Decentralized finance (DeFi) – hype or reality?

Decentralized finance (DeFi) taps into the potential of distributed ledger technology (DLT) for financial transactions. This involves creating trustworthy, transparent systems based on computer protocols that no longer require any intermediaries such as financial institutions. ^[*]

The products and services offered draw on smart contracts where pre-defined rules are enforced automatically and independently, and all the relevant data is saved by a distributed ledger platform (such as blockchain). DeFi solutions can be found in all areas of finance, e.g. lending, payment transactions, retail, investment management and insurance.

How does open finance relate to DeFi?

Open finance refers to the exchanging of data and services between financial institutions (e.g. banks and insurance companies) and third-party providers via open-access, public interfaces such as open APIs. What’s more, data and services can be exchanged in both directions. For one thing, this involves opening up financial institutions and some of their data, which at present typically relates to account/custody account information and payment transactions, by providing interfaces for trustworthy, external third-party providers such as fintech companies. At the same time, open finance also allows financial institutions to be the recipients of data and services from third-party providers.

It is a very good idea to consider the concepts of open finance and decentralized finance in their entirety. Seeing as these concepts only differ to a small degree, they have similar objectives, and they may even be somewhat interconnected in how they work. Generally speaking, open finance and DeFi represent two different approaches to open ecosystems for the financial sector. The following diagram provides a clear overview of the different concepts and participants in integrated architecture.

The architecture distinguishes between five horizontal layers that are interconnected through an application programming interface (API) environment (lines shown in magenta). The first layer is the customer. The second layer is the front end. This is the interface between the customer and the providers of financial products and services. The front end may be provided by a bank, an insurance company, a fintech company, a Big Tech company or a retailer. The third layer is execution and custody: the execution of the products and services offered and the custody of the associated assets is often not handled directly by the front-end provider, but by another party.

In open finance, this is typically handled by banks and insurance companies, though alternative platform providers such as crowdfunding platforms can also take on this role. In the case of DeFi, execution and custody is based on a DLT protocol. Systematic data management, which is the fourth layer, forms the basis for open financial ecosystems. This comprises the storage, analysis and processing of data in order to provide financial products and services. The fifth layer describes the physical infrastructure required. The four vertical layers on the right-hand side of the architecture describe the level of standardization within the APIs that allow the participants and the different layers of an open financial ecosystem to be interconnected.

Given the potential interconnectivity between open finance and DeFi, a linked coexistence of some sort between the two approaches is very likely. In other words, customers may be able to decide in future whether they (or their intelligent front end) would like to handle certain financial transactions through banks (intermediaries) or via a blockchain. Blockchain-based DeFi systems such as these already exist. The volumes are still low at the moment, but the rate of growth is high. This means DeFi is already a reality today.

[*] This blog is based on a chapter of the IFZ FinTech Study 2021 and is supported by Finnova, Inventx, SIX, Swiss Bankers Prepaid Services, Swisscom and Synpulse.

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