“Open Finance “ — open-source financial services infrastructure built on public blockchains — may be the next major digitization narrative after Fintech. Driven by the transformation of analog liquidity (deposits in a bank account) to digital liquidity (tokens in digital wallets), the playing field can be leveled for offering financial services. As a result, new profit motives are introduced encouraging innovations not previously feasible.
Technology disrupting finance is a narrative that’s existed for a long time. The dream has always been for tech to digitize financial services, increase competition/access, reduce concentration risks, and improve customer experience. Many sales-pitches have tried to achieve this: from FinTechs, TechFins, API / Open Banking, to Permissioned Blockchains.
While this decade-long lineage of innovation was transformative, it has not been disruptive. The playbook lacks imagination: copy and paste a financial system that’s been designed for the analog world, and then overlay digital interfaces to make it more accessible. As a result, it’s 2019, and while there has been progress, nothing really has fundamentally changed. Our attempts at customer-centric banking remain clunky, the unbanked are still unbanked, and we still have a system that is highly concentrated and not modular.
This article proposes that the more interesting innovation of the past decade has actually been developing right under our noses — hidden in plain sight. Public blockchains like the Bitcoin and Ethereum networks, have been progressively installed to challenge past narratives — starting with the availability of new open-source, public, self-governing, and globally accessible financial settlement infrastructure— aka “Open Finance”.
A wise person once said: “Insanity Is Doing the Same Thing Over and Over Again and Expecting Different Results”.
For this reason, it shouldn’t be surprising that previous digitization narratives have resulted in incremental but not disruptive changes. Once market participants expand their tunnel vision focus beyond the price of digital value issued on these blockchains (e.g. Tokens) it becomes possible to imagine a new financial services economy based on new constraints.
The focus of this article is to begin exploring very early innovations emerging that are only now possible — painting a picture for why Open Finance may eventually be the new FinTech.
The article is split into three sections:
- Section 1: Evolution of Banking and Liquidity in Open Finance
- Section 2: A Case Study of Open Decentralized Financial Services on Ethereum
- Section 3: Likely Beneficiaries of Open Finance
Evolution of Banking and Liquidity in Open Finance
In the traditional financial system, banks are granted a special role in the transmission mechanisms of money (liquidity) through the economy.
How does the money transmission mechanism work today?
Simplified schematic of value transmission mechanisms in the current financial services system
- Central banks moderate a nation (or set of nations’) money supply to achieve inflation (and sometimes employment) objectives. To do so, they use tools like setting interest rates, conducting open market operations and prescribing bank capital & liquidity regulations.
- Commercial banks operate under the Central bank to pool their country’s money by competing to aggregate deposits of it’s citizens. They then lend these aggregated deposits on a fractional reserve basis to create loans (credit), in a process known as maturity transformation. This exposes banks to a structural risk of borrowing short term and lending long term. To compensate for risks from this structural asset-liability mismatch, commercial banks are given two special privileges no one else gets: (1) direct access to the central bank created liquidity in an emergency; (2) deposit insurance.
- Investment banks (not technically a bank) issue various types of assets (e.g. IPOs, corporate bonds, etc. ). In doing so, they channel people’s bank savings into these assets. Some investment banks additionally perform bank-like activities like securities lending and borrowing — also known as (re)hypothecation. This practice often creates the same structural risk that commercial banks face (e.g. borrowing short, lending long). After the 2008 crisis, most investment banks on the brink of failing due to liquidity crises were forced to re-charter as commercial banks, so that they too could get commercial banking special privileges.
How does the bank transmission mechanism change in Open Finance ecosystems?
In a world where money transmission is not controlled by a network of banks, value can be transmitted in new ways not as constrained by physical borders. With Open Finance infrastructure, it is possible to design a system where money aggregates and flows in different ways.
- Fiat-crypto exchanges become the on-ramps that transform analog liquidity (e.g. fiat money sitting in a bank account) into digital liquidity (e.g. tokens sitting in a digital wallet). New entrants like Coinbase, or individuals themselves, become the de-facto banks in these new ecosystems. On the more conservative end, fiat can be converted into fiat-backed stablecoins (e.g. USDC, TrueUSD, etc.). In more novel approaches, fiat can be converted into digital non-sovereign cryptocurrencies (e.g. Bitcoin/BTC, Ether/ETH, Maker DAI stablecoin etc).
- Open-source infrastructure built on top of public blockchains facilitate the movement of this digital liquidity across (electronic) borders. Different public blockchain ecosystems will have their own set of financial services applications and protocols — depending on their governance beliefs and ideologies. For example, Bitcoin’s ecosystem is generally more conservative, and is focused on building layers of applications; while in Ethereum’s ecosystem, there is a prioritized focus on building applications using it’s Turing complete smart contract coding language (Solidity). This flexibility has both it’s upsides and drawbacks (a topic for another article).
What are the implications of Open Finance?
For the first time, there is the possibility to move liquidity from an analog world into a digital world, with minimal reliance on existing FS infrastructure (e.g. banks). Liquidity can pool and aggregate in different ways not constrained by physical commercial bank footprints and distribution networks (e.g. branches/ATMs). This erodes a long-term advantage that commercial banks have long held: a monopoly on cheap funding vis-a-vis deposits.
By attempting to re-define financial services from the core, longstanding conventional wisdoms about “how banking works” will change. The result is the possibility for something fundamentally new to emerge. This is why Open Finance may turn out to be a more disruptive digitization narrative than we’ve seen in the past.
A Case Study of Open Decentralized Financial Services on Ethereum
To get a glimpse into one possible future of digital financial services, an interesting place to look is the Decentralied Finance ecosystem (#DeFi) being built out on the Ethereum blockchain.
Decentralized financial services applications built on top of Ethereum use it’s blockchain as a global, universally accessible, open-source and 24/7 accounting ledger. Entries on the ledger (e.g. who owns what, at any given point in time) are maintained through the use of a Proof-of-Work (PoW) consensus mechanism similar to Bitcoin’s (at least for the moment).
A walkthrough of the DeFi ecosystem on Ethereum
Ethereum’s DeFi ecosystem starts with a traditional bank account. Fiat money (e.g. USD) is exchanged for the corresponding currency used in the “Ethereum economy” (e.g. Ether / ETH). Conceptually, this is not different to any other form of foreign exchange. In the analog economies of the world, when someone travels from one country to another, they too need to exchange their home currency for their destination currency. In digital economies , the destination is not a physical country, but a digital one.
Entry into this digital world / jurisdiction is made possible through blockchain interfaces and the internet (e.g. Metamask browser). From here, consumers can directly access financial services without ever touching a bank. Some real-live examples are described below.
- Stablecoins: a consumer can self-access a stable value index collateralized by fiat or other digital forms of value. Depending on the country this person lives in, this can be a significant upgrade over the local currency. Examples include: MakerDao’s DAI (crypto-native), Circle’s USDC (fiat-stablecoin), and Trust Token’s TrueUSD (fiat stablecoin).
- Lending: a consumer can self- access loans (of any size theoretically) by pledging digital collateral. Examples include: MakerDao’s CDPs, Dharma’s lending services, Compound’s borrowing pools.
- Asset management: a customer can self-access funds / portfolios tracking a variety of new and traditional underliers (e.g. utility tokens, tokenised securities, wrapped Bitcoin, etc). Examples include: Melonport’s asset management platform, Compound’s money-market funds, Iconomi’s crypto indices.
- Derivatives: a consumer can self-access derivative markets to create long/short positions on various outcomes. These can be for risk management or levered speculation. Examples include: dy/dx’s margin tokens, CDX’s exchange credit default swaps (a crypto version of bank deposit insurance), and Augur’s various prediction markets.
- Issuance: a customer can (generally) self-issue tokenised assets through investment bank like issuer platforms. Where the issuance involves a real-world asset, the issuer may need to adhere to local regulations (e.g. assets issued representing a US domiciled asset may need to adhere to US laws). Examples of issuance platforms include: digix (Tokenised gold, vaulted in SG), Swarm (securities tokens following US laws), and Polymath (Tokenised assets with programmable cross jurisdiction regulation).
Likely Beneficiaries of Open Finance
The ultimate beneficiaries in the world of Open Finance will likely be consumers, and by extension, the financial services providers who choose to adapt to this new paradigm. However, the sustainability and degree of success for new business models will be predicated on continued maturity of two nascent Open Finance-enabled paradigms:
- Leveled playing field and lowered barriers to entry for financial services. In a world with Open Finance, anybody with an internet connection can theoretically plug into an ecosystem of open financial services protocols (e.g. DeFi), built on public global settlement infrastructure. As long as this remains true, anyone can extend their business offerings to include financial services without much fixed cost investment — just OpEx to use the protocols.
- Increased competition for liquidity creating a profit motive for innovation. Most people don’t realize that when they deposit cash at a bank, they are essentially *investing* their money with them. The fact that most banks pays a similar interest rate to it’s customers, suggests that the counterparty risk should be the same across all banks. This could not be farther from the truth. As we saw in the crisis, bank risk differs greatly (depending on geographic footprint, products focus, underwriting competency). Most rational investors demand higher returns, if they are exposed to higher risks. The only place where this does not hold true is in commercial bank deposits. If access to liquidity continues to be democratized, new blockchain-native offerings can compete on a more level playing field, passing along efficiencies to customers (example below). A world with increasingly digital liquidity creates a profit motive for innovation.
In the above hypothetical example, Open Finance offers the possibility to use shared infrastructure to dramatically lower technology and operation costs. Furthermore, with liquidity being digital, costs associated with physical distribution (e.g. branches, ATMs) can also be lessened. This creates the possibility for modular financial services offerings to focus on high-value activities (e.g. underwriting) while passing along all cost savings to savers in the form of higher interest rates.
In practice, trying to guess exactly which new players and business models emerge, and win, will be difficult. It is very possible for innovative business models to come from both incumbents (banks, wealth & asset managers), through to new startups and non-banks. The underlying drivers of change are the same.
As both incumbents and startups become increasingly comfortable with the new paradigm, along with regulators and policymakers who begin to grasp the economic game theory associated with public blockchains, the conditions for Open Finance inspired innovation will flourish.
Reminding ourselves of the above quote: only by by doing something different, can one expect a different result. It will be exciting to see the new innovations — many of which we can’t even imagine — built on this new world of Open Finance.