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Open Source Banking: The Economics of Trust

We put a lot of trust in our banks, and the global financial crisis which followed the credit crunch of 08/09 proved just how dangerous that can be. We trust them to hold onto most of our money without losing it and give it back to us whenever we need it. We trust them to support business and keep our economy moving, to the extent that they have become 'too big' – or too important – to fail, meaning that if they do lose both our money and their own we must cover their loses through bailouts paid by our taxes. Not only that, but we trust central banks to create our money in the first place and issue it into the economy through interest bearing loans. We trust these central banks to set national interest rates in a way that is best for the economy, even though they are run by the same commercial banks who profit from this interest – a conflict of interest (pun not intended) if ever I heard one.

We are told that we have no choice but to trust these banks despite the danger, to bail them out with our money whilst they cream huge profits from the top with complex financial derivatives which add nothing to the world's economic production.

But now a new breed of open source projects are emerging to challenge that view, with two very different but strangely complimentary alternatives: instead of trusting the banks we can start learning how to trust each other, or we can try to eliminate trust from our financial relationships altogether.

Eliminating Trust

So far the most popular and successful approach has been the elimination of trust, which is best exemplified by Bitcoin, with its unofficial motto 'in cryptography we trust'. According to this school of thought we do not need to trust anyone or anything but the open source code which runs our financial applications.

Bitcoin is open source money – it is a currency and payment protocol which uses cryptography and a distributed public ledger or transactions called the 'block chain'. Unlike the national fiat currencies which most people use today, Bitcoin and other 'crypto currencies' are not created by central banks and issued as interest bearing loans; instead new coins are created by an algorithm and distributed to the people who use their computers to help maintain the block chain and process transactions as a reward for their work. The code which runs Bitcoin is open source and collaboratively developed by its community of users themselves.

Rather than handing over their money to a bank and trusting them to hold it and process payments without losing any, as would have happened in every country following the credit crunch if our governments had not forced us to prop up the banks through our taxes, or taking any for themselves – as happened to the people of Cyprus when they were subjected to a 'bank levy' which directly raided citizens' bank accounts to pay off the unsustainable debts of the country's banks, Bitcoin users can keep their money on their own computer or phone. That way they do not need to trust anybody but the open source code running their wallet and the broader Bitcoin network.

Other so-called 'Bitcoin 2.0' projects aim to take this elimination of trust even further, developing a wide range of financial and legal applications – way beyond the simply storage and transmission of value offered by Bitcoin. An open source project called Ethereum, for example, is working on 'smart contracts' and 'digital autonomous organisations' capable of enabling people to conduct a wide range of financial transactions and even create a whole business which would run autonomously, in a predictable way according to pre-set rules – once again eliminating the need to trust a fallible human being or profit-driven business.

These attempts to eliminate trust from the economy have, however, run into some problems. In the case of Bitcoin, the need for trust has been reduced but not eliminated. Users must trust the Bitcoin currency itself – they must trust that its value will be maintained and that the network is secure. This is something which ordinary members of the public seem to be very wary of doing. In order to buy or sell the coins they must also trust an exchange, something which the collapse of the largest Bitcoin exchange Mt. Gox with a huge amount of customers' funds proved to be a dangerous thing. If they are storing their Bitcoins on a personal computer, users must also trust their own ability to keep their system secure against hackers and to maintain proper back ups in case their computer stops working.

Decentralizing Trust

Another open source project called Ripple is taking the opposite route to solving the problem of trust in our economies. Rather than seeking to eliminate trust, Ripple seeks to decentralize trust and explicitly recognize its importance in our financial transactions.

Ripple is an open source protocol which allows users to hold any currency – either crypto currency or fiat money – in a digital wallet. An internal digital currency called Ripples or XRP is used to facilitate transactions, encourage liquidity between different markets, and protect against spam and DDOS attacks, but is not meant to be used as regular money for making payments in stores or holding your savings. All other currencies are stored in a Ripple wallet as an IOU.

The IOU system used by Ripple confused some people at first, but it actually works in a similar way to traditional banking. When you put a dollar into your bank account, the bank does not set that dollar aside and store it in a physical location which corresponds to your account; they lend it out to someone else. A bank account with a dollar in it therefore does not contain an actual dollar, but rather a promise by your bank to give you a dollar when you request a withdrawal. Originally bank notes – the paper money you carry in your physical wallet – worked in the same way; they were issued as a promise to 'pay the bearer' a certain amount of gold on request, or in other words they were in IOU for gold.

The Ripple open source protocol effectively allows anyone with a computer to 'become the bank' by issuing their own IOU which other people can then trade and spend. This could be follow the original plan for paper money and be an IOU for gold, as No Fiat Coin and Ripple Singapore are doing, or it could be an IOU for Bitcoins, dollars, a share of a company's revenues, a pint of lager, an hour of unskilled labour, a hug, or anything else you can think of.

This effectively creates a kind of distributed exchange where people can deposit anything of value with any other Ripple users, then trade, exchange or pay for things with the IOU they receive through the peer to peer market, and then withdraw anything they receive in return from somewhere else. This can be used for anything from currency exchange to remittances to communal LETS systems for bartering and labour exchange.

All of these functions are supported by an explicit trust system. In order to receive an IOU from any other Ripple member, either in return for a deposit of something of value, as payment, or in exchange for another asset, you must set up a trust line to them. By doing this you publicly state that you trust the person, and how much of what currency or commodity you trust them for.

Of course you can still trust a business to hold onto your money and issue IOUs, just like a bank or exchange would – as long as you explicitly recognize this trust relationship and state how much you are willing to trust them for. But you can also choose to trust your friends and through that create a 'web of trust' which enables you to conduct all of your transactions through a fully decentralized and peer to peer network. To do this the system relies on the idea of 'six degrees of separation' to create an effective global marketplace. The idea behind the six degrees of separation theory is that we are each separated from any other person on the planet by only six steps – from you to your friends being one step, to their friends making the second, and so on. This means that IOUs within Ripple can be traded between people with no direct trust connection by calculating a 'pathway' between them through other people.

New start ups like Ripple Co-Op are now building on this protocol to empower ordinary people to effectively 'become the bank'. The ultimate aim of Ripple Co-Op is to offer all of the services that you would expect from a bank – but without handling any money themselves at all. Instead they simply provide a platform for users take deposits and issue their own IOUs, keep track of all their transactions and get notifications when they must redeem an IOU, access credit reports from other users through Ripple Union, and together build a fully peer to peer banking system based on the open source Ripple protocol.

Categories: Business | Finance | Banking | E-Currency | Bitcoin | Ripple | Open Source


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