In August, we published an analysis of XRP, the native token of the Ripple network. We presented a bearish view of XRP tokens. A quick summary:

Ripple, Inc. – the company that builds and maintains the Ripple network – has built a blockchain-based system that banks use to issue IOUs and settle debts. XRP has two uses: to pay fees on the Ripple network, and as a “bridge currency” for value transfers between any two institutions that don’t have a trusted relationship. However, its native token, XRP, is simply not necessary for the network to function.

Since the Ripple network is permissioned as a direct result of its unique node list (UNL) system, the risk of rational actors spamming the network is low. It’s unlikely that JP Morgan would spam Bank of America, or that Hana Group of South Korea would spam Fidelity. Even if these institutions don’t trust one another, they still want to conduct business with one another. Spamming other banks just doesn’t make any sense.

The other intended use for XRP is to act as a “bridge currency:” If a scenario arises in which two financial institutions need to settle IOUs in local currencies, how does the debtor acquire the local currency of the creditor? Many currency pairs simply don’t exhibit substantial trading volume, for example, Kenyan dollars to South Korean won. Although most currency pairs are not substantial by volume relative to USD-Euro, the combination of long tails of currency pairs grows factorially, as a function of n!. Given that there are 180 fiat currencies around the world, there are about 16,000 currency pairs.

Today, this problem is usually solved by using a market maker which provides liquidity in each currency to USD because USD is the global reserve currency. Ripple, Inc. proposes that financial institutions solve this problem using the Ripple network and XRP instead of the legacy banking infrastructure and USD.

The Ripple network is superior as payment rail system relative to the legacy financial infrastructure. However, it just doesn’t make sense that rational financial institutions will voluntarily use XRP as a reserve currency to settle transactions because XRP will always be – by definition – less liquid than a global reserve such as BTC. Regardless of the quality of the underlying technological infrastructure, the single most important attribute of a global reserve currency is liquidity. This is why USD reigns supreme: the largest economy in the world by definition has the largest amount of liquidity for most currency pairs.

Given XRP’s continued meteoric rise over the last 3-4 months, we decided to revisit our original thesis. In the last month, we’ve spoken with blockchain leads at major international remittance companies, traditional asset management firms, commercial banks, and investment banks. The individuals we spoke with have all evaluated Ripple’s solution and XRP. All of them used the system in some capacity, and all of them independently came to the same conclusion: if their institution were to ever come to use the Ripple network to settle transactions – which they deemed unlikely – they would want to use the global reserve currency for settlements, and not XRP. The global reserve currency is far more likely to be BTC, BCH, or ETH because these are permissionless financial systems and experience significant native demand from consumers and businesses all over the world. It simply doesn’t make any sense that XRP – as a permissioned currency that only banks can access in substantial quantities – will ever have more liquidity than a global reserve that’s used by billions of people.

The magnitude of the liquidity discrepancy between currency pairs is enormous. Over the last 30 days, the average daily volume for BTC was just shy of $10B, and for XRP was about $500M. This gap is likely to grow as BTC becomes a global, censorship-resistant, store of value.

Ripple Inc. is aware of this problem: they recently launched a liquidity program. Since Ripple Inc. owns about 2/3 of total XRP supply – with an implied valuation of $45-50B based on current spot prices – they are deliberately discounting their service at a significant rate to entice their customers to use XRP rather than BTC. This artificial liquidity is just – artificial. It will run out. This will maintain a floor of liquidity for XRP in the short term, but there’s just no way for this program to provide the liquidity necessary to exceed that of the global reserve.

Unfortunately for XRP holders, the probability of XRP becoming the global reserve just became substantially more difficult. The CBOE and CME – two of the world’s largest futures exchanges – just launched Bitcoin futures trading. The magnitude of this development cannot be overstated. This hinders XRP’s chances of becoming the global reserve currency.

For large financial institutions, the single largest problem with cryptocurrencies, other than perhaps custodianship, is price volatility. Futures can be used to hedge price risk. In the next few months, as these futures markets mature, banks will be able to buy and hold billions of dollars worth of BTC on their balance sheets while hedging out price risk.

Given this, why would any rational financial institution want to use XRP as the bridge currency to settle transactions? BTC now has two huge advantages: ~20x the liquidity, and a futures market that allows banks to hedge price risk while holding large amounts of BTC. XRP bulls counter that XRP offers faster settlements times and lower fees than BTC. This is true, but irrelevant. The value of liquidity and ability to hedge price risk are far more important than these two relatively insignificant technology details.

So why does XRP keep pumping? The team is one of the best in crypto. The venture capital investors backing Ripple Inc. are top notch. They continue to announce new banking partners. I fully expect these banks to use Ripple’s software, and experiment with XRP. But…

We maintain our position: in the long run, we’re bearish on XRP. We simply don’t see any series of events that can occur that would cause financial institutions to voluntarily adopt XRP over the global reserve. Having said that, given the state of crypto markets today, XRP could keep pumping. There’s really not a good objective valuation model for XRP given the intrinsic velocity problem that it faces, so it could 5x before our thesis is reflected in XRP price movements.

“In the short term, the market is a voting machine; in the long term, it’s a weighing machine.” – Warren Buffett

Update: Since posting this essay on Forbes, I’ve received some useful feedback on Twitter. It seems that I undervalued the the importance of fast transaction times for financial institutions. XRP transactions clear in seconds, whereas Bitcoin transactions can take an hour to achieve finality. The reason this is important as fast transaction times allow institutions to minimize price risk by holding as little XRP on their balance sheets as possible. If XRP comes to be adopted as many of its proponents argue, the value of the token should plummet as velocity increases. For more information about velocity, please see my essay, Understanding Token Velocity.