Is Decentralized Finance the Future of Open Finance?


Is Decentralized Finance the Future of Open Finance?

Open Finance is considered a significant trend in the financial industry. In parallel, based on technological developments, a trend toward Decentralized Finance (DeFi) has also become established. Due to their similar goals, it is worth considering the concepts of Open Finance and Decentralized Finance in an integrated way. The main differences between the concepts lie in the technology used and the system of governance. Depending on the use case and customer type, the needs for the involvement of intermediaries are different. Therefore, coexistence of the different concepts is expected to be the future, which spurs a focus on their interoperability. Platforms offer ready-to-use solutions and help reduce complexity for market participants.

Open Finance describes the exchange of data and services between financial institutions (e.g., banks and insurance companies) and third-party providers via available and published interfaces, e.g., Open APIs, whereby the exchange can take place in both directions. On the one hand, this includes opening up financial institutions and parts of their data, which currently typically relates to account and deposit information as well as payment transactions, by providing interfaces for trusted external third-party providers such as FinTech companies. On the other hand, financial institutions can also act as recipients of data and services from third-party providers as part of Open Finance.

Alongside Open Finance, Decentralized Finance (DeFi) has increasingly emerged as a trend driven by technological advances in Distributed Ledger Technology (DLT). DeFi describes the merging of the traditional financial industry with DLT to create trustworthy and transparent systems based on protocols that do not require intermediaries like financial institutions. The products and services offered are based on smart contracts, whereby predefined rules are automatically and independently enforced, and all corresponding data is stored by a distributed ledger platform (e.g., blockchain). DeFi solutions can be found in all areas of finance, such as lending, payment, trading, investment management and insurance.

It is worth considering the concepts of Open Finance and Decentralized Finance in an integrated way, as they differ only slightly in reality, pursue similar goals, and are also partly interrelated in their functioning. In general, Open Finance and DeFi represent two different approaches of open ecosystems for the financial sector. The following graphic provides a structured overview of the different concepts and participants in an integrated architecture.

The architecture distinguishes between five horizonal layers, which can be interconnected by means of an Application Programming Interface (API) environment (lines shown in magenta). The first layer represents the customer. The front end is the interface between the customer and the providers of financial products and services. The front end can be provided by a bank, an insurance company, a FinTech, a BigTech, or a retailer, for example. The third layer represents Execution & Custody: The execution of the products and services offered as well as the custody of related assets is often not directly covered by the front-end provider but by another party. In the case of Open Finance, this is typically done by banks, but alternative platform providers such as crowdfunding platforms can also take over this role. This is where the biggest difference with DeFi becomes apparent, as with DeFi the execution and custody are based on a DLT protocol. The systematic handling of data, as a fourth layer, forms the basis for open financial ecosystems. This includes the storage, analysis, and processing of data for the provision of financial products and services. The fifth layer describes the necessary physical infrastructure. The four vertical layers on the right-hand side of the architecture diagram describe the degree of standardization of the APIs that enable the interconnectivity of participants and the different layers of an open financial ecosystem.

And Not or: Connectivity and Interoperability Will Be the Future

Customers and thus front-end providers want access to traditional financial institutions, in the sense of Open Finance, but also to peer-to-peer solutions without intermediaries in the sense of DeFi. Providing this connectivity and interoperability is challenging, but this could be simplified through platform solutions, because they reduce the number of interfaces and improve the degree of standardization. In the Open Finance area, bLink and in the DeFi area Ethereum could be mentioned as examples of such platforms. The first bridges between the two worlds are being built with fast progress, albeit with strict regulatory controls.

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This blog based on a chapter from the 2021 IFZ FinTech study , and is supported by Finnova, Inventx, SIX, Swiss Bankers Prepaid Services, Swisscom, and Synpulse.