What is DeFi 2.0?
What is DeFi 2.0?
Early developments of decentralised finance (DeFi)
Decentralised finance (DeFi) can be explained as a separate trend within the crypto ecosystem that encompasses a wide-range vision for a new financial infrastructure.
We often say that DeFi is an umbrella term for financial products and services known as DeFi protocols accommodated in a decentralised system backed by blockchain technology. Being one of crypto's new frontiers, DeFi soon became one of the most popular spaces within the blockchain industry.
DeFi is closely linked to the emergence of cryptocurrencies and technically one could say that the very beginning of crypto or the 2009 launch of Bitcoin is the beginning of the DeFi movement. If you're interested in finding out more about the inception of Bitcoin, check out this article: 'The Legacy of Satoshi Nakamoto'.
Despite being the crypto forerunner, the Bitcoin ecosystem was not built to accommodate DeFi protocols – the 2015 launch of Ethereum is associated with DeFi’s rise.
Let’s elaborate. Ethereum brought to the table smart contract technology that enables developers to create decentralised applications (Dapps). Interestingly, the concept of some popular DeFi protocols, such as MakerDAO, predate the launch of Ethereum.
Nevertheless, MakerDAO and some other popular protocols officially launched in 2017, along with early decentralised exchanges (DEXs). The same year was a groundbreaking one for the DeFi space since Initial Coin Offerings (ICOs) exploded in popularity.
Early DeFi protocols such as MakerDAO, Uniswap, and Compound laid down a solid foundation for the burgeoning DeFi economy, adding many vital pieces to the whole DeFi ecosystem.
In the following years, there was a shift toward pooled funds and the creation of the ‘user-to-contract' approach instead of users interacting directly with each other. Before DeFi experienced rapid growth, it went through a tough time with the start of the 2020 pandemic. It was like a stress test in which DeFi managed to survive.
Since 2020, a bunch of new DeFi protocols have been created and the values of the whole industry continue to rise.
DeFi 1.0 in a nutshell
As mentioned above, the big bang of DeFi 1.0 occurred in 2020 during the so-called ‘DeFi summer’. It marked a turning point in the financial space by removing barriers that denied open access to financial services and products; it demonstrated that intermediaries are not needed and that the power lies in the hands of anyone with an internet connection.
Therefore, DeFi 1.0 laid down the foundation for a permissionless and transparent financial infrastructure providing novel mechanisms for DeFi users to achieve financial freedom.
The whole crypto space is rightfully associated with financial inclusion and freedom. If you're interested in learning how cryptocurrencies can bring positive changes to individual users, we suggest reading this article: 'How crypto gave an Indian writer financial freedom'.
DeFi 1.0 protocols were associated with the Ethereum blockchain solely. The first generation introduced users to decentralised exchanges, decentralised autonomous organisations (DAOs), yield farming, and liquidity flow, along with decentralised lending and borrowing.
For example, the 'DeFi summer' introduced rewards based on tokens which became the primary manner of bootstrapping liquidity for emerging DeFi protocols. This is known as yield farming or liquidity mining.
DeFi 1.0 intended to replicate the same functions as traditional finance, but DeFi still has a few common vulnerabilities such as liquidity issues, interconnectedness, and maturity mismatches.
However, DeFi 1.0 wasn’t perfect since most DeFi projects didn’t manage to take care of a few issues such as security vulnerabilities, scalability and tensions with stablecoins.
Explaining DeFi 2.0
Unsurprisingly, the marketing trope is that DeFi 2.0 is just DeFi 1.0 on steroids.
You can think of it like that – after all, it presents an upgrade of DeFi 1.0. It is also considered to be a new movement within the crypto ecosystem that includes DeFi protocols built on the efforts of the first generation of DeFi.
The second generation of DeFi protocols emerged intending to fix some important aspects such as scalability, liquidity, security, governance, and user experience while preserving the legacy and vision set out by DeFi pioneers.
How does it differ from DeFi 1.0?
Certain loopholes within DeFi’s architecture needed to be resolved. In contrast to DeFi 1.0, the subsequent DeFi ecosystem aims to be more sustainable. The sustainability concept presents a core difference, along with a few other key features.
The DeFi 2.0 upgrade provides more layers deployed on the existing foundation to add more liquidity. The arrival of DeFi 2.0 has led to interest in the decentralised environment due to some unique solutions such as the protocols’ capability to buy liquidity from end-users instead of borrowing.
Apart from sustainability, the second stage is more inclined to link members of the DeFi community who may provide liquidity. Such incentives are encouraged to create an interconnected DeFi architecture breaking the former cold transaction mode.
Which challenges do DeFi 2.0 aim to resolve?
DeFi 2.0 has become a reality due to errors made by the first generation. Technological advancements have been used to amend existing defects while utilising benefits to provide users with novel opportunities.
a. Unlocking greater value and liquidity portfolios
The first generation of DeFi offered users to stake a token pair in a liquidity pool in return for liquidity provider (LP) tokens that could be staked with a yield farm. DeFi 2.0 upgraded capital efficiency and liquidity to provide extra layers of utility.
Overall, DeFi 2.0 has taken yield farming to another level. Users can enjoy greater value from staked assets by provisioning liquidity for yield farming and enabling users to utilise yield farm LP tokens as collateral for loans as well.
In simple terms, yield earning was recognised as the best solution to entice more users and capital to the DeFi ecosystem. Yet, third-party liquidity providers offered just a partial solution.
DeFi 2.0 incentivises users with high APYs to stake their tokens on the platform instead of selling them or even using them as collateral.
The slippage caused by swaps discouraged many potential users from using DeFi, especially in the case of low liquidity. Users needed incentives to bootstrap liquidity for a new coin without being exposed to the risk of temporary loss in exchange for minimal fee revenue through swaps. As a result, yield farming as a manner of bootstrapping liquidity for new protocols using LP tokens is becoming the new norm.
Furthermore, DeFi 2.0 introduced a liquidity portfolio as a kind of replacement for liquidity pools. By utilising liquidity portfolios, users can provide liquidity with a single token instead of token pairs which often results in extra swaps for liquidity provision and wrapping.
When liquidity is provided to liquidity portfolios instead of liquidity pools, the potential loss is spread over all the tokens in the portfolio. The main idea behind this innovation was to reduce the potential impermanent loss compared to traditional liquidity pools.
b. Enhanced scalability
By providing upgrades in the foundation, DeFi 2.0 promises to offer a more scalable network with a user-friendly platform interface.
Most DeFi solutions were built using Ethereum blockchain and eventually, a problem among users emerged due to higher fees and lower transaction times. This led to driving people away from using DeFi platforms. The point of creating a new financial system is to make the whole experience easier and more attractive.
DeFi 2.0 needed to address this limitation of the first generation and expand its capabilities, along with embracing a wider range of blockchains. To resolve this issue, it utilised cross-chain interoperability, Layer 2 solutions, and enhanced yield farming strategies.
c. Smart contract insurance
Another interesting novelty provided by DeFi 2.0 is insurance-backed smart contracts. Before this feature came into the picture, doing thorough due diligence on smart contracts was hard unless the user examining it had a high level of technical knowledge. In other words, if you aren’t an experienced developer, it is a really difficult thing to do.
DeFi 2.0 found a way to resolve this by offering users insurance on smart contracts. Similar to the traditional system, insurance provides DeFi users with guarantees on their deposits with the yield farm. Therefore, if the yield farm smart contract is compromised, the user who acquired insurance shall get a payout.
d. Fixing the stablecoin issue
A lesser-known fact about DeFi 2.0 is that it aims to fix problems caused by stablecoins and, contrary to the first generation, not rely on fiat-backed stablecoins.
Some DeFi projects of the second generation are determined to create a fully decentralised reserve currency instead of using stable pegged currencies. The main idea is to employ a mechanism that makes sure that one native coin always equals one dollar.
Therefore, the new system should rely on a free-floating reserve currency backed by assets that would act like a stablecoin.
e. Self-repaying loans
Taking out a loan typically included the risk of liquidation and interest payments. Taking one step further from the centralised space of traditional financial markets, DeFi 2.0 delivered an innovation known as self-repaying loans.
These enable borrowers to take out loans removing the need for manual repayments. In simple terms, collateral is provided by the borrower and held by a smart contract which automatically repays the loan by selling pieces of the collateral.
This concept is innovative because it demonstrates that intermediaries, credit check procedures, and paperwork are not needed to access the financial system.
f. Digging into governance issues
From its very beginning, the main idea of DeFi was to remove intermediaries from the picture and utilise a direct use of financial products and services. However, a broad number of DeFi protocols didn’t completely let go of centralization, and many did not incorporate all DAO principles as well.
The outcome was that users’ funds were stored in smart contracts controlled by a determined group of individuals. This centralised feature led to a loss of trust in the crypto community.
DeFi 2.0 is based on the use of decentralised autonomous organisations (DAOs) in dealing with protocols’ operations and functions. Decentralisation keeps the power in the hands of users and this governance model is intended to be totally different from the traditional financial system.
What is the link between DeFi 2.0 and game theory?
If you are a frequent reader, you might recall the correlation between popular economic theories and crypto in this article:‘How do popular theories in economics shape crypto?’.
Even though the explanation of the game theory used within the crypto world sounds a bit utopist and theoretical, DeFi 2.0 and DAOs provide a simple example of practice.
DeFi 2.0 utilises the DAO concept to safeguard retail investors from the volatility of the crypto market. DAOs encourage token holders to stake their tokens to create a treasury that shares revenue among all of them. To ensure that enough token holders are going to participate, DAOs can use game theory.
Let’s illustrate that using a simple example of two participants, each with three options. Participants can choose to either sell, stake, or bond their tokens. The worst-case scenario for both participants is selling their crypto assets because it would damage the DAO itself and push the tokens’ price down. Bonding may be an interesting option since it builds in scarcity and provides some extra rewards.
However, the best-case scenario is staking – this option pushes the token price up which in the long run benefits both the DAO and the participants. However, the best-case scenario is only possible if all participants engage since a collective decision largely benefits the protocol’s mission.
Risks associated with DeFi 2.0
Despite bringing to the table a number of new safeguards, DeFi 2.0 is not risk-free. Let's take a look at the main risks you may encounter while diving into the upgraded world of decentralised finance.
a. Smart contract vulnerabilities
Smart contracts’ technology is the backbone of DeFi protocols, Despite being audited on a regular basis, smart contracts are associated with a number of issues such as vulnerability to exploits, hacks, and bugs that can lead to a loss of funds.
DeFi 2.0 added an extra layer of security by enabling insurance, but you should still be cautious and do your own research when approaching DeFi projects.
b. Future regulation
DeFi still operates in the grey area which leaves users vulnerable to future regulatory changes. As DeFi projects expand their user base, authorities worldwide will become more eager to get involved and impose regulations.
Any investor should be aware of the fact that new regulations or legal actions of any kind could impact their use of the DeFi ecosystem. This risk can be minimised by keeping track of regulatory changes.
c. Liquidity risks
Even though most liquidity concerns have been mitigated, they have not been totally removed. DeFi 2.0 has made a huge breakthrough by providing risk management and protection against perils such as fund losses, but miners are still at risk of losing funds.
d. Market risks
DeFi 2.0 provides complex financial products and strategies that may expose users to more risks. For example, this involves the potential for increased market volatility and liquidity risks. Users can mitigate these risks by gaining a thorough understanding of the functioning of the market before engaging in investing activities.
The technology behind the second generation of DeFi protocols
The main objective of DeFi 2.0 is to address scalability and interoperability challenges that plagued the DeFi 1.0 space. Let’s explain briefly how it plans to resolve these issues.
When it comes to scalability improvements, DeFi 2.0 utilises Layer 2 solutions such as sidechains and rollups to release a broad amount of transactions from the main blockchain, along with sharding and state channels. DeFi 2.0 focuses on the use of consensus mechanisms that prioritise scalability such as Proof-of-Stake (PoS) and Proof-of-Authority (PoA).
If you want to know more about the status of Layer 2 following Ethereum's Merge, why not read this article: 'Which Layer 2 Solution Benefits Most From the Ethereum Merge?'.
To improve interoperability, DeFi 2.0 uses cross-chain bridges or, in other words, builds bridges between divergent blockchains enabling data and digital assets to be transferred smoothly across different networks. Additionally, DeFi 2.0 utilises wrapped tokens to provide cross-chain compatibility and provides the development of standardised protocols for interoperability.
Another important feature from the technological aspect is that DeFi 2.0 delivers universal crypto wallets that support a wide array of blockchains and tokens. Universal wallets offer a better user experience by giving them the possibility to manage assets from a single interface.
Finally, DeFi applications rely on oracles as middleware entities that link smart contracts to resources outside their blockchains. DeFi 2.0 focuses on the development of decentralised oracles that can verify data from multiple blockchains.
Investing in DeFi 2.0
Investment opportunities within the DeFi 2.0 space are identical to those of DeFi 1.0, yet have a broader reach. Investing in DeFi 2.0 includes a number of strategies such as yield farming, lending, staking, and DEX trading.
DeFi protocols rely on yield farming to attain liquidity. DeFi 2.0 protocols went a step further by enabling investors to put tokens up as collateral for loans. Therefore, DeFi 2.0 expanded the incentives and utility of yield farming.
When it comes to lending, providing loans in exchange for interest has been a major part of first-generation DeFi protocols. DeFi 2.0 added an extra layer of utility and security by providing self-repaying loans.
If you are a frequent reader, you are already aware that staking is mentioned a lot throughout the crypto space. It enables users to become validators for blockchains that operate on the Proof-of-Stake basis to generate passive income.
Finally, crypto transactions are facilitated by DEXs - you can invest in DeFi 2.0 by engaging in DEX trades. Compared to centralised exchanges, DEX trades are faster, cheaper and more secure, Contemporary DEXs within the DeFi 2.0 space support a variety of activities such as margin trading.
Should you invest in DeFi 2.0?
If you decide to invest in DeFi 2.0, you should do some research and make sure that you are completely familiar with all the upper-hands and drawbacks of the DeFi economy and the DeFi project you chose. DeFi projects must meet your budgetary expectations and objectives. Educate yourself about the DeFi space and all the risks it entails.
DeFi is projected to grow in the upcoming years. We cannot tell you whether to invest or not, but we can give you a helping hand in learning about DeFi’s potential.
The DeFi market has the potential to become a multi-trillion-dollar economy in the future due to covering a wide array of financial products and services in a digital manner. It resembles traditional banking services, trading, and insurance.
The global DeFi market size was valued at $13 billion in 2022 with the expectation to expand at a compound annual growth rate of 46% from 2023 to 2030.
Easy to diversify
DeFi 2.0 provides a lot of opportunities for investors to diversify their portfolios due to many niches emerging within the decentralised ecosystem. For example, one aspect of an investor’s portfolio could focus on DeFi projects that provide enhanced scalability while another segment could focus on DeFi 2.0 trading or sustainable concepts.
Portfolio diversification enables investors to mitigate risks associated with investment-based activities in general. A well-diversified portfolio reduces the impact of an investment failing to take off.
Whether we are talking about DeFi 1.0 or DeFi 2.0, financial inclusion is a key foundation of the ecosystem; the whole space emerged as the need to create a financial infrastructure that is more inclusive than the traditional financial system.
DeFi refers to the saying ‘banking the unbanked’ as it aims to include people who cannot access traditional banking services. Taking into account that more than 1 billion people do not have access to traditional financial products and services, the DeFi space poses a good alternative.
Popular DeFi 2.0 projects
The DeFi wave produced several new projects seeking to expand its user base and obtain a slice of the crypto market. Sometimes it might be hard to determine which ones are noteworthy, yet a DeFi 2.0 project should include features such as comprehensive core dynamics, regular audits, healthy tokenomics, improved security, and an active community.
1. Olympus DAO
Olympus DAO is one of DeFi 2.0 pioneers which has risen to the forefront due to its Protocol-Owned Liquidity (POL) model. This DeFi platform is a DAO with OHM as its native token. The token, backed by stablecoins to maintain price stability, is supposed to become a reserve currency for DeFi.
OlympusDAO’s bonding models provide bonds to exchange LP tokens from third parties for the native token instead of renting liquidity through yield farming initiatives. This offers an advantage to the protocol itself and to other projects that use the protocol through the bonding-as-a-service option.
Bonds basically enable protocols to purchase their own liquidity and remove the potential for liquidity exits. Users are provided with the option to generate LP tokens, issue bonds with them, and buy OHMs at a discounted rate.
2. Convex Finance
Convex Finance is a DeFi platform based on the stable exchange Curve Finance aimed towards enhancing Curve's effectiveness and user experience, along with providing a user-friendly platform for CRV lending, liquidity mining and pledging. In other words, this DeFi project focuses on the improvement of Curve Finance's liquidity providers and on the interest of CRV token holders.
For Curve Finance’s liquidity providers, Convex Finance provides an opportunity to earn boosted rewards without the need to lock in their tokens. Additionally, the platform doesn’t have withdrawal fees and charges low performance fees.
Another popular DeFi 2.0 project is the lending platform known as Abracadabra. Users that hold interest-bearing tokens such as vWETH and yvUSDC can use them as collateral for minting or borrowing a dollar-pegged stablecoin known as Magic Internet Money (MIM).
Why should users do this? Simply, doing this enables users to turn interest-bearing tokens into liquid assets. The lending platform also encompasses governance tokens known as SPELL that can be used for voting on proposals and upgrades, along with earning passive income by staking.
What about DeFi 3.0?
The discussion about the future of DeFi doesn’t end with second-generation DeFi platforms.
In the early days of DeFi 2.0, the crypto community was already discussing DeFi 3.0. This loosely refers to the next generation of DeFi protocols aiming to overcome the limitations of the previous generations.
While DeFi 2.0 focused on improving scalability, liquidity, and capital efficiency, DeFi 3.0 aims to introduce specialised strategies, smarter liquidity mining, novel staking mechanisms, and NFT lending.
The new generation of DeFi protocols introduces smarter liquidity mining, innovative staking mechanisms, perpetual derivatives, NFT lending, and options. These advancements focus on scalability, sustainability, interoperability, and user experience while upholding decentralisation and open access principles.
For example, DeFi 3.0 highlights the need to professionalise yield farming and provide ‘farming-as-a-service' to expand profitability and expand accessibility.
Building on top of two previous generations, DeFi 3.0 aims to introduce a new wave of applications and utilities created by using Layer 2 solutions, artificial intelligence (AI), and NFTs. While AI is being employed already to automate tasks such as portfolio optimisation and risk management, DeFi 3.0 aims to use it to bring user experience to the next level.