of passing around and tracking IOU’s. Ripple is a series of trust limits strung together to form a trusted pathway.

Here is an example of how the system can work…

You grant your friend, Bob, $100 of credit. You do this by telling Ripple that you would accept an IOU up to $100 from Bob. Now imagine that Bob is from the other side of the world where his sister, Marie, still lives. Bob trusts his sister and as such has grated her $50 of credit in the Ripple system.

Marie comes to visit and you all go out for lunch. Marie forgets her wallet and you cover her portion of the bill, $20. Instead of Marie finding an ATM and withdrawing $20, she logs into Ripple and sends you an IOU for $20. This is possible because there is a trust pathway between you and Marie via Bob. You are willing to let Bob owe you up to $100 and Bob is willing to let his sister owe him up to $50. Via this trust pathway a $20 IOU can get from her to you, by passing through her brother.

This trust pathway works because everyone along the path has ‘vouched’ for the person directly before him or her on the pathway. Bob accepts an IOU from Marie and then he issues an IOU of his own for the same amount to the next person in the path who accepts his IOU’s, and in this example, that’s you.

This system works to encourage a large trust network. The more people you trust and the more people who trust you, the more pathways there will be. This enables more transactions. On top of this the software also includes a number of other features such as a ranking mechanisms that allow you rate others debt.

When taking a close look at the potential networks, and imagining the flow of funds between people and through the network, things can get very complicated and difficult to follow. Some of the common stumbling blocks will be reviewed at the end of the post.

Settling

Tracking credit in your network of friends is great, but how is all this debt actually settled?

One option would be to simply say ‘Hey Bob can I have that $20 back?’, and then Bob hands you a $20 bill. To report this in the Ripple system you would simply issue Bob with an IOU of $20 which cancels out his IOU to you. Or, you can settle with a Ripple Gateway.

Gateways

What happens if you’re not interested in exchanging IOU’s with your friend’s, yet you want to send money via Ripple? For situations like this, or when no “trust pathways” exist between two users, a Ripple Gateway provides the solution.

Gateways are designed to be Ripple servers running as businesses. Ripple’s creators envision Gateways as competing businesses who will likely be compliant with AML/KYC rules and financial regulatory agencies. Gateways may make their money in a variety of ways including, account or deposit fees, converting currency denominations with a spread, placing funds in an interest bearing account, etc.

As the name implies Gateways are the bridge between national currencies, other digital currencies and the Ripple network. A Gateway would likely have a traditional bank account, a Bitcoin wallet, etc. and accept funds from Ripple users in exchange for credit or IOU’s in the Ripple system. Inside the Ripple system money, USD, EUR, BTC, etc., are represented as the network currency, Ripples (XRP) or as IOU’s denominated in that currency.

You can, for example, deposit USD with a Ripple Gateway in exchange for a USD denominated IOU from that Gateway. You can then send this IOU to a friend, who can then ‘cash out’ at a Gateway themselves.

XRP and Fees

Ripple includes its own ‘Network currency’, Ripples, also called Ripple credits or XRP. The network was created with 100 billion Ripples, with no more to be created. ‘Ripples’ can be sent between accounts or converted to other currencies and some consider them a possible rival to Bitcoin.

There are fee’s for transactions in the Ripple system, however, these are charged not ‘for profit’ but for the protection of the system. The idea is to prevent ‘spam’ transactions swamping the system. The transaction fee is meant to be very minimal, only a fraction of a Ripple. The transaction fee is not collected but redistributed evenly throughout the network in proportion to account holder’s balance.

De-centralized Bitcoin exchange?

One of the much discussed features of Ripple is the ability to exchange Bitcoins for other currencies. The way this works is essentially that every Ripple Gateway can act as an exchange agent. This is how the process would work trading USD for BTC

• Find a Gateway you trust and send them the USD you want to sell
• You will receive an IOU from that Gateway in the amount of your deposit
• Enter an exchange offer in the Ripple system
• Assuming someone holding an IOU for BTC accepts your offer, your exchange will be recorded on the Ripple public ledger and you will now have an IOU for BTC
• Take this BTC denominated IOU to your Gateway
• Your Gateway sends your BTC to your Bitcoin address

De-centralized exchange is often discussed in the context of Bitcoin surviving hostile regulation. Should Bitcoin, or Bitcoin exchanges become illegal this would also outlaw Ripple Gateways acceptance of the currency.

P2P Transactions

To understand the Ripple network, think Bitcoin. Like Bitcoin, Ripple is open source software that creates a distributed network. “At its heart, ripple is a distributed database, a network of shared information. Instead of a central server, all the servers around the globe running the free ripple software power the ripple network.”

Ripple’s architecture includes a lot of the same concepts as Bitcoin, but with some very important differences.

Like Bitcoin:

• Ripple is an open source, distributed peer-to-peer payment network.
• Ripple transactions are irreversible, sent over the Internet, and counterfeit proof.
• Ripple uses the same underlying cryptography as Bitcoin.
• Ripple has multi-signature support.
• Ripple has low to no transaction fees.
• Ripple servers can be run by anyone.

Unlike Bitcoin:

• Ripple can send any currency.
• Ripple can automatically exchange currencies.
• Ripple transactions are fully confirmed in seconds.
• Ripple has no block chain download, clients are ready in seconds.
• Ripple has no mining or direct monetary reward for running a Ripple server.
• Ripple has no currency risk as people can hold whatever fiat they want.
• Ripple solves the double spending problem with consensus instead of proof-of-work.

Consensus

Transactions in Ripple are recorded via a public ledger using “consensus”. The idea is this: when a transaction occurs your Ripple client software announces to the network the details of the transactions…”I’ve sent Bob 100XRP”. Later if Bob, or anyone else, asks the network “Did Julia send me 100XRP?” the majority answer will be ‘Yes’. Of course this is a very simplified example; the reality is a bit more complicated.

Nodes on the network listening for transactions are ‘Validators’ and every client will have a preferred Unique Node List (UNL). You can also manually select your UNL.

Anyone can run a validation node; however, there is no monetary compensation for doing so. Ripples creators believe that Gateways, merchants, day traders, libertarian groups, universities, etc. will run these servers to support the Ripple network.

Rather than a block chain, Ripple records transactions in a ‘public ledger’. The Ledger contains a list of all the accounts and their balances. Every Ripple node has a synchronized copy of the current Ledger.

Scratching your head

Ripple has added so much additional capability that the original Ripple ‘trust network’ is now simply an option in the system. However, wrapping your head around the complicated IOU network that Ripple is capable of can be a bit difficult. Ripple’s IOU’s are designed to be exchanged in a manner that could allow them to be a medium of exchange themselves. This brings up a few questions: are all IOU’s ‘backed’ by other currencies? How does someone holding IOU’s access ‘backing’ funds? What happens if there is a default in a chain of credit?

Here are some examples that will hopefully clear these issues up.

IOU’s can be ‘backed’. For example, you can back an IOU that you receive after depositing funds with a Gateway. IOU’s can also be un-backed, for example if you send an IOU to a friend. If your friend is willing to accept this IOU they must trust your willingness to repay them and that trust you have or will have backing funds. However, these funds do not have to be currently in the Ripple system. And the Ripple system does not differentiate between backed and non-backed IOU’s. Should this cause concern about defaults and systemic risk, there is another important feature of the Ripple system to consider here.

Granting someone trust, or agreeing to accept their IOU’s gives them access to your ‘trust network’ and also gives you access to theirs. Or put another way, you now have access to each other’s IOU’s from other parties. For example, if I owe you $20 and I have deposited $20 with a Gateway and I am holding the Gateways $20 IOU, you can ‘take’ the Gateway’s IOU from me. In doing this you would owe me $20, and given that I owe you $20 these IOU’s cancel out, debt settled.

Another common concern is with the way the Ripple system will allow IOU’s to ‘Ripple’ through the system via chains of credit. What happens when someone defaults? Who is left holding the bag? The quick answer is that when there is a default, it only affects those people who have specifically agreed to trust that person; those upstream or downstream are unaffected. To sort this out, here is an example.

Jane wants to pay Charlie $50 and Charlie has agreed to hold Bob’s IOUs and Bob has agree to hold Jane’s IOUs, then a chain Jane->Bob->Charlie exists to make the payment. Now, Jane owes Bob $50, Bob owes Charlie $50, and Charlie considers Jane to have paid him $50 because she made Bob owe him $50 and he has agreed to accept Bob’s IOU’s. Bob owes Charlie $50, but Jane owes him $50. Since he agreed to accept Jane’s IOUs, he’s no worse off. If Bob defaults, Jane doesn’t care; she didn’t agree to trust him.

You can also think about this situation differently by picturing the people in this arrangement as banks. After all, allowing people to act as their own bank is one of Ripple’s goals.

When your friend sends you a check and you deposit it in a bank account, your friend has made your bank owe you more money, so you consider your friend to have paid you. You trust your bank to hold your money, you are happy to hold their IOU’s. In this situation your friend’s bank owes her less money (or she owes her bank money). If your bank fails, your friend doesn’t have to pay you again; you agreed to trust your bank, she didn’t.

It’s complicated, and very interesting. The new Ripple is full of promising features and DGC will be keeping a close eye on it.

“Within a few weeks, a new option will be available: a system called Ripple, which allows individuals to create credit and disburse it to people within a peer-to-peer social network. The project could be used to implement what many Bitcoiners have been asking for—a decentralized currency exchange. But if the more-ambitious parts of the design pan out, the credit created in Ripple could itself become a new form of digital currency and the first formidable competition for Bitcoin.”

“According to those at the helm of Ripple—including Jed McCaleb, who is best known in the Bitcoin community for developing Mt. Gox, the largest centralized Bitcoin exchange—they will release a public version at the end of January, the first peer-to-peer iteration of the Ripple project.“

“Ripple is actually a concept that predates Bitcoin and was first implemented by Ryan Fugger, a Web developer in Vancouver, B.C., Canada. His idea was to create a way for people to extend credit to strangers through the people they already knew. For example, if I trust Alice, who trusts Bob, I can offer my credit to Bob in an agreement backed by Alice.”

“When Fugger built Ripplepay in 2005 and 2006, ‘the goal was to create a system of debt money without artificially imposed scarcity,’ he says in an e-mail. What that meant in practice was giving individuals the power to operate as their own banks, with the ability to issue credit.”

“When you join the Ripple network, you designate primary contacts and establish levels of trust by choosing the amount of credit you are willing to offer each individual. I might feel okay lending up to $1000 to a few close friends whom I know will have a deep obligation to pay me back, while making only $50 available to the man I talk to every morning at the deli. But with Ripple, the credit isn’t only available to my acquaintances. It becomes available to anyone else who knows the people in my network.”

“Let’s say, for example, that I want to sell a Web application to Bob, who knows my close friend Alice (credit limit $1000). Ripple allows Bob to trade with me using his credit limit with Alice. If she trusts him for $100, that becomes his credit limit with me. I would send Bob the merchandise in exchange for his promise to pay. But instead of owing me, Bob would actually owe Alice, who would in turn owe me. Once Bob satisfied his debt, the Ripple network would destroy the entire chain of IOUs.”

“According to McCaleb, the new version of Ripple will include an exchange platform built right into the network. ‘For the currency exchange, you create offers, and these offers are stuck in the ledger. Anyone that has a trust path to the currency you are buying can take your offer,’ McCaleb explained in an e-mail.”

“For many who use or want to begin using Bitcoin, this is a welcome development. ‘If it does achieve that, I’d say that’s pretty big news, because the main weakness of Bitcoin, obviously, is that you have to rely on an exchange,’ says Eli Gothill, a Bitcoiner who has played with the new beta version of Ripple”

“Not only will this reduce the risk for individuals who want to trade in bitcoins (or other currencies, for that matter), it will also be much harder to shut down than a centralized exchange, because the upcoming version of Ripple will be the first iteration to run on a peer-to-peer network with open-source software.”

“‘The database that stores all the transactions and relationships is shared across the network. So everybody hosts it. And then every 10 to 20 seconds, there’s a consensus process where everybody’s node is brought up to date,’ says Gothill.”

“So far, Ripple’s founder approves of the new version. ‘An open, distributed transaction network is a hard problem, and I think Jed’s approach has tons of potential,’ says Fugger.”

“And that potential encompasses much more than a slight improvement for the Bitcoin economy. Embedded in the Ripple concept is the possibility that the network could become so large that its users would start to participate in a closed loop of trade, treating personally issued credit as a unique form of currency. In this scenario, rather than immediately demanding payment on IOUs, Ripple users would pass them on as payment in another transaction. And then IOUs would circulate like currency until they canceled each other out.”

“This is the bigger idea behind Fugger’s original design. ‘What Ripple is designed to do is get rid of the need for money to settle debts, because debts can be canceled out against each other. So if I send you an IOU for 10 and you send me an IOU for 10, then we don’t need to settle anything, because our debt will just cancel out,’ says Gothill.”

“Although the architecture of Ripple will be conceptually similar to that of Bitcoin, by design it will consume much less electricity than Bitcoin and will be able to conduct transactions over the course of seconds rather than minutes.”

“But even those who have tried the new version are reining in their expectations. The original version of Ripple has been around for a few years now, and it has yet to prove that you can build a mature economy from a network of acquaintances. There are plenty who think it’s a bad idea to make friendship the basis of a credit network.”

Read the review in its entirety here.

The business’ founders, Chris Odom (Fellow Traveler) and Johann Gevers aim to make this ‘financial system 2.0’ possible by developing commercial versions of the Open Transactions digital finance library. This software will allow digital finance entrepreneurs to startup micropayment services, financial markets, community currencies, escrow services, and many others all without depending on the traditional banking or legal system.

Johann, Monetas’ CEO, recently shared with me his thoughts on finance, his belief in decentralized systems and his plans for Monetas.

“Monetas is a transaction system not just for financial transactions but for transactions in general. Financial transactions are a special case, a subset, of legal transactions. So Monetas is actually a legal transaction system which includes both legal and financial transactions.“

A transaction system like Monetas is designed to operate as an alternative to the current banking system. It works brilliantly with Bitcoin, however, the software is “agnostic” and allows you to use any asset type. “You can use fiat currencies, digital gold currencies, Bitcoin, basket currencies, or the most sophisticated derivatives. Our system works with any asset type, but it works particularly well with Bitcoin and solves very important problems in the Bitcoin economy, so it will help strengthen the Bitcoin ecosystem. But Bitcoin also allows our system to do things that it cannot do with other types of currency.”

The Monetas system is built using the open-source Open Transactions digital finance suite created by Monetas’ CTO, Chris Odom. To understand how Open Transactions works, it is helpful to compare it to the functioning of traditional transaction systems.

Traditional transaction systems use databases. A database is a centralized repository of information. A user’s transactions and account balances are recorded as numbers in the database. When a user conducts a transaction, the accounting software simply edits the numbers in the database. What’s important to note, is that the bank has the ability to edit the numbers in the database to whatever it wants to. So the user has to trust that the bank will not abuse this power, and that hackers will not break into the database.

The Monetas/ Open Transactions software doesn’t use a database. It uses digitally signed receipts, which operate in a decentralized way without any databases. The receipts have to be signed by all parties to be valid. This makes it literally impossible for the parties to cheat. The software uses advanced cryptographic protocols that create unforgeable transactions and balances.

A ‘bank’ using the Monetas/ Open Transactions software can provide all the normal banking services, accounts, checks, transaction receipts, etc. but without needing a centralized database. Instead of editing numbers in a database, The Monetas/ Open Transactions software works by digitally signing and transferring cryptographic data (such as receipts) and digital assets (such as Bitcoins). A Monetas/ Open Transactions ‘bank’, or server, cannot forge transactions or alter balances.

The brilliance of the system is that even if servers fail, or are hacked, the user’s assets are safe. Because there are no assets stored on any servers. The receipt is the asset. All the user needs to prove his asset balances is a copy of their last transaction receipt, which cannot be forged.

This means that users do not need to rely on trusted third parties. The technology itself guarantees the integrity of transactions. For details on how this works, go to the Open Transactions website.

Open Transactions can be used for a wide variety of transactions, such as to:

• Issue and manipulate digital assets.
• Create pseudonyms, issue currencies, and create asset accounts.
• Transfer digital assets securely between accounts.
• Operate “cash-only” (without accounts) for maximum privacy.
• Use a range of financial instruments, such as cheques, vouchers, and digital cash.
• Use higher-level, contract-based transactions such as payment plans and markets with trades.
• Create online markets that support market orders, limit orders, fill-or-kill orders, day orders, stop orders, and stop limits, just like trading on a real market.
• Use basket currencies.
• Provide proof of which transactions have cleared and which instruments are authorized, without having to store their entire transaction history, but instead by merely keeping the last signed receipt.
• Execute smart contracts.

Monetas’ commercial-grade version “will have a lot of additional features that are especially important to enterprises and big corporations. For example, it has to be scalable so that you can have millions of simultaneous users, and it has to be highly secure.” These of course are “not easy problems to solve,” and the current projection is that it will take another year before the commercial platform is ready.

Offering financial services on a global level is a legal nightmare and developing a good business model that addresses these concerns took months of legal research and brainstorming.  “What is really important to us is that everything we do is 100% legally compliant. At the same time we need to be profitable, plus we need to achieve our mission of providing access to next-generation financial and legal services to everyone worldwide.”

The solution was to not be a financial services operator. “We will never handle anyone’s assets. That is how Monetas is designed. It never, ever touches or has access to anyone’s assets or information. We are purely a software publisher. This puts us in the same category as book publishers, who are protected under international free speech conventions and laws.”

Monetas’ business model is to license its commercial software to consumers as a mobile app (available Q3 / 2013), and to businesses as an enterprise platform (available Q3 / 2014).

The mobile app will enable users, including the world’s 2.5 billion “unbanked”, to:

• Securely and privately store digital assets
• Buy and sell goods and services worldwide with no bank or credit card required
• Instantly send and receive money
• Execute legal contracts with any party anywhere in the world, without a lawyer.
• It will also have “convenience” features such as automating recurring transactions, storing transaction history, operating with multiple currencies, etc.

The Monetas enterprise platform will be licensed to businesses, including the millions of merchants who currently have no access to a merchant account, “who will use it to create amazing new products and services that weren’t possible before, as well as make existing transactions far cheaper, faster, more secure, more private.”

Imagine…

• Jose’s Easy Contracts “Powered by Monetas”
• Julia’s Bitcoin Bank “Powered by Monetas”
• Ragish’s Derivatives Exchange “Powered by Monetas”

Monetas’ aim is not to just add polish to existing systems, but to create a fundamentally different, less centralized, system. “The interesting thing is, if you look at the offerings out there, even the new startups, they are all centralized systems. And centralized systems are inherently fragile. They concentrate information, money, power, and technology in a single place—creating a single point of control, attack, and failure. Not surprisingly, centralized systems are failing all around us.”

Johann is passionate about decentralized systems, and decentralization is the theme not just in the Monetas software architecture, but also in Monetas’ organizational structure and processes. “The problem if you look at the world right now, the financial crisis and economic and political crises, it is precisely because of centralization that we have these issues.”

“Existing financial transaction systems—even those that use the ‘peer-to-peer’ buzzword—are centralized. For example, in the case of PayPal, it appears on the surface to be a ‘peer-to-peer’ payment system, because when one customer sends money to another customer, it seems that the money is transferred directly between them via email. But what actually happens behind-the-scenes is that customer A sends a message to PayPal, then PayPal transfers the money from customer A’s PayPal account to customer B’s PayPal account. So PayPal is the intermediary, the middleman, the third party that controls both customers’ assets and information. And as we know, PayPal often abuses this privilege. It freezes customer’s assets. It charges high fees. It takes days, even weeks, to complete transactions such as bank withdrawals. It refuses to open merchant accounts for merchants that do not meet its criteria. And so on.”

“These kinds of problems and abuses are predictable when you have to deal with a centralized entity that has, in effect, a monopoly position. And if a hacker breaks into PayPal, your information is at risk. This happens all the time, we see it in the newspapers every day. Another database hacked, another million credit cards stolen. And of course centralized systems are also vulnerable to government control which is exactly what has happened with PayPal and all other large, centralized entities, including ‘the Big Four’ data companies—Facebook, Amazon, Apple, and Google—the large telcos such as AT&T and Verizon, and financial institutions worldwide.”

“So that’s the problem when users’ assets and information are controlled by a centralized provider—the old provider-centric paradigm. Monetas is a complete system for financial and legal transactions that operates as a decentralized, self-organizing, peer-to-peer network. No person or entity controls the system—it presents no single point of control, attack, or failure—like the internet. The user—and only the user—controls their assets and information. Users enjoy autonomy and provider independence—the new user-centric paradigm. This design is inherently more reliable, secure, and private.”

“If two parties want to transact using our system they do not need a middle man such as a bank or lawyer or other agent to ensure the integrity of the transaction. The software itself prevents cheating and guarantees the integrity of the transaction. So the parties can transact directly with each other. They don’t need to entrust their assets or information to a third party. This is what true ‘peer-to-peer’ means.”

In keeping with their belief in decentralization, Monetas is working to integrate their system with Ripple.  “Ripple is a system for exchanging value in your friends network, so this allows decentralized exchanges instead of the centralized exchanges we have to rely on today, that are being targeted by governments.“

Monetas works particularly well with Bitcoin, but at the moment, transacting in Bitcoin usually requires using a centralized exchange. The exchanges are the most vulnerable point in the Bitcoin economy as they have to interface with the traditional banking system. “And so that is where governments are applying pressure. They are requiring exchangers to be licensed as money services businesses, and they are requiring them to collect information on the people that use their services.” The Ripple integration is intended to reduce customers’ need to interact with the traditional banking system and centralized exchanges.

The world’s “unbanked” population is estimated to be around 2.5 billion in Africa, Asia, and South America. The services Monetas offers are aimed in large part at the unbanked as Monetas provides global access via mobile phones, at prices that are affordable even to the poorest people, without needing a bank account or a lawyer. “As we know from economics, transaction costs are a critical factor that limits entrepreneurship and wealth creation.”  And transaction costs aren’t only measured in terms of money, but also in the time, effort, licenses, and other obstacles put up by bureaucracies. “So by radically reducing transaction costs and eliminating middlemen, we can dramatically expand entrepreneurship and wealth creation.”

“What we are going to have is contracts that are dramatically simplified, so someone who just has a mobile phone, who is in Africa who does not have an education but can understand their local language or English, will just have a few check boxes. It will say I want this clause, check, etc. click and done. So by eliminating the middleman, you do not need a bank account, you do not need a lawyer, and it dramatically reduces transaction costs.”

Monetas’ aim is simple, to make it possible for those who cannot afford, do not have access to, or are not well served by the current banking and legal system to have the ability to freely transact with one another and participate in the world economy.

You can visit Monetas’ site for more information on their upcoming products.