March 13, 2020
The current game is broken
The current financial system is broken, but not in the same way that a watch or vase may be. For the latter, cracks are at least visible from the outside. For the average financial citizen, such fissures may at first be too subtle to escape notice.
Little things are telling. Long queues at the bank, tedious layers of bureaucracy, having a request denied on a technicality after countless forms - the everyday experience with the financial system is built on familiar scenes of various, small inconveniences which allude to opaque inefficiencies behind the counter. These hairline cracks widen when things go very, very wrong. The financial crisis of 2008 illustrates the systemic risk when things spiral out of control, exposing the danger inherent within the existing financial order.
At the other end of the spectrum, there are those who remain invisible and unseen, who intuitively understand the exclusionary nature of a truly broken financial system. Close to 2 billion people, referred to as the unbanked population, continue to reside globally today. Truth is, not everyone wins the geographic lottery, and for those who don’t, basic financial services can be a distant dream.
Open Finance as a whole
The ultimate objective of the global financial system is to facilitate the exchange of funds or value between those who need it, such as the borrowers, and those who are able to provide it, such as lenders and investors. With many intermediaries in this process, the challenge is to figure out the shortest path for value to flow efficiently from Point A to Point B.
(Existing financial pipe game on the left, Open Finance pipe game on the right)
In many ways, finance can be simplified into a pipe game, with value flow circulating constantly within the system. With the rise of Open Finance, the same pipe game becomes freely reshuffled, capturing the potential upside of an emerging financial movement. This will be elaborated upon in the later part of this article.
Let’s delve deeper into the term ‘Open Finance’. We view this as the suite of financial applications and services that are built on top of open infrastructure, with the common goal of enabling free participation by any individual in the wider financial ecosystem. Open Finance is not about giving the middle finger to the archetypal big bad bank, but instead about the creation of a borderless system democratizing access to the financial ecosystem. With its promise of economic mobility, anyone anywhere can create a savings account, apply for loans, or purchase insurance.
Often characterized as Money Legos, Open Finance’s permissionless nature allows new, innovative applications to be quickly built on top of existing ones by anyone. Services are decentralized and trustless, bypassing centralized third parties such as banks and therefore minimizing custodial risks. An element of interoperability also allows financial value to be transferred more easily and efficiently between various parties. Much of the innovation is currently being developed on the Ethereum blockchain, a decentralized, permissionless protocol.
How will Open Finance play out?
To better understand how Open Finance can achieve its vision, let’s zoom in to the pipe game again. There are 3 key objects involved in the “financial pipes”:
However, each of these objects have certain restrictions that prevent the successful facilitation of value exchange for specific segments of the population:
Pipes: Permissioned vs Permissionless
Significant barriers prevent the underbanked population from accessing financial services. A large reason for this is simply the cost of “laying down the pipes”. Financial institutions often find that building the necessary infrastructure to tap into this population may be neither cost-effective nor feasible. Hence, pipes are not “permissionless” if they are unavailable and inaccessible to begin with. At the same time, players who manufacture their own pipes to connect to the larger pipe system may find that they are unable to do so. New entrants looking to contribute to the ecosystem must first seek permission from existing players, modify their pieces accordingly before being allowed to link up.
Under Open Finance, pipes no longer discriminate against any segment of the population, and are permissionless and agnostic. The only prerequisite to joining this ecosystem then is the ownership of a mobile phone equipped with an internet connection. Small businesses in developing countries often have trouble securing loans, but blockchain-native platforms such as MakerDAO and Compound offer a new way to borrow USD-pegged stablecoins such as DAI or USDC. Agnostic pipes also bring about an increased speed of innovation, since anyone can build new products and services on top of existing ones simply by connecting their own pieces. MakerDAO’s DAI stablecoin has already been integrated into most lending platforms, and new players can do the same without seeking permission from any authority.
Valves: Many Intermediaries vs Few or No Intermediaries
In traditional finance, intermediaries such as financial institutions play the role of controlling the valves. They decide if value flows should be allowed in, and where to direct them. Fees are charged in return for these services, ranging from insignificant to exorbitant percentages, and sometimes even hidden. These can be seen as “leakage” of the original value flows, since the transaction journey retains less value upon reaching Point B from Point A.
While intermediaries bear significance in the current system, they can also represent centralized points of failure. As pipes handle increasing volumes, this could eventually lead to them ‘bursting’ in defaults or security breaches, resulting in the loss of assets held in custody. Intermediaries are in a position to influence the types of financial content that can exist, subject to societal and political pressures. WikiLeaks, for example, while pursuing worthwhile whistleblowing attempts, faced a bank blockade led by Visa, Mastercard and Paypal, who cut off funding to the website.
Open Finance offers a decentralized alternative, which replaces the valves with open-source code run on blockchain, where users are no longer reliant on traditional institutions. This form of Open Finance reduces the risks of financial censorship, and lowers fees that are often transparent and flat.
Fluids: Low Viscosity vs High Viscosity
Value comes in different forms and asset classes. In turn, fluids vary in viscosity i.e. their resistance to flow. When borrowing and lending in domestic markets, fiat works well enough as the “fluid” of exchange, and the process is relatively straightforward. In developed countries, for instance, assets like real estate can be used as collateral for mortgage loans. However, in countries in Southeast Asia or Africa, a farmer may find it significantly more challenging to obtain short-term crop loans using their land as collateral. To put it simply, the types of pipes that transport oil and gas differ from the ones used for transporting water. The task of transporting all these different fluids at once would seem impossible. If additional costs are required for any transaction to occur, certain types of value transfer are neither as feasible nor efficient as others.
In Open Finance, tokenization means that real-world assets can be represented in the form of a digital token, carrying the same properties. Real estate tokenization, for example, allows for fractional ownership of assets that was not possible before. Currently, investors can purchase fractional ownership of properties tokenized by the RealT platform on Uniswap, a decentralized exchange. They receive daily rental income that is higher than before, as collected income can accrue interest in Compound while waiting for distribution. The same logic extends to more complex and unconventional forms of asset ownership, such as art, coffee, or even limited edition sneakers.
In the future, a farmer could potentially tokenize his land into LAND tokens and successfully feed them into the financial pipes, exchanging them for ETH on Uniswap, which can then be used on MakerDAO as collateral for minting new DAI. This allows said farmer to receive a short-term loan using an asset that may have previously been incompatible with the conventional financial pipe system. With tokenization, the value of assets owned by the disenfranchised can be unlocked, providing them smoother access into the Open Finance ecosystem.
Is Open Finance a pipe dream?
Despite the lofty vision and the broad possibilities that have been explored throughout this article, it is true that Open Finance is still very much a work in progress. There are numerous, significant challenges yet to be overcome. Issues such as the current need for over-collateralized loans and the lack of identity solutions are some examples, along with technology risks emerging with the reliance on smart contracts and code.
Along the way, we have seen first hand the groundwork going into building this ecosystem, and many of these innovations are already live and ready to be utilized. Open Finance on the Ethereum blockchain ecosystem recently hit a milestone of $1 billion of value locked up in February, and this is only the beginning. The Open Finance market will undoubtedly be constantly tested, and while setbacks are expected, the community has assuredly come out stronger and more resilient each time.
For now, here are some of the transactions you can perform with Open Finance.
1. Convert your fiat into ETH through gateways such as XanPool or Changelly
2. Send your ETH to a Web3 wallet such as Metamask, and connect it to InstaDApp for easier management and interaction
3. Swap your ETH for DAI stablecoin through Uniswap (which is also already integrated on InstaDApp)
4. Lend out your DAI on Compound to begin earning approximately 8% interest rate
5. Swap your DAI for sUSD on Uniswap, and buy sXAU on Synthetix for exposure to gold
Although the above are still far from the outlined vision of Open Finance, they represent the baby steps that will one day bring us to our final destination. With enough time, as the community continues to build and connect, we just might see an interconnected pipe system that serves every single one of us.