Decentralized Finance (DeFi) is a cutting-edge, blockchain-based finance that does not depend on centralized financial intermediaries (such as exchanges or banks) but uses smart contracts built on blockchains.
DeFi differs from traditional financial services in that a transaction can be completed via DeFi without the need for an intermediary. DeFi’s blockchain technology eliminates the need for banks and other intermediaries like brokers, stock exchanges, and similar entities.
DeFi 2.0 focuses on improvement and an ambitious push toward new crypto protocols.
This article thoroughly explores the concept of DeFi 2.0, providing detailed insight into how it works and its different use cases.
Why Do We Need DeFi 2.0?
Revolutionary DeFi protocols such as Uniswap, MakerDAO, and Compound Finance have created the perfect environment for the burgeoning DeFi ecosystem. Users can swap tokens without ever giving up custody of their assets. Early participants in the decentralized Automated Market Maker (AMM) space and DeFi applications like Uniswap contributed to this.
Decentralized lending and borrowing platforms (such as Compound and Aave) provide permissionless access to operating capital as well as the ability to earn on-chain interest on deposits. Also, MakerDAO’s recent launch of DAI, a decentralized stablecoin, has introduced stablecoins into the DeFi mix.
The constraints of the pre-existing DeFi models serve as the starting point for the development of the DeFi 2.0 protocols. For instance, unlike centralized corporations, the infrastructure supporting various DeFi protocols offers significantly different advantages in terms of transparency and user control. DeFi protocol development, however, depends on the technologies that support the services.
The majority of the issues with the current DeFi model stem from the components that enable each service to function.
Limitations of DeFi 1.0
The amount of money invested in DeFi protocols shows that security is a top priority and a major concern for DeFi 1.0 projects. Regular software updates and modifications highlight the challenge of maintaining security in DeFi protocols. It’s important to remember that even the most reliable DeFi security providers have provided unnecessary and out-of-date information.
The liquidity required by most DeFi solutions is determined by the total value of assets and a lock-up of funds. When the assets spread across multiple blockchain networks and markets are considered, the impact of financial rigidity becomes clear.
Because liquidity is one of the most important aspects of DeFi 1.0 protocols, it makes sense to use DeFi 2.0 crypto to address capital inefficiency issues.
Decentralized finance projects are vulnerable to the blockchain trilemma because they must sacrifice decentralization for increased security and scalability.
Other than the distribution of LP tokens, none of the DeFi protocols provides long-term and realistic incentives for liquidity providers. In general, liquidity providers regularly take allocated rewards and resources. The supply is eventually depleted due to the recurring sales of the DeFi protocols’ native tokens.
Data congestion is a common issue with most DeFi protocols when there is high network traffic. In the DeFi 1.0 protocols, data congestion typically results in slow transaction speed and higher network fees.
The use of oracles to access external data is crucial to the effectiveness of the current DeFi model. Oracles are the only unofficial data sources. Hence, DeFi users and the protocol itself may depend greatly on the accuracy of the information provided by the oracles.
What is DeFi 2.0?
DeFi 2.0 refers to a collection of decentralized financial projects that seek to build upon the efforts of DeFi 1.0. The movement is centered on enhancing governance, security, scalability, and liquidity.
The origin of DeFi 2.0 can be traced to OlympusDAO, a decentralized autonomous organization (DAO) built on the OHM token. This company regulates the use of its signature token through a set of rules, and the protocol is supported by resources held by the linked Olympus Treasury.
Olympus, which was launched in May 2021, featured a new array of DeFi capabilities. Since its inception, several DAOs and projects have sprung up in its wake.
Use Cases of DeFi 2.0
The following are some of the most well-known DeFi 2.0 use cases from different blockchain networks.
Some DeFi 2.0 use cases are already in use. Yield farm liquidity provider tokens and liquidity provider tokens can be used as collateral for a loan on some platforms. This enables access to loans as well as pool benefits.
Another option is to allow collateral to generate the required interest. The interest earned will aid in the repayment of the loan without the need for additional payments.
DeFi 2.0 will introduce cross-chain bridges to tackle the challenges of low liquidity. Liquidity pools and layers of smart contracts can be used to connect different blockchains.
Users can access additional resources in addition to native resources.
Trading between pools on different chains may help to address an asset’s lack of liquidity.
Unlocking the Value of Staked Assets
Investors can earn liquidity provider tokens by staking a token pair in a liquidity pool. However, with DeFi 1.0, the liquidity provider tokens can be staked with a yield farm to increase profits.
DeFi 2.0 improves this procedure by using yield farm liquidity provider tokens as security. It works similarly to MakerDAO (DAI), where tokens are either created from scratch or obtained through a loan scheme. The main idea is that while earning APY, the liquidity provider tokens’ value should be unlocked to allow for new opportunities.
Smart Contract Insurance
Investing in decentralized finance projects presents a significant risk. A project must undergo extensive due diligence to be evaluated effectively. For instance, if you use a yield optimizer and stake liquidity provider tokens, you risk losing all of your deposits.
However, the deposit with the yield farm can be guaranteed by an insurance project for a specific fee. Most of the time, compromising the contract will not result in any payout, but investors may be eligible for one if their insurance policy covers it. Nevertheless, DeFi 2.0 makes obtaining insurance using particular smart contracts possible.
Insurance of Impermanent Loss
DeFi is considering novel strategies to reduce the risk of impermanent loss. For instance, assuming one token is added to a single-sided liquidity provider that does not require a pair to be added, the protocol will add the native token to the opposite side of the pair.
As a result, the protocol can earn gas fees, which can be obtained by swapping the appropriate pairs. The fees can eventually be put to use by creating a business fund to protect the deposit from the impact of impermanent loss. The protocol can create new tokens if the payment is insufficient. If there are extra tokens, they can be burned (to reduce the supply) or saved for later.
DeFi 2.0 Projects
Now that the most important use cases for DeFi 2.0 have been explored, here are the projects that are influencing the future of DeFi:
This is a decentralized autonomous organization with OHM as its native token. The price of an OHM coin is relatively stable because it is backed by many other crypto assets such as DAI and FRAX.
Olympus offers token holders the chance to vote on crucial decisions, much like any other DAO. Users can earn money by staking their OHM tokens on the platform. Users who stake also receive sOHM (i.e., staked OHM), which they can use on different DeFi platforms. A sOHM token can be converted to an OHM by burning it.
Convex Finance (CVX) was built on top of Curve Finance. It provides Curve LPs and CRV token owners a new way to earn interest and trading fees on their tokens.
The main advantage of using Convex over Curve for staking CRV tokens is that Convex offers higher rewards.
Abracadabra.money (a lending platform) is a significant DeFi 2.0 project. Interest-bearing tokens such as yvUSDC and yvWETH can be used as collateral to borrow or create the platform’s dollar-pegged stablecoin, Magic Internet Money (MIM).
The platform offers consistent interest rates and minimal borrowing fees. The platform also provides a SPELL governance token. Holders can access voting privileges and earn platform fees by staking their SPELL tokens. With the help of this system, users may convert their idle interest-bearing tokens into tradable assets and increase their earnings.
Risks of DEFi 2.0
Risk is inherent in all forms of innovation, and the DeFi and crypto fields are no exception. This appears to be especially true for DeFi 2.0, which is being built on a platform with numerous issues that still need to be addressed.
The industry appears to agree that the potential benefits of successfully implementing DeFi 2.0 concepts outweigh any potential risks. This is not to say that the risk factors should be ignored.
There are ways to mitigate these risks, such as educating users, using strict auditing protocols for smart contracts, and ensuring that failures have no impact on the larger ecosystem.
- DeFi still struggles with issues preventing sustainability. The good news is that the early DeFi efforts set the stage for the dApps that followed. DeFi 2.0 started when project teams applied their understanding of the DeFi 1.0 limitations to support the advancements we now enjoy.
- The next wave of decentralized finance will involve creating novel strategies for transparently obtaining rewards. This is because DeFi 2.0 rewards more liquid markets, more flexible blockchains, and better user experiences.
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