Thanks TradeFortress, I think you're doing everyone a service by getting them to take a hard look at how ripple works.

I was just at the bitcoin conference, and I had at least a dozen conversations about ripple. Pretty much none of the people I spoke with understand it. Even some of the guys in the ripple booth (though they were courteous and eager to help), got stumped on some issues.

My primary concern with ripple is exactly what TradeFortress has just demonstrated. Ripple IOUs have different values based on the issuer. If they traded on an open market, you would see this. IOUs for a trusted institution are worth more than IOUs for a less trusted one. E.g. you might see Bitstamp USD IOUs trading against Weexchange IOUs at a non-1 rate, such as 1.1.

But we don't see that in ripple (as far as I can tell). Instead, we see a markets labelled by the currencies only, such as USD/XRP. But whose USD? Where's the Bitstamp USD / Weexchange USD market?

The fact that default risk fluctuates is acknowledged by participants in the real financial markets. We have credit markets. The values of various entities' credit float against one another. They are not all the same.

When I posed this question in the ripple booth yesterday, here is the (paraphrased) answer I got:
me: "So what's up with this automatic liquidity providing, given that some IOUs are more valuable than others? Couldn't we have a 'bank run' type situation when a gateway starts to look like they're in financial trouble, and innocent ripple users who happened to be 'asleep at the wheel' at the time wind up holding all the bad debt?"

ripple employee: "Good point. I think that the protocol supports setting a price at which you are willing to exchange a certain issuer's IOUs for another issuer's. It doesn't have to be 1:1. I think the client just doesn't support this yet."

me: "Okay, cool. But does it have to be a fixed amount or is there some kind of floating rate?"

ripple employee: "I think it's just a fixed amount."

Needless to say, I was not particularly impressed by this answer.

Honestly, I expect to be wrong about this, because there are seemingly a lot of smart guys involved and they really seem to have strong technology. Can they really have missed some basic facts about how markets work? Na, probably I missed something. But I'm definitely not betting on it until I hear a satisfactory answer.