During the COVID-19 pandemic a new consensus has emerged which castigates modern finance for its tendency towards excessive leverage, and short-termism. As all this activity took place against a background of disappearing disposable incomes, it is not surprising that it also boosted inequality, especially between the asset-rich and the asset-light classes with the latter having to borrow ever greater amounts of money to acquire capital assets. In its present state, global finance hardly contributes to the funding of the real economy, especially when it comes to long-term and sustainable investment. The challenge of tackling the underlying weaknesses of global finance is enormous.
Agency costs are at the heart of the modern investment chain and thus stand as a formidable obstacle to any beneficial transformation. Namely, while investors’ investment horizon is normally medium to long-term, intermediaries strongly prefer to take a short-term view in order to both maximise commission income and boost short-term performance relative to their peers — the prevailing performance and compensation benchmark in the investment industry.
Accordingly, we see repatriation of investor control and market democratisation as paths to alleviate the disparity of interests between investors and intermediaries. Decentralisation is the only way to avoid the absolute domination of financial technology by huge financial institutions offering cutting-edge infrastructure and by gigantic technology firms (BigTechs) that will soon enter the finance space.
Aside from cryptocurrency technology, decentralised finance has largely been a black box thus far. Our recent paper attempts to provide a holistic model of decentralised finance on which integrated financial platforms based on the cooperate and compete model can be built and operate.
The rapid entry of large financial institutions and BigTechs into the space will bring fee reductions and huge distribution networks. In this context, most of today’s financial technology firms (FinTechs) may arguably only survive through co-existence on decentralised platforms where they can the cooperate and compete. In a recent interdisciplinary research paper, we argue that the evolving merger of payments technology with technology that underpins investment markets’ infrastructure will impact the mode of supply of financial services.
Decentralised Open Finance Platforms – A New Market Paradigm
“One-stop-shop” multi-purpose and multi-asset platforms based on Distributed Ledger Technology (DLT) are bound to become a key characteristic of post-COVID-19 finance. Decentralised finance platforms can allow most business-to-business (B2B) and business-to-customer (B2C) FinTechs to flourish through the platform’s market fora and distribution channels while sharing operating costs. The central idea is that smaller FinTechs would have a reliable framework to compete for business and cooperate with respect to platform governance and regulation. Even where network externalities happen attract larger financial service providers, these providers would still operate on the basis of the same compete and cooperate model.
Decentralised open finance platforms can bring a radical transformation of the marketplace in three respects:
- markets will become less centralised,
- investment will become democratised as broader access and reduced agency costs lead to a re-alignment of investors’ medium and long-term horizons with financial intermediary asset allocation strategies, thus altering the composition of investment portfolios, and
- finance will better serve socio-economic goals by allowing the emergence of tradeable social market products. To facilitate this transformation, we offer a model of decentralised finance that goes far beyond so-called “autonomous” finance.
Decentralised finance can allow new types of asset markets, such as markets for social housing, to emerge and thrive. For example, in our paper we offer a characteristic consumer credit use case to show how decentralised platform-based open finance can introduce competition in the market for low-grade consumer creditors while also maintaining user privacy. In addition, multi-asset platforms could boost liquidity in previously illiquid assets and thereby facilitate long-term and committed investment. Furthermore, smaller issuers will enjoy greater access to equity capital, thanks to the platform’s lower admission fees and advantageous disclosure regimes for SMEs.
Yet, increasing automation and integration in the supply of investment services present considerable challenges, both at the regulatory and the technical level. A proactive approach is required to resolve the technical and regulatory tensions. Nonetheless, subject to some simplification, certain parts of regulatory rulebooks can be coded to automate compliance. We explain how platforms can automate compliance with such rules as counterparty position limits, order and price limits for short-sellers, and prohibitions on front-running. Implementation of such automated controls would diminish the cost of regulatory monitoring and augment ex ante compliance.
We identify three fundamental properties that define decentralised finance systems. First, we use cryptographic integration as the foundation for the supervening applications that will create a more open and competitive financial system. Second, we suggest that decentralised applications will give rise to positive network externalities which will remove the need for investment intermediation by big institutions, even at the investment origination level. Broadening access will lead to more pluralistic investment choices. In this context, we offer case examples which underscore the potential of multi-purpose and multi-asset platforms to further socio-economic goals. Third, we use parametrisation to account for the pluralism of investor preferences that may go beyond risk and return to encompass social and ethical preferences. This architecture is summarized in Figure 1:
Fig. 1 Architecture/Logic Of Decentralised Finance Platforms
The integration of infrastructure and client interface into an accessible, single, multi-asset platform is not just the realm of financial and information technology. Automation of regulatory compliance and detection of wrongdoing (based on effective ex ante operating algorithms and thorough post audit systems) would be essential in order to stem fraud, front-running and other forms of abusive and illegal conduct. We offer below a visual representation of the main players and key functions of a decentralised finance platform.
The model of decentralised finance we propose takes the concept of open banking a decisive step closer to achieving the objectives of financial inclusion and sustainability. We suggest that policymakers’ support for integrated decentralised platforms is the only realistic alternative to the domination of the financial services industry by gigantic financial institutions and the potential future monopolization of fintech services by the BigTechs. Similarly, integrated decentralised platforms are the most promising route to alter investment industry’s narrow asset allocation practices to foster sustainable investment and increase through diversification financial market resilience to large scale shocks like those expected to follow the CovidCOVID-19 pandemic.
Emilios Avgouleas holds the Chair in International Banking Law and Finance at the University of Edinburgh and is a Member of the Securities and Markets (Stakeholder) Group with the European Securities and Markets Authority (ESMA). Usual disclaimers apply.
Aggelos Kiayias holds the Chair in Cyber Security and Privacy at the University of Edinburgh and Director of the Blockchain Technology Laboratory. He is also the Chief Scientist of IOHK an R& D fintech.
This post is adapted from their paper, “The Architecture of Decentralised Finance Platforms: A New Open Finance Paradigm,” available on SSRN.