Editor's note: The venture referred to in this story as OpenCoin changed its name to Ripple Labs in October 2013.
In 1996, Chris Larsen founded one of the nation's first online mortgage lenders — E-Loan Inc. — which allows borrowers to shop directly for loans and cut back on fees charged by sales agents and brokers. Eight years ago, the 1991 graduate of Stanford Graduate School of Business launched one of the first peer-to-peer internet-based lenders, called Prosper.com, which connects investors directly to borrowers looking for loans.
The common thread has been the goal of knocking out financial intermediaries, and their fees, as much as possible. Larsen's latest venture, OpenCoin, aims to do the same thing at the most basic level of commerce — the payments system.
It's money without borders, allowing ordinary people and companies to complete transactions anywhere in the world and in whatever currency they like — including virtual currencies — in a matter of seconds and at less expense than it takes right now.
"The goal isn't just to rewire finance. It's to flatten finance," Larsen said in an interview at OpenCoin's office in downtown San Francisco. He takes some of his inspiration from Charles Schwab, another Stanford GSB alumnus, who pioneered discount stock-brokerage services and upended the model for "full-service" brokers in the early 1970s.
OpenCoin has created its own virtual or "math-based" currency, called Ripple, which is similar to one called Bitcoin. But Larsen says virtual currencies are only part of his broader idea: letting buyers and sellers transfer money between each other more directly.
Think about what it costs an ordinary bank customer to transfer $200 to someone's else's account at another bank. Even if both people are in the United States, banks routinely charge $20 for a one-time transfer. Banks also charge "swipe fees" to retailers for every payment made with debit or credit cards. For international transactions, banks and credit card issuers charge additional currency-conversion fees that run as high as 3% on every purchase.
For all the developments in online banking and online shopping, Larsen argues, the underlying structure of the financial payments system is still "pre-internet." Besides being expensive, it's slow. Transactions often take days to completely clear, and it's that state of affairs that Larsen is attempting to turn on its head.
If that idea sounds brash, it is nonetheless attracting the interest of serious investors. OpenCoin's venture capital investors include Andreessen Horowitz, Google Ventures, and IDG Capital Partners.
OpenCoin's Ripple System
OpenCoin is a for-profit company that created the Ripple system, an open-source distributed network that essentially runs itself. Ripple is a protocol, like the HTTP protocol for the World Wide Web, that allows people to transfer money without going through a bank payment system.
Larsen compares the current state of electronic payments to the early years of email, but it may help to think back a bit further. Thirty years ago, the only way most people could send international messages was by telegram, at a cost of a dollar or more per word. When email made its commercial debut in the late 1980s, most systems could send messages only to people on the same networks — AOL members to AOL members, Prodigy to Prodigy.
What revolutionized email, Larsen points out, was the development of a universal protocol that made it possible to automatically route messages across independent servers and networks that were simply connected to the internet. Almost overnight, email became ubiquitous, instantaneous, and virtually free.
The Ripple protocol is similar. It provides an automated set of procedures that allow independent servers around the world to interact with each other and collaboratively verify transactions. If all the servers agree that a transaction is valid — that the same money isn't being used twice at the same time — the transfer goes through within seconds. It's analogous to crowdsourcing systems, such as Wikipedia, but the collaboration is automated rather than going through legions of human participants.
The advantage, Larsen says, is that payments don't have to go through a series of balkanized bank-clearing systems. People open Ripple accounts and fund them with either "real" currencies, such as dollars or euros, or virtual currencies, like Bitcoins or Ripples. When they want to make payments, they use a system of private and public "keys" — passcodes — to transfer money to recipients' accounts.
A person doesn't need a virtual currency to make payments through Ripple. But, Larsen says, the creators of Bitcoins made a critical breakthrough by showing that payments could go through a decentralized network of servers that runs on its own and still be secure.
The Ripple system relies on a central ledger, managed by a network of independent validating servers that constantly compare their transaction records. The validating servers belong to all kinds of participants in the system: retailers, banks, market-makers, currency traders. If all the validating servers agree that a transaction is valid, the transfer goes through.
Larsen emphasizes that he isn't planning to replace banks or credit-card processors like Visa and MasterCard. In fact, he predicts that traditional financial institutions will develop their own products and services to run on the Ripple system. But the end result, he says, should be faster and cheaper transactions. The most obvious potential is in international transactions, but the system could also make it much easier to process "micropayments" — such as paying fractions of a penny for small bits of data at a time.
While Ripple customers don't need to use a virtual currency, the savings would be greater if Ripples became widely accepted as a method of payment, because buyers and sellers in different countries wouldn't have to bother with currency conversions.
The Challenges For Virtual Currencies
Virtual currencies are controversial. Financial regulators worry about their use in money laundering, because the systems often boast about providing the same kind of anonymity as doing business in cash. And Bitcoins became the center of a speculative frenzy in the spring of 2013, when the prices for "coin" rocketed from about $50 to $266 and then back to $90 in a matter of days. Much of the activity stemmed from news that Tyler and Cameron Winklevoss (the twins who sued Mark Zuckerberg, claiming that he stole their idea for Facebook) had become heavy Bitcoin buyers.
Larsen is mindful of the regulatory obstacles, and he maintains that operators of alternative payment systems need to work with regulators on issues like money laundering.
It's anybody's guess whether Ripples or any other virtual currency will catch on. Alternative currencies aren't new, and sometimes spring up when countries are in financial straits. In the mid-1990s, Russian companies were so strapped for cash that they began paying their bills in IOUs for the products they made: tires, tractors, electricity. The IOUs became so widespread that companies began trading them over a vibrant online secondary market.
The challenge for virtual currencies will be to win market acceptance by getting companies to take payments in "digital cash." It's a chicken-and-egg problem. To be stable, a currency needs to have a deep market and widespread acceptance. But to gain such acceptance, a currency has to be stable enough to withstand speculative attacks.
"We live in an era that goes back 150 or 200 years at most, in which the confidence we have in money is that it's backed by the state," says Benjamin J. Cohen, a professor of international political economy at the University of California, Santa Barbara, and the author of The Future of Money. "The nub of the issue is how you match the kind of confidence that's created by the sovereignty of the state."