Adios, 3-to-5 day money transfers

Mar 21, 2014

FORTUNE -- On March 18, the National Automated Clearing House Association declared that it was leading the way toward same-day transaction settlements through the ACH system, which is used in the majority of U.S. interbank transfers, credit card payments, and a growing percentage of bill payments. Anyone who has ever conducted a transfer through an institution using ACH will welcome the initiative -- most ACH transfers still take 3-5 days, not including weekends, even between major U.S. banks.

That timeframe is painfully out of step with the speed and liquidity of almost every other aspect of today’s financial infrastructure. But the NACHA statement, with its call for a “phased approach and industry study,” suggests that any change may be as frustratingly slow as the ACH system itself. Among other obstacles, NACHA CEO Jan Estep says ACH is inherently limited by Federal Reserve rules requiring interbank transfers to stop each day at 6pm ET.

One place trying a more aggressive solution is the San Francisco office of Ripple Labs, Inc. With a staff of 40 and funding from Andreessen Horowitz and Lightspeed Ventures, Ripple is building a secure international payments and transfer system that aspires to replace 3-to-5-day waits with instantaneous fulfillment, while also bringing wholesale foreign exchange pricing to swaps between an unlimited number of currencies and allowing smaller institutions and individuals direct access to the same network as large players. And, like David taking on Goliath, Ripple is wielding what some would take for an unlikely weapon – the cryptocurrency model at the heart of bitcoin.

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“The real big idea here is that we’re building an internet for value,” says Ripple CEO Chris Larsen. That’s quite literal -- Ripple executes transactions using the same omnipresent global wires and protocols we use to watch Netflix. ACH operates through a closed infrastructure of highly secure portals between institutions and clearinghouses, and can’t realistically operate more openly because its centralization leaves it fundamentally vulnerable to attack. But Ripple doesn’t need a walled garden, because it uses the same distributed ledger model that made bitcoin the first digital currency able to operate securely on an open network.

Ripple’s model does differ in technical terms from bitcoin’s, replacing bitcoin’s processor-heavy proof-of-work security with a lighter, faster consensus model. More important, though, are differences in the system’s basic intent.

A virtual currency, called the XRP, is central to Ripple’s infrastructure, but that currency is not meant to be either a store of value or a general medium of exchange. Instead, the XRP currency functions primarily to mediate between other currencies on the Ripple network, alleviating the challenge of creating direct trade matches.

This is similar to the way users can currently transfer between global currencies using bitcoin, for instance by buying bitcoin with dollars, then sending the bitcoin to a payee who exchanges them for a third currency. That process, though, requires engagement with an exchange partner on each end, inserting multiple time lags in addition to the relatively slow (15 minutes to one hour) transaction confirmations inherent to Bitcoin. Add to that bitcoin’s volatility, and you have a significant obstacle to its use for fiat currency transfers.

Ripple streamlines the process and reduces risk by integrating various financial institutions, referred to as “gateways,” directly into its network. These include foreign exchange market makers and currency holders such as banks. Gateways make their holdings, or portions of them, available on the Ripple network, essentially as virtualized obligation notes. “We have a sender, receiver, and market maker, all on the Ripple network,” says Dr. Susan Athey, a Stanford economics professor who advises Ripple Labs. “I can confirm all three steps at once.”

In addition to speed, Ripple will offer more liquid exchange pricing as new gateways join. “Ripple always finds the most efficient way,” says Larsen, by connecting users to currency holders through active market-makers. “This opens up the entire world to wholesale currency pricing.”

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Of course, obligations posted to such an open network are only as real as the holdings of the gateways. ACH guarantees its transactions by requiring all of them to go through vetted, established, and backed financial institutions. Ripple takes a much different approach, allowing any entity to join its network and make holdings available, but requiring individual trading parties to agree to accept obligations from any particular counterparty by adding them to a list of trusted partners.

This increases both risk and flexibility for users. For the most part, Larsen expects that users will default to widely accepted lists of trusted gateways, rather than personally vetting them. In fact, he says that Ripple is “not really consumer stuff,” and will ultimately be a backbone system accessed primarily through existing institutions.

But less trusted gateways can gain a foothold by offering competitive pricing to risk-tolerant traders. “Each deposit has to be evaluated as its own currency,” says Larsen, meaning that, for example, dollar-denominated holdings with a less reputable gateway can be traded against other currencies at a lower value than dollars from a more trusted institution, with such pricing mediated by market makers. Lesser-known gateways that consistently proved able to meet their obligations would gain price parity as they gained trust. In theory, this flexibility would make Ripple remarkably open not just to consumers, but to new and unconventional institutions.

Currently, though, much of this is theoretical. Ripple is focused on building its network of gateways, but it presently only includes three accredited institutional market makers and 15 gateways, including a U.S. gateway called SnapSwap.

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For Susan Athey, Ripple is important not just because of its specific functions, but because “Ripple is the first [cryptocurrency] alternative to bitcoin that has a substantially different structure.” Its development points to the various ways cryptocurrencies could be built to meet various needs.

Bitcoin proper has already proven robust for person-to-person transactions and retail payments, in large part because on-network transactions eliminate counterparty risk. Payments in bitcoin are not obligations, but instantaneous and final transfers. But the reality is that many people want to be able to easily transfer funds to various currencies, and bitcoin has so far had a rocky road integrating with existing financial services that allow that mutability. This was most recently illustrated by the collapse of the Mt. Gox exchange, whose decline seems to have begun in earnest when it lost access to a reliable banking partner due to anti-money laundering compliance issues.

Ripple melds the speed, ubiquity, and distributed security of cryptocurrency with the existing world market, including more robust compliance systems. “If institutions are going to plug into the system, they need to understand who their customers are transacting with,” says Athey. “Ripple is architected to allow that.”

But Ripple is looking forward at least as much as it is looking back. CEO Chris Larsen foresees the technology being important for developing countries, where small microfinance organizations would be able to connect to global markets more easily than ever before. Ripple’s funding model is also unique to the cryptocurrency world – Ripple Labs Inc. will retain ownership of 25% of the XRP in the Ripple system, projecting that as demand for network service rises, so will the value of the currency required to transact. (This is much the same as how demand for bitcoin for payments drives the value of that currency).

And, last but not least, you can use the Ripple network to buy bitcoin.

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