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Professional Credentials: The reports that I write are my personal research and opinions. They are not associated with any firm or organization, and are not intended to be taken as investment recommendations or advice. They combine my passions of economics, finance, writing and education, and... More
  • Ripple; Bitcoin 2.0 Or Just Another Fad? 0 comments
    Apr 12, 2013 9:23 AM

    Recently I wrote an article warning people about the Bitcoin. After the Bitcoin crashed 3 days later I wrote another article warning people about the Bitcoin. I wrote another article explaining why the entire concept of the Bitcoin, a deflationary currency, actually disqualified it from ever becoming a viable currency. I even wrote an history of Central Banks and the Gold Standard in an effort to remind people that these ideas aren't new, and have failed before. Another article I wrote highlighted how the Bitcoin doesn't even work well for its intended us, drug dealing and illegal trade. It got rejected for obvious reasons, but at least I tried to warn people...even the drug dealers. I simply haven't studied, practiced and taught economics for over 25 years to sit back and watch a preventable train wreck.

    It was clear to me that the people behind Bitcoin and those who use it are very familiar with computer languages, computer programming, computer science, the mechanics of illegal trade, the need to hide the transaction history of drug deals and the libertarian political ideology and agenda. I agree, the Bitcoin is a marvelous piece of encrypting software, there is no need to send me ANOTHER e-mail about how the Bitcoin works, what it is good for and why I am wrong. My issue is not about the code, the security, or the concept, my issue is simply about the economics. In my opinion, the economics of the Bitcoin are irreversibly and critically flawed.

    The first issue is that the Bitcoin is deliberately designed to create deflation. On its surface that sounds perfectly logical, but depressions are associated with deflation. Economies should attempt to avoid deflation at all costs, not manufacture it. I've already addressed that issue in previous articles, so I won't beat that dead horse.

    Another critical flaw is that there essentially are no barriers to entry to the virtual currency market. Basically everyone and their grandmother can go out, buy a server, download some software and claim they've created the newest and hippest virtual currency. Counterfeiters do that all the time with existing currencies...but that is illegal. Creating a virtual currency doesn't appear to be illegal...yet. There is a very sound reason why Article 1 Section 8 of the US Constitution grants Congress the power to "coin money and regulate the value thereof," and makes it illegal for all others. They wanted to prevent a repeating of the competing currency fiasco of the free-for-all Continental Currency. The unregulated virtual currency movement does just that, it attempts to repeat the mistakes of the Continental Currency.

    And sure enough, read through the headlines today and like clock-work "Introducing Ripple, a Bitcoin Copycat." Ripple however isn't a "copycat" it is basically Bitcoin 2.0, a new and improved Bitcoin. It studied the Bitcoin, identified many of the problems I've tried to identify, and made a better Bitcoin. Far from perfect, but better.

    Now some of Bitcoin's earliest evangelists and supporters have created what they say is a Bitcoin for the rest of us-another digital currency, called Ripple, that, unlike Bitcoin, transfers easily into and out of other currencies from around the world.

    Competing currencies is a wonderful concept on paper. Problem is, once a currency out competes the currency you are holding, it is like trying to exchange a Betamax for a VCR or a HD DVD for a Blueray. If and when a better Bitcoin comes to maket, people will rush to sell their Bitcoins before they become obsolete. The ability to become obsolete isn't a good characteristic for a currency, especially if you have your life savings of Bitcoins stored on a flash drive buried in a mason jar somewhere in your backyard, and you've lost your treasure map.

    The Ripple is even seizing on the libertarian political angle and out flanking them. They are bringing muscle to the party, and some very solid backers. Whereas the Libertarians view the secrecy of the Bitcoin as an asset, the new kids on the block understand most people want to know who the man is behind the curtain, and simply won't blindly put their faith in a collective network run by unknown individuals. Ripple is all about transparency, the kind of transparency Libertarians demand when they want the Federal Reserve audited.

    Today, OpenCoin, the company managing Ripple, is announcing new funding from some venerable Silicon Valley names like Andreessen Horowitz, Lightspeed Venture Partners, and Founders Fund. It's also unveiling some ambitious goals. "You don't have to be a wacky libertarian to understand that trust in political currencies is eroding," says Chris Larsen, OpenCoin's chief executive. "Our objective is to build a new global currency."

    The Ripple has simply built a better mousetrap, and fixes one of the major flaws of the Bitcoin, execution speed. As the Bitcoin has recently proven, seconds mean a whole lot when a currency can drop 50% is a day or less. Imagine agreeing to accept 1 Bitcoin for an Alpaca Sweater when it was trading at $260, and by the time you get everything worked out, the Bitcoin is worth $140.

    Larsen says that Ripple-the company bought the URL from a Grateful Dead fan-has one big advantage over Bitcoin. In many cases it can take a long time for Bitcoin transactions to clear because coins have to be "mined," a computationally intensive process that involves sifting through large amounts of data to find numerical patterns that confirm the transaction is legitimate. OpenCoin maintains a single global ledger; transactions are confirmed as the network's servers automatically check the ledger. The process takes about 10 seconds, the company says.

    Ripple has no problem highlighting the weakness of the Bitcoin. I've tried to highlight how stability is essential for a currency, and now Ripple is using the Bitcoin's instability to their marketing advantage.

    Of course, with Bitcoin prone to big swings, the future of digital currencies still seems very much in question, but Larsen argues that Bitcoin's volatility underscores the need for Ripple.

    The Ripple however may be a better Bitcoin, it still isn't close to being a viable currency. It seems intent on making the same mistakes the Bitcoin did. Talk about not learning from history, even when history is real time. The Ripple has failed to address the Bitcoin's fatal flaw of being a highly inelastic deflationary currency. The instability of the Bitcoin isn't only due to the servers, it is the inherent nature of anything with an inelastic supply. Ripple shouldn't be striving for a currency that will out appreciate the Bitcoin, it should be attempting to develop a currency that when you use it, $1 worth of Ripple will be worth $1 when you buy the product and when you pay for it 30 days later when the Ripple Credit Card bill comes. Stability, not creating the next bubble currency, should be the goal of the Ripple. As long as virtual currencies continue to demonstrate insane volatility, no one in their right mind would ever sign a contract valued in Bitcoins or Ripples.

    A few Ripples are already in circulation-OpenCoin did an initial giveaway to Bitcoin enthusiasts-and trade at almost 1,000 per $1 on Bitstamp, a Bitcoin exchange. Starting today, OpenCoin will begin to seed a broader market by putting 100 billion Ripples in circulation: It will gradually distribute 50 billion to users who sign up on the site; it will hold the other 50 billion. (The company hopes its Ripple reserves will appreciate.)

    The fact that OpenCoin issues currency and then holds some in reserve hoping the reserves will appreciate should be a dead give away. When Ben Brenanke prints money, he isn't doing so to line his pocket. Ripple appears to be just another virtual currency hoping to get rich off its users, and like the Bitcoin and their "minting" they don't even try to hide it.

    While I'm clearly no fan of virtual currencies, I do think the Ripple is a step in the right direction, and some of what they offer is clearly an improvement over the Bitcoin. They are addressing the main issues people want in a currency, not just secrecy. They even have an exchange to convert your Ripple to other currencies, even Bitcoin.

    It is also introducing tools to manage the currency. On its website, people will be able to register for a Ripple account, monitor their balances, and send and receive payments. They can also exchange their Ripples for other currencies, including dollars and-yep-Bitcoin.

    I would imagine the next time the Bitcoin crashes, that exchange will become extremely popular, and once those Bitcoins are converted to Ripples, dollars or Yen, I doubt they will be converted back.

    Unlike Bitcoin, transparency seems to be key to Ripple. Ripple seems seem eager to identify the man behind the curtain. Of course in the shadowy world of Bitcoin, Ripple is really a conspiracy and the founder of Ripple is also the founder of Bitcoin. And you know what, he may be, that is the inherent flaw in this system. Anyone can create a virtual currency in their garage. Jeb may have created a flawed Bitcoin, I've identified flaws any evil genius should have known, and once the Bitcoin crashes once or twice, he releases the Ripple. The Ripple will solve all the problems the Bitcoin created. Pure marketing genius, and it would explain why the Ripple doesn't solve all the obvious problems of the Bitcoin. That conspiracy isn't even hard to believe. My articles prove that anyone with a basic understanding of currencies and economics could have identified the flaws, and would understand why the Ripple isn't the real answer. However, you don't need a conspiracy to see the flaws in the Bitcoin or the Ripple.

    One of the aspects of the Bitcoin mystique, of course, is the identity of its anonymous creator, who called himself "Satoshi Nakamoto." The genesis of Ripple is no mystery: It was created by Jed McCaleb, a 38-year-old Berkeley dropout and, more important, the founder of the Mt.Gox Bitcoin marketplace. Some Internet users speculate that McCaleb is actually Nakamoto. McCaleb denies it; regardless, he developed Ripple with Arthur Britto, Stefan Thomas, and David Schwartz, all early contributors to the Bitcoin community and active members in the Bitcoin forums.

    This final quote demonstrates that the intent of the Ripple is to simply be an improvement of the Bitcoin. The term "iteration" he uses implies the Bitcoin 2.0 nature of the Ripple. Problem is, do you really want to beta test with your life savings? Riding the popularity of these virtual currencies can get expensive when the bugs are getting worked out.

    In this light, it's not a stretch to see Ripple as the Bitcoin community's second attempt at a potentially world-changing concept-a virtual global currency, backed not by central governments but by the animating notions behind the Internet itself. McCaleb says he always found Bitcoin difficult to promote to other people. "If it gets big, there will be a huge waste of resources spent on mining. It's totally unnecessary and it will just get worse as the system gets bigger. I wanted a system that didn't need that." He says Ripple "is just a better iteration."

    In conclusion, the Ripple is definitely an improvement over the Bitcoin. It is clearly an attempt to go "mainstream." The Ripple attempts to bring legitimacy to the virtual coin world. They introduce transparency, speedy transactions, a nice website where you can open an account and even a currency exchange. I bet they will even soon pay interest on deposits. The problems I have with the Ripple are the same problems I have with the Bitcoin:

    1) No barriers to entry. Currencies shouldn't be fads.

    2) The people running the program benefit from printing the money.

    3) They have deliberately created a deflationary inelastic currency.

    4) It is only a matter of time before Ripple 2.0 is released and we have to go through this all over again.

    5) If Ripple becomes a success, it to will become a bubble. Bubbles don't make good currencies. As we speak, the Bitcoin is down to $120...and falling.

    6) Extreme volatility prevents their use in contracts.

    Until these obvious flaws are addressed, future iterations of virtual coins are doomed to fail, just like we are witnessing now with the Bitcoin. Beta testing software is usually done in a controlled environment, you simply don't release it to the entire market and watch what happens. That is what is happening with the Bitcoin right now. Unfortunately they don't seem to teach economics in the computer science departments of our universities. Until they do, I would stay away from virtual currencies, not matter what iteration it is.

    Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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