4 scenarios for the future of DeFi

Andy Singleton
7 min readSep 14, 2022


DeFi TVL has declined from $200B to $60B. That is about 6% of crypto market cap, and 0.06% of bank assets. DeFi is either irrelevant, or it has a lot of upside. This article looks at four ways it might go:

  • Die: Not worth the risk of technical loss
  • Die: Regulatory strangulation
  • Survive: Professional sandbox
  • Thrive: Mainstream integration
Photo by Dawid Zawiła on Unsplash

Not worth it

In scenario 1, DeFi is not worth the risk of loss due to mistakes and hacks. This is the world we live in now.

Most TradFi transactions are reversible. I can get money back after a bank wire, ACH, or credit card transaction if there was a problem, or a mistake, or a misrepresentation, or a hack. This reduces risk.

However, reversibility has costs. All of the participants have to put aside money for refunds, and do credit checks on their counterparties to make sure they can do refunds. It’s slow. Both sides of the transaction have to take extra steps to “reconcile.” It’s exclusive. I can only deal with people that I know can give money back. And, it eliminates a lot of opportunities for automation. I’m not going to run step 2 of a transaction when there is a chance that step 1 might get reversed.

Crypto transactions are riskier because they are not reversible. If something goes wrong with a transaction, the assets can disappear. However, non-reversibility also provides benefits. Transactions are cheap. They are fast. You can do them with anyone. And, you can automate and compose lots of steps.

I estimate that reversibility adds about 2% to the cost of financial services. 2% is about the price difference between a reversible credit card transaction, and a crypto transaction. Users have a practical approach to losses. Users are willing to put up with losses from hacks and mistakes as long as its cheaper than the extra cost of a reversible system.

If losses are higher than about 2%, then people will not use DeFi. It will be too expensive.

Currently, the cost of hacks and mistakes is almost surely higher than 2%. DeFi lending pools typically add token rewards of 2% to 5% on top of a competitive borrowing rate. That might be a good measure of the risk of loss to hacks and mistakes in these protocols. If protocols can’t earn back the extra risk of DeFi honestly, they will try to cover the cost of that risk with token rewards, and hope they can push the risk level down over time.

Losses may decline over time. Early crypto exchanges were risky. They lost a LOT of customer deposits to hacks. Today, exchange custody is much more reliable, and exchanges rarely lose customer funds (unless they lend them out). It’s likely that other crypto services will follow a similar path to increased reliability.

Regulatory strangulation

In scenario 2, regulators strangle DeFi.

It’s fanciful to think that blockchains can bypass national regulations. Regulators can’t shut down all of the servers. However, they can make those servers useless by cutting them off from real life. In order to have a wide positive impact, blockchain applications must be legalized.

Regulators have straightforward reasons for avoiding DeFi.

Ability to do their job

Regulators have a job to do. They do their job by regulating intermediaries. They funnel financial services through licensed banks and brokers, and then they tell the licensed banks and brokers how to operate. Often, those intermediaries pay fees to support the regulators. If DeFi removes the banks and brokers, then it’s difficult for regulators to do the job that they agreed to do. Also, the banks and brokers are licensed in one country, and global blockchains go outside of the country, making regulation even more difficult.

So regulators want to add intermediaries, which increase costs, creating something like Bastiat’s negative railway. When regulators add intermediaries, they destroy the product. The old SEC/FINMA rules for trading require a crippled and unattractive product. Every attempt to make regulated security tokens or regulated security token exchanges has collapsed in failure. Nobody wants those products because they are bad. According to the letter of the law, they can’t offer rewards to users and contributors; they can’t do software metered-issuance; they have to carry the costs and speed degradation that comes with reversibility; they can’t do automated trading; they can’t exchange tokens on a public blockchain. They can only die a miserable death while paying a lot of legal fees.

Protecting systemically important industries

Regulators have a responsibility to protect the economy’s core financial industries. Forces that disrupt the existing bank and brokerage industries threaten their mission. The US has a strong securities industry, so US regulators are focused on protecting it from crypto with securities law. Europe depends more on banking, so European regulators are more focused on pushing back with banking rules.

Capital control policies

Many (maybe most) nations have policies to increase local investment by capturing capital. They have various rules that prevent or discourage investment outside of their countries. These can either be outright “capital controls” or more subtle “financial repression.” You can argue that these are bad rules that block local investors from fair returns, and reduce efficiency by interfering with the free market. Or, you can argue that they are good rules that prevent rich and rootless tycoons from extracting capital. China is very committed to capital controls, and they banned crypto.

Bad actors

Regulators have good excuses for wanting to shut the whole thing down. DeFi has scams. Crypto transfers bypass the AML surveillance that regulators have imposed on banks. Crypto is structurally not any more likely to support bad guys than other parts of the financial system, but monitoring it requires systems that regulators don’t have.

There is a long list of reasons that regulators might not like crypto and DeFi. It has to provide significant benefits to win them over.

Professional sandbox

In scenario 3, DeFi is pushed into an offshore, professional, and interbank “sandbox.”

Regulators allow experimentation in markets which are

  1. Offshore. Blockchains form their own offshore market because they don’t fit into any national market
  2. Professional. Regulators don’t feel strongly about policing professional and interbank transactions

Regulatory pressure is pushing DeFi services into this box. Early-stage token funding comes from offshore professional funds. We see DeFi services, pools and assets that only include qualified participants. Typically the participants are professional non-US investors, or licensed banks. Programming an exclusive “sandbox” for these participants is easy to do. It will become easier when participants adopt the new generation of wallet IDs with portable and provable credentials.

This solves problems with regulation. Participants pass AML checks, regulators don’t care about protecting them, and they can freely trade private securities with tokenization and automation. There are many DeFi services involving securities that currently can only exist inside a professional sandbox.

The result is a wholesale version of DeFi that provides automation and shared services for businesses. That has value. For example, consider margin lending. It is massively inefficient for every bank and broker to handle margin lending with their own systems. It costs billions just for IT integration. And, they have to staff margin trading and lending desks to operate those systems, and provide capital. It’s vastly more efficient to have a shared service that handles collateralized lending.

Regulators have tolerated crypto so far because the world needs innovation. A weight of regulation has piled up in layers that prevent licensed finance from doing anything new. This forces financial services into a new channel where they can meet the needs of the moment. A new system can evolve quickly until it reaches “product market fit,” where it will become systemically important and start getting frozen under its own layers of regulation.

A wholesale sandbox provides a regulatory safe harbor for DeFi. There is a high probability that a lot of DeFi services will spend some time in this sandbox. It isn’t as useful or creative as truly accessible DeFi, but it adds value, and it could end up handling trillions in assets.

Mainstream integration

In scenario 4, DeFi automation becomes part of mainstream financial services. DeFi adds value with:

  • Efficiency. DeFi automation and shared services allow us to spend less money and time on people, systems, buildings, reporting
  • Risk. Real-time transparency allows us to see systemic risks and respond before they become problematic
  • Supply. Experts can join the decentralized network to supply money and services to new, underserved and specialized markets
  • Consumer access
  • Responsiveness. Crypto rails increase dealmaking speed and coordination
  • Innovation. Open source infrastructure allows providers to rapidly extend and improve services

A high-level strategy for DeFi would include these steps

  1. Reduce technical risk to an acceptable level
  2. Don’t destroy the product with regulatory compliance. It has to be a good product. A good product comes less from rules, and more from strongly-felt principles of user value and user protection
  3. If necessary, retreat to a professional sandbox and keep building shared and transparent services
  4. Add value with mainstream financial services

Most startups fail. However, the startups that succeed pay back 100X and give the economy a great overall return. The DeFi industry as a whole is a classic startup bet. It succeeds in less than 50% of the scenarios listed here. However, in the scenarios where it does work, it brings our world together and adds a lot of value.



Andy Singleton

Software entrepreneur/engineer. Building DeFi banking at Maxos — https://maxos.finance . Previously started Assembla, PowerSteering Software, SNL Financial.