What’s up with Ripple?

Ripple has the distinction of being one of the largest companies in the cryptocurrency and blockchain business that is up and running and working with hundreds of customers, including a couple of major banks.

The XRP token it bases its business on—and owns the majority of—is the third largest cryptocurrency by market cap, after Bitcoin and Ethereum. 

And it has a very specific, and very large, niche in the decentralized finance industry. That is making cross-border financial transactions—particularly low value, high volume transactions—far cheaper and faster than they are now. It aims to do this by cutting out SWIFT, the middleman more than 11,000 banks and money services businesses worldwide currently rely on to ensure payments sent and received are legitimate.

Yet for all those achievements, it is among the most controversial companies in blockchain, with a host of critics who accuse it of two failings: 1) Trying to obscure its involvement with the origins of the XRP cryptocurrency—regularly referred to as “ripple” despite the company’s best efforts to change the nomenclature—which it insists it did not create; and 2) Overselling XRP, bringing in hundreds of millions of dollars while driving down the market price of the token to the detriment of retail investors.

But the biggest bump in the road the company faces is a class action lawsuit claiming that XRP is a security sold by Ripple. That’s because it is, potentially, an existential one.  

If XRP is found to be an unregistered security issued by Ripple in violation of SEC regulations, the company could be ordered to compensate investors for their losses—including the XRP purchased when the cryptocurrency’s price spiked to $3.84. It is currently at $0.29. 

Losing the lawsuit would also open Ripple up to an enforcement action by the SEC, potentially bringing huge fines and even an order to stop selling XRP. 

What Ripple does

Ripple has two basic products: RippleNet and On Demand Liquidity. 

Used by more than 300 partner banks and money services businesses in 45 countries, RippleNet is the would-be SWIFT killer, reducing the current three- to five-day wait and average of $25-$35 transaction fees to seconds and pennies. This is particularly important for small transactions such as remittances sent home by migrant workers, who currently pay an average of 7%—about $15—to send $200 home to family without bank accounts, according to the UN’s World Bank. It puts the annual total of these payments at more than a half trillion dollars. The agency in 2019 called for reducing that to 3% by 2030.

RippleNet is a proprietary network built with distributed ledger technology. It connects banks and financial institutions in order to send payments across borders instantly, securely and … cheaply. In less than three years, the company has processed more than two million transactions on RippleNet, with a notional value of over $7 billion.

Unlike the energy-intensive proof-of-work used by Bitcoin or the increasingly popular proof-of-stake Ethereum is slowly transitioning to—which relies on what amounts to validators putting up a bond for good behavior—XRP uses a polling-based consensus mechanism. This requires a supermajority of 80% of network validators (there are currently more than 150) to agree on the validity and authenticity of a transaction. 

While many of the 300 clients relying on this method are smaller outfits, some—notably American Express and the multinational banks Santander and Standard Chartered—are not. Others are big regional players, like Siam Commercial Bank in Thailand. And following a substantial investment by Ripple, MoneyGram last year began using both RippleNet and On-Demand Liquidity.

And they are serious about it. On Aug. 21, RippleNet customer Standard Chartered tweeted out “Digital assets, including #crypto assets, are here to stay. The new asset class is transforming the financial services industry, especially the way transactions and settlements are done.”

Transactions can be funded in two ways. Traditionally, institutions will have accounts with funds parked in other banks that can be used to settle transactions once their authenticity is confirmed. RippleNet customers can use that system, which leaves trillions of dollars worth of working capital sitting unused in bank accounts around the world, said Eric van Miltenburg, senior vice president of operations for Ripple.

RippleNet customers can also use Ripple’s On-Demand Liquidity (ODL) product. That uses XRP, with the sending institution buying the cryptocurrency and passing it via the blockchain to the recipient, which immediately resells it for fiat currency. As this is done in seconds, it bypasses any problems with the price volatility of cryptocurrencies. 

“It basically allows the funds, the liquidity, to move with the data,” van Miltenburg said.

This, of course, relies on there being sufficient liquidity in the ODL system—that is, enough XRP on the market—to permit ODL customers to quickly buy and sell XRP within seconds. Otherwise they would be exposed to the price volatility experienced by all cryptocurrencies. 

Price and Demand

While not all RippleNet clients use ODL, there’s enough demand for it, according to Brad Garlinghouse, CEO of Ripple. In a lengthy phone interview with Modern Consensus, Garlinghouse said that the company has “actually throttled that growth because one of the things that’s important when using ODL is you have to have really good liquidity on both sides of the transaction. And so, if XRP doesn’t have enough liquidity in the marketplace and you can’t put as much demand through.”

Demand for ODL is, he added, growing faster than RippleNet.

“Ripple continues to expand globally, bring on new customers to RippleNet, specifically ODL, and see an increase in RippleNet transactions,” said Asheesh Birla, senior Vice President of product for Ripple. “In fact, it has accounted for more than $2 billion in transactions since its launch, and last quarter, nearly a fifth of RippleNet transactions were ODL.

That plays back into the heat Ripple was catching from private XRP owners for its monthly sales, which were blamed for holding down the price. Of course, those were also used for operating expenses and keeping the company cash-flow positive.

With the price of XRP essentially stagnant over the past 12 months—particularly irksome as other alt-coins have been rising—the company began facing serious complaints from retail XRP holders, even its XRP Army superfans. The latter group is an unofficial fraternity of XRP owners with a reputation for strongly supporting Ripple—and attacking those who attack the company.

Private owners of the cryptocurrency claimed Ripple’s large monthly sales of XRP were keeping the price lower than it otherwise would be. Regularly in the eight-figure range, Ripple began a pause in its programmatic sale of XRP to exchanges in Q4 2019. Some contend that slowdown was in response to the uproar from XRP holders who feared the sales were suppressing the price, while the company maintains it paused programmatic sales to help stimulate healthy, liquid markets.

There was also concern at the company about the reliability of the overall market data. Ripple had been selling XRP relative to reported volumes. By June 2019, the company grew concerned about reports indicating that some of the data sources, like CoinMarketCap, had been intentionally misled by dubious actors in the space. who inflated trading volumes for their own aims. The company paused programmatic sales of XRP and switched to a new, presumably more reliable benchmark, Crypto Compare Top Tier. Ripple’s full store of about 55 billion XRP is locked in an escrow account that releases one billion a month, with any unsold XRP going back into the escrow account. Sales numbers are released quarterly and transparently available to all via a dedicated Twitter feed that tracks the movement.

“I pay a lot of attention to the liquidity in the XRP marketplace,” Garlinghouse said. “I do not spend a lot of time and energy focused on the ups and downs. I don’t think about the price on a short-term basis. I have said publicly before, I think about it over many years, not over many days or even weeks, as long as we have the liquidity in the marketplace to be able to deliver on the products we are building for our customers.”

XRP: Ripple’s chicken or egg?

Did Ripple create XRP? It’s an important question, and one that has an answer that is both fairly complex and very simple. It’s also one that goes to the core of the securities law question. 

Ripple’s argument that it did not create XRP but was merely the recipient of its developers’ generosity is certainly splitting legal and linguistic hairs. But then, in the legal world, hairs can matter. 

It goes like this:

After Jed McCaleb, Arthur Britto, and Ripple CTO David Schwartz developed the XRP Ledger, McCaleb and Ripple Executive Chairman Chris Larsen “knew that it was important that there was an entity, there were people that would be looking after some of the long-term health and issues related to the XRP ledger,” van Miltenburg said. “So, they did create this company called Ripple and basically put aside a large fraction of the XRP that was created.”

Twenty billion of the initial 100 billion XRP that were pre-mined at the blockchain’s genesis block was retained by the developers and founders. The rest was given to the company.

There’s another way of summarizing this that is popular with Ripple’s critics: 

“The same people who created the token gifted it to—essentially—themselves and Ripple,” said Tone Vays, a Bitcoin-centric trader, analyst, and podcast host who has roasted Ripple fairly regularly over the last couple of years. “I mean, that’s kind of the idea that it’s separate, which they keep pressing. It’s kind of BS.”

Insecurity

Of all the issues to explore, none is as important as the question of whether XRP is a security sold by Ripple. 

The four class action lawsuits—now consolidated into Zakinov v. Ripple Labs—characterize Ripple’s ongoing sales of XRP as, “essentially a never-ending initial coin offering.”

Losing the lawsuit would also open Ripple up to an enforcement action by the SEC, meaning potentially huge fines and an order to stop selling XRP. (The SEC declined to comment.) 

That, in turn, would challenge the liquidity Ripple needs for its On-Demand Liquidity product to work.

XRP: security or utility token?

The U.S. Supreme Court defined securities—investment contracts—in 1946 with the Howey test, referring to the case on which it was ruling.

That says that a transaction represents an investment contract if it meets a four-part test: A person (1) invests money (2) in a common enterprise (3) and is led to expect profits (4) solely from the efforts of the promoter or a third party.

That means the question is, does Ripple’s sale of XRP meet all four of those criteria? The company, needless to say, argues that it does not. Instead, it says, XRP is a utility token, used as a transaction unit in transferring funds across borders.

Attorney Stephen Palley, a partner at Anderson Kill who co-chairs the law firm’s blockchain and virtual currency group, argues that just because XRP has utility it does not mean it cannot also be a security.

“It’s possible for something to have a functional use value, if you will, to have utility as software and also to be a security,” he told Modern Consensus. “It can be both. It can be an investment contract and it can also have utility outside of status as a financial instrument.

He added, “[i]f it’s both, its status as a security requires either registration as such or claiming an exemption… the fact that you can use it for something else is not an excuse for non-registration.”

Asked flat out if XRP is a security, Palley replied, “Sure seems like it to me, but I’m just a simple country lawyer.”

Blaming the lawsuits on a legal vacuum left by “the absence of regulatory clarity,” over what is or is not a security, Stuart Alderoty, general counsel of Ripple, said it is a competitive issue for the U.S. as well. “[A]s we see other global jurisdictions, really responsible economic jurisdictions like Japan or Singapore, or the UK or Switzerland, getting this right, in terms of a clear and predictable regulatory framework… I think what we’ve started to see is that this innovation is simply going to move offshore because folks want predictable outcomes and in the U.S. right now, I think it’s getting more and more difficult to predict.”

That said, regulators are starting to pay attention and even become vocal, Garlinghouse argued. “We’re in the most formative years of crypto regulation, and almost every jurisdiction has their eyes on this space.”

He pointed out that in the U.S., the Consumer Financial Protection Bureau “recently highlighted how ODL with XRP could be used to benefit consumers with cross-border remittances, and the New York Department of Financial Services published a greenlist of assets, including XRP, that companies are allowed to hold or trade. Globally, banking regulators such as the UK Financial Conduct Authority view XRP similarly to an exchange or utility token.”

Giancarlo wades in

The company received some high-profile backing in a June 17 op-ed column in International Financial Law Review by former Commodity Futures Trading Commission Chair Christopher Giancarlo, a figure so well respected in the space that he was universally known as “Crypto Dad” during his time leading the CFTC. Giancarlo argued that Ripple should be classified as a utility token rather than a security—an important opinion from someone critical to the recent classification of bitcoin and ether as non-securities.

“[T]he SEC has prudently recognized that the application of securities laws may not be warranted in every instance,” Giancarlo said. “Although it would be unreasonable to expect the SEC to weigh in on each of the over 5,500 cryptocurrencies in circulation, noticeably absent from the agency’s comments on the regulatory status of bitcoin and ether is any mention of XRP, the third largest cryptocurrency.”

Running through each of the four arguments, he concluded, “under a fair application of the Howey test and the SEC’s presently expanding analysis, XRP should not be regulated as a security, but rather considered a currency or medium of exchange.”

It prompted a harsh rebuttal from Dean Steinbeck, general counsel for data-privacy focused blockchain platform Horizen. 

Writing in Cointelegraph, he called into question Giancarlo’s independence, noting that the former CFTC chair now works for a law firm which has Ripple as a client. He also called Giancarlo’s arguments “nonsensical and absurd.”

Giancarlo declined to comment on his Ripple argument, saying he would let his column speak for itself.

As for investing in a common enterprise, Alderoty pointed out in an interview with Modern Consensus, when someone buys “a unit of XRP you have no right, title or interest whatsoever in anything that a shareholder, holding an equity interest in Ripple, would have. So, Ripple is not XRP and XRP is not Ripple. They may buy XRP because they’re a commercial customer who’s deploying it in one of Ripple’s products, maybe they’re buying XRP along with a basket of other cryptocurrencies for speculation or speculative purpose. But none of those represent an investment as one would think about an investment.”

Expectations and efforts

As for the expectation of profits, Alderoty said, “if you want an equity interest in Ripple and you believe in the enterprise value of Ripple and you believe in what Ripple is trying to build… go in the secondary market and you can still buy shares of Ripple. That’s what you should be doing.”

In taking on Giancarlo, Steinbeck addressed this argument, saying “just because Ripple doesn’t promise future profits in its marketing does not mean that people don’t purchase XRP with the expectation of profit. Anyone who has been following crypto at all over the past few years knows that people buy XRP with the hopes that its price will go up.” 

As for the fourth prong, Alderoty points out that there are several other companies using the XRP blockchain, among them micropayments firm Coil and gaming company Forte. Ripple has a division, Xpring, dedicated to helping companies build on the XRP blockchain. 

Giancarlo took up this argument, saying retail XRP buyers “cannot reasonably rely on the efforts of Ripple as the XRP architecture is fully autonomous and exists entirely independently of Ripple.”

In his criticism of Giancarlo’s arguments, Steinbeck pointed to the size of Ripple’s development team. 

“[I]t is possible that the XRP ledger could continue to function without the Ripple team,” wrote Steinbeck. “But that would undoubtedly bring down the price of the token dramatically. As such, it is clear that XRP’s growth and the corresponding profits for token holders depend heavily on the efforts of the Ripple team.”

XRP purchasers, he added, “are simply passive investors that are counting on the work of the Ripple core team to come up with new products, promote adoption and boost the value of the token overall.”

“To be clear, nobody controls the XRP ledger,” van Miltenburg said. “It is an open-source, permissionless, distributed ledger. Anybody who’s a developer and wants to develop on top of the ledger [and] submit code in terms of how the XRP ledger evolves is welcome to do so. [I]s Ripple a steward and a supporter of the XRP ledger? Absolutely. And we do invest and we have developers that we pay for that help to ensure that the XRP ledger stays healthy, but we don’t control it. We don’t have unilateral say.”

Ripple vs. Crypto

In some ways, the most interesting thing about the Ripple/XRP argument is why people care so much.

Ripple, needless to say, has its own explanation of why it gets so much abuse from the cryptocurrency community.

“There’s an ethos that started in early days of Bitcoin of this anarchistic, libertarian, big businesses are bad, governments are bad, down with the man” philosophy, said van Miltenburg. “That is sort of the purist point of view. Ripple doesn’t subscribe to that approach and philosophy. We’re a company building a business. We have determined that the best way to build that business is to work with banks and work with regulators, and we think it’s the right thing to do. [W]e try to be very transparent in those interactions.”

He adds, “I think for some of the more passionate purists in that kind of crypto community, they view Ripple as a sell-out. Like, ‘You guys, you don’t get it. That’s not what this is all meant to be.’ And we respectfully disagree. We understand that that kind of earns us some ire and wrath from those that would like to disintermediate the institutions that exists.”

Of course, plenty of companies using Ethereum and other DeFi-friendly blockchains are building businesses that seek to work with banks and regulators.

Vays, meanwhile, has been loudly critical of Ripple, accusing it of explicitly marketing XRP as an investment in the past. 

“Ripple can revolutionize remittance and they can make remittance cheaper for everyone,” Vays said. “But the way they got there, in my mind, was unfair and illegal. But if you want to make the argument that the ends justify the means to get there, it’s an argument… We can have that argument. I think it’s too early for that argument. They first have to succeed in the mission, because if they don’t succeed in that mission, then in hindsight, it’s obviously a giant scam.” 

Needless to say, this has brought him into conflict with the XRP Army.

“[A]nytime I see a Twitter handle with the Ripple logo, I just block them,” Vays said. “They’re not going to do anything. I’m not scared, but I’m used to it. I knew what I was getting into. Anytime you say anything about Ripple, I get like a hundred replies from the XRP army and I just block all of them and it just makes my life a lot better. So, it’s annoying. And that’s all it really is. I don’t take any of it seriously. Everyone just barks. No one bites.”

Going the IPO route?

Regardless of whether the class action lawsuit is right about Ripple’s XRP sales being “a never-ending initial coin offering,” the company is considering another, SEC-approved route for further fundraising: An initial public offering of stock.

In an interview at the World Economic Forum in Davos, Switzerland, in January—before COVID-19 upended the world—Garlinghouse spoke candidly about going public.

“In the next 12 months, you’ll see IPOs in the crypto/blockchain space. We’re not going to be the first and we’re not going to be the last, but I expect us to be on the leading side,” Garlinghouse said. “It’s a natural evolution for our company.”

(Disclosure: Modern Consensus founder Ken Kurson sits on the board of Ripple.)

Updated 3:57 p.m. on Aug. 28, 2020 to add quotes by Brad Garlinghouse and Asheesh Birla.