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If you hold an IOU from a gateway for $1,000, there's a good chance you'll be able to pay that to nearly anyone at very close to face value. If you have an IOU from some random guy for $1,000, you may not be able to find any payment path to people you want to pay and no payment path to a gateway if you want to cash out.

Isnt that a huge flaw in the system? That the one $1,000 can has less value than the other $1,000, based on who the debtor is. The whole power of Bitcoin is that all coins have equal value, and to preserve that philosophy they will never allow tainted-coins.

But with Ripple it looks like my wallet can show $1000, but based on the 'taint' its real value can be as low as $50.

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Maybe the title should be changed to something more clear like "Are Ripple IOUs fungible?" or "Are Ripple IOUs with the same denomination worth the same?" –  jtimon Mar 5 '13 at 15:17
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That's just reality. IOUs will be valued differently depending on who you got them from.

You probably value $100 in cash higher than the fact that your friend Joe owes you $100. You can use the cash right away while you have to wait for Joe to pay you back or you could transfer that debt to some common friend of you and Joe's (a friend who is fine with Joe owing him $100).

Now compare it to having $100 in a bank account at your local bank (i.e your local bank owes you $100). You'll probably value that a bit higher than having Joe owe you $100 since it is easier to instantly transfer it to your friends that have accounts at the same bank.

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You're definitely right that tainted coins would be bad for Bitcoin. For something to be useful as a medium of exchange, you really want it to be fungible. If something costs $35, that price is useful because there's nothing special about any particular bill or coin and you can form that $35 however you want.

Since not all IOUs in the same currency are fungible in Ripple, Ripple needs a mechanism to keep the IOUs useful for payment. It does this by allowing each user to specify what issuers they trust and using robust pathfinding to make payments possible.

This mechanism would be needed in Ripple even if all IOUs in the same currency were fungible. Ripple supports cross-currency payments, so it has to find payment paths in case someone who holds only dollars wants to pay someone 50 Euros.

So IOUs not being fungible across issuers is no more a problem for Ripple than IOUs not being fungible across currencies. So long as everyone trusts at least one major gateway and there are paths between all combinations of major gateways, payments will be possible. And Ripple has a few features to try to encourage this end result. So this problem doesn't really affect Ripple's utility as a payment system, and that's how Ripple is being promoted.

However, this still leaves two areas of potential problems. One is using Ripple as a store of value when issuers may change in reliability. The other is reporting a useful balance when your asset portfolio may include IOUs of different value even if denominated in the same currency.

The first problem is just the nature of the system. If you choose to trust an unreliable issuer, you may wind up with worthless IOUs. The very risk averse could respond by not using Ripple as a store of value.

We hope to get at least one regulated financial institution, preferably insured by a major government, to be a Ripple gateway. Ripple gateways hold funds denominated in ordinary fiat currencies, all of which they owe to others. This is analogous enough to what banks do that there's a good chance this can be accomplished.

The second problem is mostly a user-interface issue. Since Ripple is open source -- the client code is already available -- people are free to try different ways of resolving this. One method that has been discussed is listing assets separately (and not in the raw total) if you dropped the credit limit to zero.

So if you don't trust an issuer, you drop their credit limit to zero. This will cause you to start shedding their IOUs automatically as people use you as a payment path and you can't acquire any new IOUs from them. The client could show IOUs from issuers with zero credit limits separately and not include them in the total.

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The strength of Bitcoins is that it is really P2P and zero-trust. With Ripple I need to trust at least one major gateway to keep my coins safe. Isnt that a step backwards? –  Muis Feb 16 '13 at 16:18
    
@Joshua: With Bitcoin you can only store bitcoins. With Ripple you can "store" anything, but it's a lower grade of storage. (And you can store XRP securely.) –  Meni Rosenfeld Feb 16 '13 at 17:00
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@Joshua: Every system has tradeoffs. And Bitcoins really isn't zero trust -- for example, you have to trust that 51% of the mining power won't wind up in the hands of a malicious group, you have trust that Bitcoin users won't get together and agree to change the block reward, you have to trust that people won't to decide to replace Bitcoins with something else tomorrow and render your store of Bitcoins worthless, and so on. –  David Schwartz Feb 17 '13 at 23:15
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All existing conventional securities (currencies, stocks, bonds, debt-based "fiat" cash, etc) that have any counter party risk are "tainted" by the issuer (Apple, The Fed, BOJ, etc), Bitcoin, gold, silver, etc are not tainted because they have no issuing counter party (i.e. they represent nobody else's liability). As I understand it, Ripple is primary a system for exchanging IOUs denominated in various other "units", it helps facilitate transactions that would not otherwise take place because they don't require an intermediate "trusted" asset between the trading parties, but are conducted instead in self-issued credit. So in a sense everything in Ripple (except XRPs) is "tainted" by design, but that's OK as long as most of the time most of the transaction circuits are closed and eventually extinguished.

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