What is DeFi 2.0?
The DeFi revolution has been a groundbreaking wave of blockchain-based innovation, with decentralised finance (DeFi) being one of its most influential and successful components. DeFi is an expansive array of decentralised applications that enable alternative financial services while leveraging the capabilities of blockchains and secure oracle networks like Chainlink.
By taking advantage of their permissionless composability and open-source development, DeFi protocols are continuously advancing, with the recent rise of liquidity-focused projects leading to the emergence of DeFi 2.0.
This article looks at the DeFi 2.0 wave, a subset of protocols built on the breakthroughs of DeFi, such as yield farming and lending. It dives into the liquidity constraints that many on-chain systems with native tokens face and how the DeFi 2.0 movement is attempting to solve this issue. Moreover, it discusses the breakthroughs that led to the emergence of DeFi 2.0 and how it has become a significant and successful part of the blockchain world.
So what exactly is DeFi 2.0?
DeFi 2.0 is the second generation of decentralised finance (DeFi) and is characterised by the issuing of applications and projects based on various models of financial-based agreements. This new era of DeFi has seen rapid growth since 2021 due to its efficiency and has been revolutionised and upgraded from its predecessor, DeFi 1.0. DeFi 2.0 has seen the resolution of limitations of DeFi 1.0, making it a more comprehensive description of decentralised finance. With every new innovation in technology, the world moves into a new space, and DeFi 2.0 is no different. It provides a range of benefits and opportunities to its users, allowing for further evolution in the field of DeFi.
Significance of Defi 2.0
The introduction of DeFi 2.0 has ushered in a new era of revolutionary protocols. Aimed at resolving the restrictions of previous generations of DeFi, the second version offers innovative solutions and advances the growth of the DeFi space in the blockchain world. It provides users with new, unique mechanisms that promote financial independence.
Early DeFi projects suffered from scalability issues and an unfriendly user interface, mainly due to their Ethereum blockchain roots. These complex features made them difficult to use, especially for newcomers unfamiliar with decentralised products. Additionally, users had to contend with high gas fees and long waiting times for transactions. DeFi 2.0 is set to solve all of these problems and establish the necessary infrastructure.
In decentralised finance, liquidity is sourced from users themselves instead of large, central entities. Suppose you are exchanging ETH for USDT on Uniswap. You choose the tokens, enter the amount, and receive USDT in exchange. But the question is: Where did the USDT come from, and where did your ETH go? The answer is a liquidity pool. This is a reserve of coins kept by a protocol that can be utilised by users to quickly swap. The liquidity is provided by other users, named liquidity providers or LPs. They are rewarded with a yield from the exchange for leaving their tokens in the pool.
However, this brings about a problem. The yield for LPs is highest in exchanges with the lowest liquidity in order to attract them, but then the rewards decline when liquidity is brought back to the protocol.
The DeFi ecosystem is highly dynamic and volatile, with platforms in a perpetual battle for user liquidity and LPs seeking better incentives for their liquidity. This can lead to inadequate token liquidity for protocols after the native token rewards have been depleted.
Introducing DeFi 2.0 aims to address scalability issues faced by most DeFi solutions. During peak network activity, DeFi 1.0 protocols experience data congestion, leading to slower transactions and higher network fees.
Security is a major issue for DeFi 1.0 projects due to frequent upgrades and modifications in the software. Even the most reputable DeFi security firms have provided outdated and inadequate information, leaving many users unaware of security risk management and effective ways to validate network security. Given the considerable amount of funds locked up in DeFi protocols, security is a critical necessity that needs to be addressed.
Stablecoins are generally supported by a reserve asset, such as the US Dollar. This means that, in theory, each stablecoin is backed by one dollar, and it can be redeemed at any given time – thus providing a reliable and trustworthy value.
However, in order to maintain this reserve, a centralised entity is required - a 'treasury'. This raises questions about trustworthiness, as well as potential conflicts with governmental regulations and seizures.
Recent headlines have shown that this can have serious consequences for stablecoins, leading to lawsuits and disputes. It is clear that the current approach to creating coins with stable value has significant drawbacks.
The effectiveness of existing DeFi models is highly dependent on the use of external data from Oracles. As a third-party source, the accuracy of information provided by Oracles can be a determining factor for DeFi users and the protocol's success.
The unsung hero of the DeFi world: Olympus DAO
When OlympusDAO launched in 2021, its ambition was to revolutionise the DeFi space by providing a decentralised and community-driven infrastructure for finance. The project’s unique Protocol-Owned Liquidity (POL) model was lauded as a breakthrough, and its OHM token quickly skyrocketed to a market cap of $4.4B in November. This made OlympusDAO the leader of the “DeFi 2.0” movement, offering a powerful solution to the issue of sustainable liquidity for native tokens. DeFi enthusiasts were quick to recognise the potential of this game-changing project, and it has since held its position at the forefront of open finance.
Advantages of DeFi 2.0
An overview of the foundations and technologies of DeFi 2.0 reveals its necessity in today’s world. What are the value advantages of the second generation of decentralised finance for users? Here is a summary of the notable beneficial use cases of DeFi 2.0.
The use of DeFi 2.0 for insurance-backed smart contracts is an interesting example. With its open-source infrastructure and focus on transparency, DeFi can be difficult for those with limited technical knowledge to assess risk and carry out due diligence. DeFi 2.0 crypto may offer solutions in the form of insurance on smart contracts, providing users with a guarantee of their deposits for a fee. Currently, these platforms are in development and need to be configured with smart contracts.
The second iteration of DeFi is known to decrease the associated risks of lending activities. It also helps to reduce or even eliminate the interest payments on loans.
DeFi 2.0 offers a cost-effective solution for executing transactions with a low gas fee and rapid processing. Additionally, it promises an efficient supply of liquidity.
Changes in price ratios can have an adverse effect on users investing in liquidity pools through liquidity mining. To mitigate the risks of impermanent loss, DeFi 2.0 protocols are developing new approaches. Users need to work with the protocol to form token pairs - where a user adds a token to the pool; the protocol adds the corresponding native token to balance the pair. Both the user and the protocol can collect fees from swaps associated with the pair. The protocol can use the generated fees to create an insurance fund to protect against impermanent loss.
Risks of DeFi 2.0
The advantages of DeFi 2.0 are numerous, but there are risks associated with the system that must be considered. These include:
- Potentially poor user experience
- Lack of smart contract security
- Changing regulations
- The possibility of impermanent loss (IL).
Users may find themselves unable to withdraw assets if a DeFi project becomes unavailable, and smart contracts can never be 100% secure. It is important to weigh the risks and rewards of DeFi 2.0 before investing and to ensure that the protocols used are both trusted and secure. Regulations may also shift, resulting in unforeseen losses. Lastly, market volatility may lead to unexpected issues, such as temporary data loss.
Investing carries a risk. It is vital to be aware that any form of financial product can be risky. Smart contracts in the new digital asset space may also be susceptible to risk. It is recommended that investors carry out thorough research before investing in any project. Liquidity is another risk to consider. It is possible to reduce liquidity risk; however, it cannot be completely eliminated. DeFi 2.0 offers protection against risks such as impermanent loss, but miners may still be exposed to potential losses. Therefore, liquidity miners should be cautious and well-prepared.
DeFi 2.0 Protocols
OlympusDAO is a pioneering DeFi 2.0 solution designed to create a policy-governed currency system which utilizes a decentralized reserve protocol and the native OHM token. The Olympus Treasury supports a variety of assets and allows investors to purchase OHM tokens at a discounted rate in exchange for their assets. Staking the discounted OHM tokens can result in potential returns unless the token experiences any price appreciation. Olympus offers various bonds with varying ROI shares, such as those with fixed or floating interest rates, asset-backed bonds and bonds with lock-up periods. Some of these bonds include;
- DAI Bond
- FRAX Bond
- OHM-FRAX LP bond
- OHM-DAI LP bond
What Is Defi Staking, and How It Can Benefit You?
DeFi Staking is becoming a popular method of gaining interest on crypto investments. It involves holding digital assets in smart contracts in order to generate returns. This method has become more accessible as some providers allow users to pool their tokens, with a fee, to achieve a minimum investment amount.
Binance has enabled users to take part in a DeFi project without needing to manage private keys, resources or make trades. Lido, a DAO community, provides a liquid staking service that does not require a minimum token amount making it easier for individuals to use the tokens within the DeFi ecosystem.
By staking assets on the Ethereum, Solana, Kusuma, or Polygon blockchains, users of Lido can generate additional yield. This allows DeFi 2.0 to promote more consistent liquidity provision, while providing further incentives such as yield farming tokens for loans. Furthermore, smart contracts insurance can be used to reduce lender risks by offering deposit guarantees, whilst self-repaying loans enable the lender to use the interest earned on deposited collateral to pay off the loan.
Is DeFi 2.0 The Next Big Thing?
This new generation of DeFi is based on an open-source model that allows developers to create quickly and easily. With this, DeFi can evolve faster than traditional finance since progress doesn’t need to wait for lengthy business processes.
DeFi 2.0 exemplifies this, and the longevity of the term is uncertain. What we can be sure of is that protocols like Olympus and Ampleforth have opened up new possibilities for the crypto industry, and these use cases will shape the future of DeFi.
The latest iteration of decentralized finance is creating new possibilities for users to gain rewards in a more transparent manner. This is a result of DeFi 2.0 providing better user experience, increased liquidity, and faster blockchain execution systems. Thus, gas fees should become more economical as Ethereum 2.0 rolls out. Furthermore, DeFi 2.0 should increase scalability, security, and liquidity. The emergence of DAO communities operating on DeFi staking, such as Lido, may further bolster DeFi 2.0 operations. Consequently, projects like Binance Smart Chain, Ethereum 2.0, Solana, and others should be more capable of delivering these advantages to their users.
This is how DeFi 2.0 is changing the game.