DeFi and the Rise of Open Banking
Table of Contents
Introduction to Blockchain and Smart Contracts
Decentralized Finance (DeFi)
2.1 Definition and Goals
2.2 Challenges and Criticisms
Open Banking
3.1 Concept and Origins
3.2 Comparison with DeFi
Intersection of Open Banking and DeFi
4.1 The API Connectivity Problem
4.2 Solutions and Future Prospects
Conclusion: Towards a Standardized Ecosystem
1. Introduction to Blockchain and Smart Contracts
Blockchain technology has taken the world by storm, since its inception in 2008 as an underlying ledger for the mother of all cryptocurrencies, Bitcoin. Bitcoin famously solved the double-spending problem of digital currencies, creating a decentralized payments system that is both efficient and censorship-resistant. However, blockchain only gained massive adoption as a technology after Ethereum was created.
Ethereum introduced smart contracts; digital agreements deployed as programs on a blockchain, with terms written directly into the contract code. A unique benefit of smart contracts lies in their ‘self-executing’ nature, as they’re intended to automatically execute all or parts of the agreement when the terms are met. As such, they eliminate the need for a trusted third party, thereby promoting transparency, decentralization and efficiency.
Smart contracts unlock limitless possibilities by creating an open economy on the blockchain. In this new economy, assets of all classes — including tangible, real-world assets — can be traded and, even better, transactions are transparent, trustless and conducted for a fraction of the cost. This new economy is now popularly known as Decentralized Finance (DeFi).
2. DeFi
2.1. “DeFining” DeFi
In and of itself, DeFi represents a collective movement of financial solutions and open protocols designed to unlock the full potential of blockchain technology. DeFi aims to make it easier, faster and cheaper for anyone, anywhere in the world to access the finance industry.
2.2. Challenges and Criticisms
DeFi has been on a roll since 2019, however, the current landscape is far from perfect. The fledgling DeFi space is rife with several fundamental issues (like scalability, market volatility, smart contract vulnerabilities, etc.) All these contribute to a poor user experience, particularly for traditional investors looking to venture into the space.
The sad truth: DeFi projects are sometimes guilty of false advertising. Worse still, some experts have argued that most of these projects might not be as “decentralized” as they claim. This makes food for thought, especially considering the fact that developers of most protocols usually retain some form of power on a basic level and the protocols themselves typically rely on centralized (read: inaccurate) data sources. Without the former, they wouldn’t be able to do “damage control” if the protocol was ever under attack.
Even more, it can be said that DeFi’s obsession with decentralization — in reality, the protocol (developer) maintains control — has led to a grave oversight of the key challenges it initially set out to address. As a prime example, the governance token became popular among most DeFi protocols to give power back to the users, while these protocols continued to suffer from other equally pressing issues like flash loan attacks, poor UX, smart contract exploits among others.
As a result of these drawbacks, a new global movement known as open banking is steadily gaining popularity, driven by the core philosophies of decentralized finance.
3. Open Banking
3.1. Concept and Origins
Open banking is a major innovation driver in the financial services industry. According to global accounting firm EY, open banking is poised to “change how consumers engage with their banks and financial services providers, introduce new channels and promote innovation and competition in financial products.”
Open banking was first introduced in 2015 through Europe’s payment services directive 2.0 (PSD2). At the time, the novel concept was more of a paradigm shift than actual technological advancement in the finance industry. More specifically, it radically changed how banks view customers’ financial data: a treasure trove they could harness to better serve them.
Although financial providers now value customer data, the open banking movement puts the customers in the driving seat regarding their data privacy. For instance, the PSD2 enforces banks to disclose to customers what data they’re collecting from them, and how it will be used.
By definition, open banking is a novel financial movement driving financial services providers — banks, mainly — to open up their existing infrastructure, making it easier for third-party providers (FinTech companies) to offer these services through API endpoints.
This has the added benefit of promoting healthy competition between financial providers to develop innovative financial solutions, improve transparency and lower costs so users can make better financial decisions. In the United Kingdom alone, over 2.5 million residents and companies enjoy a variety of FinTech solutions to help them improve their financial lives.
3.2. Comparison with DeFi
In the open banking setup, customers would typically have to grant banks access to anonymized financial data, and this information would then be securely shared with third parties. However, open banking is solely based on existing centralized infrastructure and fiat currency. In contrast, DeFi applications rely solely on blockchain’s smart contract functionality and crypto assets to eliminate intermediaries and democratize access to user data.
It should be noted that DeFi was never meant to “kill off” centralized finance — as some would argue. Rather, it was created to unlock the possibilities of traditional financial solutions by making them accessible in a decentralized, trustless environment. Open banking makes this possible by providing a robust regulatory and legal framework aimed at pushing the boundaries of decentralized finance without its decentralized component.
In the next section, a case is made for how DeFi intersects with open banking, with a brief look at one of the global collectives making this intersection a possibility.
4. Intersection of Open Banking and DeFi
4.1. The API Connectivity Problem
At this point, it’s clear as day that open banking and DeFi share numerous similarities, even though they remain fundamentally different.
Open banking walked so DeFi could run, as protocols are becoming increasingly focused on interoperability and less on trust — and rightly so. In the wake of Ethereum’s scalability challenges, several other smart contract blockchains (Internet Computer, Solana and Polkadot, for instance) have worked to bring DeFi onto their networks.
Just as with Web 2.0, there’s a booming ecosystem of FinTech products on Web 3.0. However, blockchain-based FinTech providers have limited access to “off-chain” financial data (i.e., open banking data). Dubbed the “API connectivity problem”, this disconnect is largely responsible for the flawed narrative that DeFi will eventually replace centralized finance.
4.2. Solutions and Future Prospects
The API3 foundation merges open banking with Web 3.0 to enable the development of enhanced financial solutions adopting the open banking philosophy on the blockchain. To achieve this, API3 provides secure, decentralized oracle data feeds operated by the world’s leading API providers.
5. Conclusion: Towards a Standardized Ecosystem
The currently fragmented DeFi ecosystem will benefit from API3 and, in any case, the open banking philosophy. The message is crystal clear: protocols should focus less on decentralization and more on collaborative competition towards building a standardized ecosystem.
Through the development of open protocols, clear regulatory frameworks, and reliable data feeds, new crypto-banking products will emerge as traditional financial providers can easily share data with the blockchain.