The Ripple mutual credit and payment system: Will It Work?

Should it work, its consequences would be great. A mutual credit system which could scale around the world would put people in control of the money supply. It would create a decentralised source of credit money freely available whenever individuals and institutions were prepared to trust each other, and immune from the monetary abuse and fiscal policy decisions of governments. Money which was backed by trust between people, rather than the threat of force or the fear of bankruptcy, would be a profoundly disruptive monetary leap.

Excerpted from the excellent open money blog of ‘Webisteme’, this is one of the better analytical pieces we have seen on Ripple:

By ‘webisteme’:

“To understand the point of Ripple, we have to go back and look at an old story about money: credit. Not all money has been based on credit, but many monetary historians believe that debt-based, ledger money predates commodity money. In other words, before money existed as a physical ‘thing,’ it existed as a relation – of debt. Archeological evidence indicates that ledger-based money was used 5,000 years ago in Ancient Sumeria.

Under such systems – the first examples of mutual credit arrangements – money was created as debt whenever somebody received a good or service from someone else. The debt was quantified in an underlying value, such as a weight of silver or wheat, and recorded on a centralised ledger by the local authority, who also set prices. In order to repay the debt, the debtor would be expected to provide equivalent value of goods and services to somebody else in the currency community, bringing their balance back to zero. Today, LETS (Local Exchange Trading Systems) is probably the most prevalent example of mutual credit in action around the world. It tends to be operated in small community settings with a central administrator overseeing transactions.

It’s worth remembering that modern day fiat money is also debt-based money, but with a critical difference. In a mutual credit system, money consists in the credit a community issues to itself. In a debt-based fiat regime, the predominant form of money is bank credit – an IOU for government-printed cash. Government money is, in turn, no more than an IOU against future taxes, backed by the threat of government coercion. Ellen Brown has argued that the cognitive flaw of the banking model resides in the fallacy that money is a ‘thing,’ and that therefore ‘reserves’ in an underlying asset must be built up before credit can be extended. Mutual credit, on the other hand, is based on the powerful insight that money essentially consists in credit between people. As such, it can simply be created whenever people agree to trust each other to pay later.

Mutual credit is championed by people interested in community currency, as well as those seeking a progressive alternative to the modern financial system and its debt-based, fiat money. While LETS has been successful in getting communities to trade on credit, it has never managed to scale to the extent that national money has. In my view, LETS and other mutual credit circles suffer from a paradoxical constraint. On the one hand, if bonds of trust between the community are too weak, individuals will neglect to pay down their negative balances, leading to stagnation and atrophy. On the one hand, if community bonds of trust become too strong, individuals lose the desire to transact with one another, as credit comes to be viewed as an unnecessary obstacle to a gift economy.

This perhaps explains why LETS and similar systems have so far failed to scale significantly. On the other hand, I don’t want to suggest that this will never happen, as it might. There are many people thinking about the problems with LETS and scaling, and some interesting ideas, ranging from guarantor systems to credit ratings are currently floating around the internet.

This brief sketch of mutual credit should now set the scene for explaining what Ripple is, and why it is a unique solution to the scaling problems faced by LETS and other forms of mutual credit. Ripple is mutual credit, but with a twist: credit is extended only between friends or trusted parties, not between individuals and the community. In other words, Ripple’s particular understanding of credit is based on credit relationships which already exist – between friends. In effect, whenever two friends agree that one will pay the other later, they are entering into a credit agreement. We do this when we share daily expenses with friends, but promise to pay back in money, rather than leave the exchange to be completed in a less formal gift economy. For example, an agreement to spot a friend for lunch, buy a theatre ticket, cover half the cost of a holiday, etc., are all examples of credit.

The major advantage of credit relationships between friends, rather than between individuals and a system or community, is that friends have a natural incentive to pay each other back. The credit relationship is embedded in a social relationship which depends on reciprocity to survive. This is another way of putting the statement that prolonged debts turn friendships (and other relationships of trust) sour. We want to pay our friends back because we want to get rid of the feeling of debt towards them.

So, Ripple’s IOU constraint rests on a basic observation: that trust between friends provides a greater incentive to pay down negative balances than a more abstract relationship to a community, which can lead to shirking of obligations and stagnation, as we have seen. Individuals extend credit lines to their friends, up to the limit they are willing to trust them with. But what good is an IOU system between friends? How could this be the basis for a currency?

Ripple really gets interesting when we consider the second major feature of the system: payment routing. Ripple allows you to use your IOUs between friends to pay strangers and acquaintances who you would not trust with a credit line. This works through trusted intermediaries: if person A wants to pay person C for their painting, but person C does not trust person A with a line of credit, they might be able to trade if person B, who is friends with person A and person C, acts as an intermediary between them. Person A will write an IOU to person B, increasing his obligations towards him, while person B will write an IOU to person C. A has paid C, without C needing to trust A.

Payment routing is a powerful idea which allows personal IOUs to become a kind of money based on trust between friends. The more friends you have, and the more credit they are willing to offer you, the more payments you can make and receive within the Ripple network. Payments can be routed through unlimited numbers of intermediaries, as long as there is enough credit capacity (willingness to extend credit) in the chain connecting any two nodes.

The Ripple project aims to create an open source project to create a decentralised, peer-to-peer network based on these ideas. Much like Bitcoin, Ripple would have no centralised issuing authority to keep track of transactions or to issue new money. However, unlike Bitcoin, money will be created between nodes when they extend each other credit. Each node only needs to remember its transactions with its friends, rather than the whole network. Such a network is also quite compatible with LETS – a community credit system could have its own Ripple node, allowing it to transact with and route payments between other LETS systems, for example.

The question of whether Ripple will actually work as a currency is entirely down to whether it can create enough credit capacity to be useful. It’s not hard to see why a simple IOU system would work, as such systems already exist in non-digital form between friends. On the other hand, the ability to use Ripple as payment between strangers really depends on the strength of the connections in the network, both in terms of the quantity of credit extended (depth) and the number of people willing to accept it (breadth.) Could Ripple create enough depth and breadth to work?

I think there are a number of reasons to be optimistic:

* Not just for friends

One point about credit lines is that they do not only exist between friends, but also between acquaintances as well as businesses. Its common practice for businesses to hold accounts with each other, which they settle on a periodical basis. This is effectively extending a line of credit which can be repaid in money at a later date, or possibly written off against goods and services received from the debtor.

This suggests that there will be many types of entities interested in taking advantage of a Ripple credit system. Business may use it to trade with each other, relieving them of dependence on fiat money. This helps businesses free up cash flow, as they no longer need cash to settle some of their transactions. Ripple would work particularly well for businesses which participate in close loops of trade, and where fiat money is therefore redundant. It could also encourage such closed loops to form, boosting local trade – the aim of many community currency schemes such as the Brixton Pound. Businesses might also use Ripple to manage their tabs with customers, which they can settle in cash.

* Small worlds

Credit capacity depends on the quality and quantity of connections of trust individuals can form with each other, but also the degree of connectedness of each node to every other node. In reality, social networks are often called “small worlds” by network scientists, based on the low average distance between nodes. In lay terms, we speak of “six degrees of separation” between any two people on the planet, in the social graph of acquaintances. In trust networks, there are similar short paths between nodes, meaning high degrees of connectedness.

* Network effect

Once Ripple becomes useful as a simple IOU tracking tool, it will start to grow faster, as the possibility for payment routing increases. Such growth is self-perpetuating, as the more useful Ripple is, the more people join, who in turn add more credit capacity to the network. The distributed architecture of Ripple also means that once a tipping point is reached, technical limitations won’t prevent Ripple from growing exponentially, enabling it to become much like money.

* Architecture of Participation

Ripple’s ability to scale could be increased by building what Tim O’Reilly calls an architecture of participation. Such an architecture is a system which rewards the very behaviour which creates value for the rest of the network. Bitcoin’s architecture of participation is mining: as nodes lend their processing power to the network for transaction verification and processing, they are rewarded with the chance to generate new coins.

Ripple may need to develop a similar incentive to hubs in credit networks – the people who are disproportionately connected in the network, and who are therefore more critical to payment routing. Transaction fees might incentivise hubs to emerge who build trust relationships with other hubs, and route payments quickly in exchange for fees. Additionally, trust metrics which measure credit worthiness and levels of participation could become important ways for hubs to cash in on their trustworthiness to the network. If such an idea seems far-fetched, consider that Hawala, an ancient mutual credit system for remittances, has operated on a similar principle of trust for centuries already.


Of course, these are just some reasons why I think it is possible for Ripple to succeed. In the end, only practical experience will tell. However, should it work, its consequences would be great. A mutual credit system which could scale around the world would put people in control of the money supply. It would create a decentralised source of credit money freely available whenever individuals and institutions were prepared to trust each other, and immune from the monetary abuse and fiscal policy decisions of governments. Money which was backed by trust between people, rather than the threat of force or the fear of bankruptcy, would be a profoundly disruptive monetary leap.”

2 Comments The Ripple mutual credit and payment system: Will It Work?

  1. AvatarTom Crowl

    Ripple seems like a GREAT idea! And really gets to the idea of a truly distributed method of credit creation… (and its in this broader network that the true source of ‘value’ exists anyway… rather than the decisions of a small group of central bankers with their own interests which may not always be shared by all!)

    But what will happen (as has happened before)… is that the minute it actually attains any significant usage it will be relentlessly attacked by very powerful interests…

    (e.g. What happens when businesses try to do transactions between themselves and the government says “WHOA dudes… you’re trying to avoid taxes?” And banks start screaming to the population about how its going to ‘destroy the value of their retirements’ and support drug-running, terrorism or whatever other boogeyman they can come up with. You gotta know that’s gonna happen!)

    UNLESS it can grow in a way that can counter that opposition. I believe that a broadly based, user-owned and controlled neutral network handling traditional currencies for at least certain kinds of transactions has the potential to become… for lack of a better phrase… “the elephant in the room”.

    And if such a network wants Ripple… it can have it. And no existing institutional force would be capable of stopping it.

  2. AvatarTom Salfield

    Hi Michel,

    This is a great article, particularly in its explanation of mutual credit systems. Its full of fascinating insights and I’ve been a fan of Ryan’s (ripple) work since 2004 when he wrote

    I see the potential of ripple as a transaction network, and a credit system whereby I can give you credit based on something I hold, or don’t even hold. However, intuitively and logically I fail to see how it could be used to create a currency or something like a currency. The problem is that the nature of currency is that we have to have a shared “unit of value”, and as far as I can see this can only be done where there is some kind of community (or central authority) controlling the issuance of new units. In other words a currency needs to have broad acceptability and a shared understanding of it as a unit of value.

    Whether ultimately we need a shared unit of value (currency) is questionable. However without a massive increase in our ability to manage the informational problem of measuring heterogeneous value creation, I feel we do.

    I know my explanation isn’t as clear as it could be and I accept the possibility I am wrong…but do you see where I’m coming from?


Leave A Comment

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.