Stellar: the Ultimate Guide
In cryptocurrency, imitation is the sincerest form of appreciation. This is true even when the imitation comes from one of the creators of the original concept. News that Fidelity Investments may embrace the Stellar blockchain as the backbone of its crypto assets business has not only had XLM rise against the current bear market but return in conversations about its relevance against Ripple. This is following news of IBM officially launching its money transfer business on the Stellar protocol and denied rumors that Facebook is seeking a partnership with Stellar.
This article will look at what Stellar is and how it works.
“Financial infrastructure is currently a mess of closed systems,” the Stellar Consensus Protocol whitepaper reads. “Gaps between these systems mean that transaction costs are high and money moves slowly across political and geographic boundaries. This friction has curtailed the growth of financial services, leaving billions of people undeserved financially.”
“To solve these problems, we need financial infrastructure that supports the kind of organic growth and innovation we’ve seen from the Internet, yet still ensures the integrity of financial transactions. Historically, we have relied on high barriers to entry to ensure integrity. We trust established financial institutions and do our best to regulate them. But this exclusivity conflicts with the goal of organic growth. Growth demands new, innovative participants, who may possess only modest financial and computing resources.”
“We need a worldwide financial network open to anyone, so that new organizations can join and extend financial access to unserved communities. The challenge for such a network is ensuring participants record transactions correctly. With a low barrier to entry, users won’t trust providers to police themselves. With worldwide reach, providers won’t all trust a single entity to operate the network. A compelling alternative is a decentralized system in which participants together ensure integrity by agreeing on the validity of one another’s transactions. Such agreement hinges on a mechanism for worldwide consensus.”
Stellar is a non-profit digital currency to fiat currency money transfer protocol. Created in 2014 by Ripple co-founder and founder of Mt Gox Jed McCaleb and former lawyer Joyce Kim, Stellar is ran by the Stellar Development Foundation – which was formed in collaboration with Stripe CEO Patrick Collision and with $3 million in seed funding from Stripe.
While Stellar is like Ripple in many ways – as they are designed to simplify cross-border payments – there are notable differences. Both are centralized blockchains based on open-source software. Stellar’s blockchain software, however, remains open-source, while Ripple is proprietary. Ripple is a for-profit company, while the Stellar Development Foundation is non-profit.
The token for Stellar is the Lumen (XLM), compared to XRP for Ripple. Like Ripple, while Lumens can hold value as a tradeable asset, they work on the Stellar platform as a transfer token. Fiat currency is exchanged for a Lumen, which is moved through the blockchain from one connected bank to another. Once the Lumen reaches its destination, it is converted back to the fiat currency. It is akin to buying a money order and sending it by mail to its destination; the actual fiat currency never crosses border, so thee is no fear of entanglements.
This is important because real-time gross settlement and payment is a problem-full area for global commerce. If you were to transfer money over a global money network, such as that of a major credit card or a transnational bank, the money transfer would be as simple as an email from the source to the destination. However, if you were to send money across multiple nations, shenanigans can occur. The reason for this is that each network has its own processing fees, processing schedules, and tracking and verification methodologies. Cross-network payments (correspondent banking) can take days or weeks to process, can have excessive fees, and can – on occasion – be lost entirely.
“Over the last few decades, there has been a steady rise in global businesses and international trade along with diaspora contributing to an increase in intricate cross-border payments,” according to NASDAQ. “Cross-border payments account for about 40% of global payments transactional revenues with payment flows of more than $135 trillion during 2016 (as per McKinsey).”
“However, the current protocol suffers certain shortcomings, such as non-fixation of exchange rate until arrival of funds. Further, involvement of multiple financial institutions creates a complex web of procedures resulting in delays and inaccuracy in addition to accompanying fees and charges at each stage of transaction.”
“One crucial limitation of the system is its inability to cater to the unbanked population (38% according to the World Bank data) as well as those residing in regions where Corresponding Banking Relations (CBRs) have been withdrawn (such as Caribbean region). A report by IMF analyses such exodus, it highlights the fact that, ‘the cost of services has increased substantially, some services have been cut back, and some sectors have experienced reduced access.’”
Blockchain and crypto have already been implemented to help resolve this. SWIFT, the world’s largest interbank payment network, has embraced a blockchain-based messaging service to track international payments. This, however, does not solve the “handover problem” where the payment is being handed to multiple banks on its way to its destination. The SWIFT solution only places a marker on where the payment is at on its track.
Using Blockchain to Solve the World’s Problems
This begs the question. If the current system is so fraught with problems, why don’t the banking community just move to blockchain for cross-border payments? The truth is that there are no “real” blockchain solutions to the problem.
Let’s look at Ripple. A defining factor of Ripple is that users must trust the system to protect deposits and to ensure settlement.
“Like Bitcoin, Ripple is comprised of both a payment protocol and a native cryptocurrency (XRP),” Let’s Talk Bitcoin explains. “There will only ever be 100 billion XRP in the network. XRP serves two functions in Ripple: it’s primary function is as an anti-spam mechanism to prevent attackers from overwhelming the network with useless ledger entries, and it’s secondary function is as a bridge currency. Despite having this native cryptocurrency, Ripple is currency agnostic. Any user running the rippled software can issue new currencies as a Gateway and trade in any currency available on the Ripple network. It’s up to each Gateway to earn the trust of other nodes in the network if they expect others to use their currency.”
“Trust is the backbone of the Ripple network. If a user wants to hold a balance issued by a Gateway, the user must first create a trust line for X amount of currency from that Gateway. For example, if I want to be able to accept payments up to $100 from ABC Gateway, I must first create a $100 trust line with them. Since creating a trust line is a ledger entry, it costs a small amount of XRP. Users will only accept balances from Gateways they have trust lines with. If no trust line is present, the Ripple network uses its pathfinding algorithm to automatically find a payment path between Gateway A, which User A trusts, and Gateway B, who User B trusts. This ability to set trust levels, perform distributed currency exchange, and only hold balances from Gateways one trusts is what sets the Ripple network apart from other attempts at decentralized exchange and why I believe Ripple is poised for success.”
“Where Bitcoin uses a blockchain and proof of work to generate new currency and provide security to the payment network, Ripple uses a global ledger and consensus. Consensus occurs approximately every 5 seconds as all of the ledger validators come to an agreement regarding the current state of the Ripple ledger. The benefit of using a ledger and consensus rather than a blockchain and proof of work is that payment confirmations happen as fast as consensus occurs. The downside is that the native currency XRP was created not one block at a time, as in Bitcoin, but rather all up front by the developers of the protocol. Ripple Labs is addressing the challenge of distributing XRPs by giving them away to early adopters, developers, and charities. The founders are keeping 20% of the total XRP for themselves as a reward and incentive for developing the network. The rest will be distributed over time through sales and giveaways as the currency gains value.”
As Ripple used a distributed ledger as an intermediary for payment and settlement before transactions reach the blockchain and because user trust is a mandatory ingredient in the recipe, Ripple cannot be called a true crypto payment solution.
The key to Stellar is that there is no need for trust as the fiat to crypto part of the conversation is handled outside the Stellar ecosystem. A user set up an account with the number of Lumens he/she wishes to transmit. The account is stored on a ledger that is unique to the servicing server. The user then starts a transmission, which change the state of the account by spending the “transmitted” amount and the fee. Every three to five seconds, the system attempts consensus, where the servicing server contact the receiving server and make a request for the Lumens to be “deposited.” Once the receiving server verify that the request is valid, it add Lumens to the receiving account, settling the transaction.
“Actions that change things in Stellar, like sending payments, changing your account, or making offers to trade various kinds of currencies, are called operations. In order to actually perform an operation, you create a transaction, which is just a group of operations accompanied by some extra information, like what account is making the transaction and a cryptographic signature to verify that the transaction is authentic,” the Stellar FAQ reads.
“If any operation in the transaction fails, they all fail. For example, let’s say you have 100 lumens and you make two payment operations of 60 lumens each. If you make two transactions (each with one operation), the first will succeed and the second will fail because you don’t have enough lumens. You’ll be left with 40 lumens. However, if you group the two payments into a single transaction, they will both fail and you’ll be left with the full 100 lumens still in your account.”
“Finally, every transaction costs a small fee. Like the minimum balance on accounts, this fee helps stop people from overloading the system with lots of transactions. Known as the base fee, it is very small—100 stroops per operation (that’s 0.00001 XLM; stroops are easier to talk about than such tiny fractions of a lumen). A transaction with two operations would cost 200 stroops.”
“You don’t actually need to do anything to receive payments into a Stellar account—if a payer makes a successful transaction to send assets to you, those assets will automatically be added to your account.”
“However, you’ll want to know that someone has actually paid you. If you are a bank accepting payments on behalf of others, you need to find out what was sent to you so you can disburse funds to the intended recipient. If you are operating a retail business, you need to know that your customer actually paid you before you hand them their merchandise. And if you are an automated rental car with a Stellar account, you’ll probably want to verify that the customer in your front seat actually paid before that person can turn on your engine.”
While neither Ripple nor Stellar offer true crypto money transfer, both present a way forward toward breaking the correspondent banking system breakdown that threatens international commerce. It is unclear if one technology will win out over the other or if either have enough appeal to dethrone SWIFT.
However, as new groups and companies sign up to try Stellar, Stellar bears light on what is important about this moment in time: we are on the cusp of a technological revolution. While we are not sure what form that will take in the future, we are sure that we will be able to use it to solve the world’s problems. That gives hope to the prospect of the future world.