If it is possible to transfer cryptocurrencies (such as Bitcoin, Ethereum or Ripple XRP) around the world in minutes or even seconds (sometimes at a cost of a few cents) shouldn’t it be possible to build a system that makes use of that functionality to move conventional currencies quicker and more cheaply? Moving money like information in the “Internet of Value”. Multiple firms have tried to build international payments businesses based on the concept of transferring funds via a cryptocurrency that acts as a “Bridging Currency”. The funds sent are converted into a cryptocurrency, another party in the home country of the recipient converts the cryptocurrency into the recipient’s home currency and makes the final payment to the recipient. Some cryptocurrency businesses claim this not only cuts costs but deals with the problem of limited liquidity for some combinations of sender and recipient’s currencies or “corridors” as they are called in the payments world.
Progress by firms using the model, particularly based around Bitcoin as the bridging currency, have been limited. However one, Ripple Labs, using its own cryptocurrency, XRP, claims to have made great progress through its partnership with MoneyGram, a major international payments firm
So is this impossible finance that cannot logically work or a ground breaking innovation?
To understand the basics of money transfer, using the simple example of an international bank account to bank account transfer requires a simple diagram. In between the sender and recipient are one or more parties required to make the transfer happen. Let’s call them/him “The Middle Man”.
In this case of a transfer from the UK to Hong Kong, the Middle Man needs
· A UK bank account to receive the sender’s pounds
· To be able exchange pounds for Hong Kong dollars
· A Hong Kong bank account receive Hong Kong dollars and transfer Hong Dollars to the recipient’s account
· The staff, systems and processes to manage the receipt, exchange and transfer of funds
· The staff, systems and processes to ensure that all the elements of the transaction, including managing the details of both sender and recipient, comply with all the laws and regulations relevant to anti-money laundering and terrorist financing
The middle man is sometimes one party, for instance an international bank with branches in the UK and Hong Kong with a foreign exchange desk or it can be multiple parties that all provide specialist services. It is a very easy to draw a diagram with many, many parties involved in a transactions but typically each provides a specific service in carrying out the transaction and they are only used if they are most cost effective that the payments provider, providing all the elements of the transfer themselves.
Logically there are more steps and more costs associated because the middle man/men have to do more but it gets worse if you consider the foreign exchange costs.
Cryptocurrencies, whose price is based on nothing but hype, speculation and price manipulation[i] , are spectacularly volatile compared to most major currencies. Applying basic financial economics the volatility of cryptocurrencies means that the spreads on buying and selling cryptocurrencies are considerably higher than the spreads in conventional currency markets. It really does not matter if the whole transaction takes place in seconds or minutes, there will be higher spreads and hence higher costs because the dollar to peso conversion involves two fiat/cryptocurrency conversions.
In the specifics of the model created by Ripple Labs, US dollars are used to buy the XRP cryptocurrency at a US Cryptocurrency exchange which are then transferred to a Mexican Cryptocurrency exchange where they are exchanged for Mexican pesos, which are then transferred to a Mexican bank account for transfer to a recipient. With the whole process being managed by MoneyGram, a leading payments company. The whole process relies on the existence of parties willing to exchange XRP for dollars and Pesos for XRP. Finding parties to sell XRP in exchange for dollars is not hard. Ripple Labs, management and company founders control billions of XRP are generally very happy to convert it into a real currency. Ripple itself has sold over $1.2 Billion worth of XRP over a two year period. Finding a party willing to buy XRP with Pesos is more problematic.
A conventional FX dealer makes money making a market (by offering to buy or sell at particular rates with a spread in between) because there is demand to both sell and buy. This means they do not have to hold long-term balances in the currencies they trade. Usually net balances are zero by the end of the trading day. The flow of XRP into the Mexican cryptocurrency exchange from the US is largely one way, because the flow of remittances between US and Mexico is almost one way (dollars flowing to Mexico). Some of the sales of XRP for pesos will be absorbed by Mexicans wanting to invest in XRP but any significant flow of XRP to the Mexican exchange will rapidly exhaust that liquidity.
This means any party providing liquidity for XRP to Peso exchange is going to end up with a very difficult choice,
1. hold large long-term (at least overnight) positions in highly volatile XRP and risk bankruptcy caused by sudden price movement
2. Rapidly sell their purchased XRP on more liquid exchanges i.e. those trading in US dollars and then convert those dollars back into Pesos to provide the liquidity to buy incoming XRP
Option 1 is extremely risky, in a more conventional business the volatility would be reflected in the spread but too high a spread and the whole process of converting Dollars to Pesos vis XRP becomes extremely expensive.
Option 2 involves bringing back into the equation the foreign exchange costs that the whole structure was supposed to avoid
To summarise Crypto versus conventional payments
The cryptocurrency route potentially saves the very real costs for a payments provider of holding balances in foreign currencies but only by adding in the cost of additional currency exchanges and putting exceptional costs and/or risks on a liquidity provider.
That’s the logic but what is the empirical reality?
Over the last five years Bitcoin based international payments schemes have either failed to make any impact of simply closed down. Some of this may be due to the economic logic described above but other factors have had an impact. The association between Bitcoin and illegal activity has made it difficult for some firms to keep bank accounts, furthermore the cost for processing a single Bitcoin transactions has fluctuated between 50c and $50. Not ideal for small value remittances.
Ripple Labs in its Q1 2020 XRP market report[ii] claimed that “From Q4 2019 to Q1 2020, RippleNet’s On-Demand Liquidity (ODL) service tripled in transaction volume, and the dollar value transacted increased by more than 294%.” However that claim of a 294% increase in payments using XRP as a bridging currency did not reveal the base it has grown from. Potentially it grew from $100 million to $294 million or $1 to $2.94. There is no way of knowing what the actual value based on numbers released by Ripple. MoneyGram CEO Alex Holmes stated in an interview with Bloomberg[iii] in December 2019 that around $100 million dollars of total volume have involved Ripple but added that “but like any efficient market you need a buyer and a seller”. In the absence of more detailed values about the daily volume of business and profitability it is worth looking at the wider context.
The leading firm in the international remittances, Western Union, which has a considerably higher market share than MoneyGram, previously experimented with Ripple in 2018 but chose not to adopt a technology involving a cryptocurrency because to quote CEO, Hikmet Ersek[iv], “It’s five times more expensive” using a cryptocurrency than using their existing infrastructure. In order to get MoneyGram to commit to using XRP in payments flows, Ripple Labs had to invest $50 million dollars in the company, provide the relevant software for free[v] and provide an on-going subsidy to MoneyGram in excess of $10 million per quarter, under an agreement that runs until July 1, 2023. A total potential transfer of up $200 million to use something that should stand on its own two feet because of the claimed efficiency, cost reduction and speed.
So is the cryptocurrency bridging currency, genuine innovation or impossible finance? Based on logic, economics and progress so far, it is clearly Impossible Finance.