By Michael Anderson, Co-Founder of Framework Ventures
In the aftermath of the Great Financial Crisis (GFC), regulators tightened their belts around the types of financial instruments and industry best practices considered acceptable for banks. One of the causes of the crash was that legacy banks controlled most of the lending industry and consolidated a lot of its consumers’ financial data behind closed doors. Regulators’ response in England was to pass the Payment Services Directive (PSD2), which enabled outside financial technology (fintech) companies to create secure solutions for banks to safely share financial data with consumer consent. PSD2 emphasized open source solutions, which grant public access to the underlying technology. This development has come to be called “open banking.”
At its core, open banking uses open source APIs to securely connect consumers’ financial data across multiple services on the backend in order to display an integrated picture of consumers’ financial health on the frontend. A separate desired outcome for open banking was to increase competition among third-party providers (TPPs) and legacy banks. However, it may have caused the unintended consequence of consolidating financial power. In response to this trend of legacy bank consolidation is something new and egalitarian called “open source finance.”
Open source finance empowers individuals to participate in a novel, open framework of financial governance, where access to assets and financial services extends to anyone with an internet connection. In this new model, opt-in consumer consent is a prerequisite to participation. As such, open source finance can help expand the mission that open banking set out to accomplish.
Historically, large legacy banks and financial institutions have had outsized influence on the financial flexibility of those who bank with them and those who exist outside of the system. While financial inclusion has been a priority for many legacy institutions, the barriers to entry remain high. An estimated 25% of Americans and 1.7 billion people worldwide still do not have access to traditional financial services.
Even after making the jump from unbanked to banked, large disparities remain. Retail consumers mainly have access to traditional exchanges like Vanguard and TD Ameritrade, where they can trade financial instruments like equities, commodities, and ETFs at market rates. Meanwhile, accredited investors get to play in a different arena where customized OTC trades are common and more exotic options like credit default swaps exist explicitly for institutional investors like hedge funds and banks. Open source finance aims to level the playing field and make a growing range of financial instruments more accessible to banked, unbanked and underserved communities worldwide.
Instead of relying on centralized entities to govern the exchange of assets, open source finance users can participate, share, and modify both the trading mechanism and assets traded in a decentralized manner. A prime example of this is bitcoin, which is issued, distributed, and exchanged freely without the need of centralized control. This change in governance lowers traditional barriers to entry like needing to meet account funding minimums, while increasing the need for personal due diligence. As a result of broader access to risk-on investments, incredible community-led innovations have already begun taking place.
To date, protocols like Yearn Finance, Chainlink, Compound, SushiSwap, Synthetix, etc. have created previously inaccessible financial instruments like automated market making and credit default swaps in an open source manner, raising over $8.5 billion USD and garnering the attention of mainstream investors in a matter of months. This rapid pace of innovation and participation is truly humbling. What once took years of centralized, strategic planning is unfolding in real-time with real assets at play.
While relatively new, this online grassroots community has quickly proven to be innovative within an outdated industry and is becoming a hotbed for developing open source finance. As the underlying technology continues to improve its scope and scalability, more open source financial instruments can be expected to roll out for the masses, by the masses. The competitive innovation that open banking tried to achieve could in fact be realized with the democratization of open source finance.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.