Corrections and clarifications: gateways and the value of XRP

My previous article, about Ripple and its currency attracted some criticism from some in the Ripple community. And it deserved it, so here I’m going to correct and clarify what I said earlier.

First, gateways. I was trying to explain how XRP solves the problem of how to join a decentralized payment network when you don’t already trust someone in that network. I imagined (but didn’t spell out) a situation where you would go to someone already in Ripple, put your money down in front of them, wait for half a minute or so while they transfer to you the agreed number of XRP, verify on your own equipment that the payment has reached you, and walk away.

You can do this without placing any long-term trust in that person — or in anyone else in Ripple —, and barely any short-term trust.

I still think such a transaction is possible with the Ripple network, but I really shouldn’t have called the person a “gateway”, since that isn’t the primary function of gateways, and you probably don’t even need to be a gateway to do it.

The purpose of a gateway is to issue IOUs within Ripple for a currency (or something else of value) that exists outside Ripple. So an NZD gateway would take your NZD and send you, within Ripple, an IOU for the same number of NZD (minus any fees they might charge). If lots of people trust that gateway (directly or indirectly through trust networks), then these IOUs can be traded back and forth within Ripple.

Suppose you’ve spent the IOUs, and the people you paid have spent them, and so on, and they’ve ended up in the hands of someone who, for whatever reason, wants NZD in their bank account outside of Ripple. They send the IOUs back to the gateway that issued them, along with instructions on which bank account to deposit the NZD into. The gateway then deposits the NZD into the bank account (again, minus any fees the gateway might charge, which competition among gateways should keep to a minimum).

Now, the value of XRP. When I said

I think that the total value of all XRP in existence shouldn’t fall below the expected total of the time-discounted marginal values of all future transaction services provided by the Ripple system

I chose my words carefully (which is why there were so many of them). I was less careful when I said things like “this system of destroying transaction fees effectively puts a floor on the value of XRP” and “I’ve described a mechanism that shouldn’t allow the value of XRP to fall below a certain amount”. Such statements might have given the impression that there is a value, now known or theoretically knowable, below which the value of XRP will not fall. This is not the case.

The word “expected” in my careful statement is important, because it’s not what will happen with Ripple that determines the minimum present value of XRP, but what people expect will happen. So there might be a rational minimum value for XRP now, but when new information becomes available, it might change people’s expectations about Ripple, and lower or raise the rational minimum value for XRP.

The word “marginal” is also important. As JoelKatz illustrated, the average value of air is very high, because we couldn’t live without it. But because it’s so abundant (and no-one has a monopoly over it), its marginal value is zero; you wouldn’t pay anything for an extra jar of ordinary, atmospheric-pressure air unless you wanted the jar.

Likewise, Ripple might provide very valuable services to a lot of people, but if its server capacity is so abundant that it never needs to be rationed, then the marginal value of an extra Ripple transaction might be very low — as low as the smallest permitted fraction of an XRP, currently a millionth of a ripple, which is called a “drop”.

Here I must confess another fault of my previous article. I didn’t draw enough attention to the assumption I made in saying “when Ripple becomes popular enough to make full use of all its servers”. It is possible that, despite the lack of direct, fee-earning incentives to run Ripple servers, there might always be surplus server capacity.

If people currently expect that there will always be surplus server capacity, then my conjectured minimum value of XRP falls to zero, since the marginal value of an extra Ripple transaction at any point in time could be arbitrarily small.

Such low-cost transaction services would be expected to attract more users, filling up the server capacity, but it is plausible that more computing power will be devoted to Ripple than is needed for the entire world’s financial transaction requirements (given that people may still be paying small gateway and exchange costs, limiting their demand for Ripple server time). I wouldn’t like to guess the likelihood of such a scenario, though.

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