Decentralized finance 2.0
One of the most influential and successful waves of blockchain-based innovation has been decentralized finance or DeFi.
Decentralized financial applications, or DeFi for short, are a broad spectrum of applications that are powered by blockchains with built-in smart contract capabilities and secure oracle networks like Chainlink. These applications aim to disintermediate traditional financial services and unlock whole new economic primitives.
Fueled by the inherent benefits of permissionless composability and open-source development culture, DeFi protocols are constantly evolving and iterating upon proven models of financial-based agreements. This continual evolution and iteration is what drives DeFi.
The DeFi ecosystem advances at breakneck speed—over the last few months, a surge in liquidity-focused decentralized finance projects has ushered in a new generation of DeFi innovation known as DeFi 2.0. Is there such a thing as DeFi 2.0 at this point?
In the realm of blockchain technology, the term “DeFi 2.0” refers to a subset of DeFi protocols that were built on prior breakthroughs made by DeFi, such as yield farming, lending, and other things. This is a relatively new concept.
Many on-chain systems that use native tokens are subject to liquidity constraints, which is why notable implementations of DeFi 2.0 have made this a primary area of focus.
This article explores previous breakthroughs that set the stage for the evolution of decentralized finance and the movement toward decentralized finance 2.0. It also discusses the liquidity problem that decentralized finance 2.0 protocols aim to address. Finally, the article delves into the usefulness and new financial paradigms that the DeFi 2.0 ecosystem brings.
Early developments in DeFi technology
The early pioneers of the DeFi economy, such as Uniswap, Aave, Bancor, MakerDAO, and Compound, have laid a solid foundation for the developing DeFi economy by contributing a large number of essential and composable “money LEGOs” to the ecosystem.
The first decentralized automated market makers (AMMs), such as Uniswap and Bancor, were the first to give users the ability to trade tokens without giving up custody of the tokens they owned.
Both Aave and Compound offered decentralized lending and borrowing options, which made it possible to earn interest on on-chain deposits and obtain working capital without the need for permission.
A decentralized stablecoin was made available by MakerDAO for members of the ecosystem to keep and use in transactions. This served as a hedge against the price swings that are associated with cryptocurrencies.
By utilizing these protocols, users were granted access to dependable exchanges, frictionless lending and borrowing, and stable pegged currencies. These are three essential financial primitives that are typically made available through conventional financial markets.
The infrastructure that supports these well-known DeFi-based services is, however, very different from that of centralized companies, both in terms of how transparent it is and how much control users have over it.
The numerous technological implementations that form the basis of these decentralized services are the foundation upon which DeFi innovations are built.
The Limitations imposed by DeFi 1.0
DeFi 2.0 is an improved version of the current DeFi model that aims to fix existing flaws while also capitalizing on strengths to provide customers with novel and exciting options along the path to achieving financial independence. The following sections will go over the various deficiencies that existed in DeFi 1.0.
The first obstacle is one that pertains to the practicability of the DeFi platforms. Because of the complexity of the user experience and user interface, it is difficult for crypto newcomers to use decentralized products. As a result, the vast majority of active users are crypto veterans.
People do express a desire for digital inclusion, and the success of Defi 2.0 projects in bringing crypto to the mainstream will determine the next iteration of DeFi.
Additionally, scalability does not result in things becoming simpler. The user experience is being continually hampered by issues such as high fees and extended wait times for approved transactions.
As is common knowledge, the vast majority of DeFi solutions are based on the Ethereum blockchain. As a consequence of the enormous number of users on the network, there are significant delays, and the costs associated with transactions are skyrocketing.
As a consequence of this, customers with incomes of a few thousand dollars or less render the use of DeFi devices unprofitable.
People, especially in crypto, have short attention spans, and you can tell that people are moving away from DApps to pursue bigger financial prospects.
Especially for DeFi’s blue chips, yields are not as appealing as they once were when compared to other investments. This has resulted in a recurring farm-and-dump scenario, which has led to an unhealthy cash flow for practices as well as a number of other issues that contribute to the inefficient use of assets.
In addition, all cryptocurrencies need liquidity so that they can be traded on decentralized exchanges (DEXs) and automated multi-signature markets (AMMs) without the price of the token being affected.
Small investors face greater exposure to the underlying risk from incentive programs, despite the fact that these programs may provide some temporary relief. They are far from ideal.
Oracles are utilized quite frequently in DeFi; however, there are still some projects that are unaware of the significance of oracles and are unwilling to integrate with a trustworthy oracle. As a direct consequence of this, a great deal of protocols have been attacked, and those responsible have been forced to compensate for their losses.
The purpose of DeFi 2.0
In contrast to the previous generation of DeFi apps, which were designed with the end user in mind, the newcomers take a business-to-business (B2B) approach instead.
The DeFi 2.0 protocols take advantage of the fact that the first generation of DeFi products was successful in bootstrapping the industry. This was accomplished by establishing an initial user base and developing the essential DeFi primitives that future manufacturers can now use to construct the next wave of DeFi applications.
In addition, the next generation of DeFi protocols has been developed with the intention of ensuring the continued success of the industry as a whole.
The dependence of the industry on third-party providers and token incentives to secure liquidity, along with DeFi’s virtually non-existent correlation with traditional finance and the economy as a whole, are the fundamental problems that are preventing the industry from becoming sustainable at this time.
Defi 2.0 and subsequent versions will continue to exist solely for the purpose of addressing issues such as these.
Several of the early adopters of the DeFi 2.0 movement are concentrating their efforts on the creation of strategies for long-term liquidity.
One of these pioneers is OlympusDAO, which is a protocol with the goal of constructing a decentralized reserve currency. OlympusDao also announced Olympus Pro, a tool that demonstrates the business-to-business (B2B) orientation of DeFi 2.0. Olympus Pro enables other DeFi protocols to use the bonding mechanism to gain their liquidity.
One more way in which DeFi 2.0 is anticipated to assist decentralized automated organizations is through the construction of protocol-controlled value mechanisms (DAOs).
The B2B orientation of the movement will be strengthened by the new wave of DeFi products, which will produce useful tools that will make it possible for DAOs to compete with companies.
Innovation in DeFi 2.0 and second-generation DeFi protocols
Please continue reading if you are still curious about the reasons behind the widespread adoption of DeFi 2.0.
DeFi 2.0 research began when users and projects understood DeFi’s limits, which prompted them to find appropriate solutions.
Each solution to each problem has resulted in minor upward movements in the market, which are precisely what the market needs at this point in time.
Let’s take a look now at the solutions that have been instrumental in the growth of DeFi 2.0 projects.
Scalability: Layer one, layer two
Interacting with the Ethereum network has proven to be a significant challenge for DeFi users, especially those who are just starting out.
Unfortunately, the majority of customers have not been able to try DeFi because of the high cost of gas and the lengthy wait times.
On the other hand, DeFi offers a diverse selection of opportunities, which contributes to its overall attractiveness.
As a consequence of this, the question that arises is as follows: How can users experience DeFi without having to deal with the scaling issues that Ethereum is experiencing?
The funds were distributed among BSC, Polygon, and Solana, which are some of the blockchains that are able to provide users with the functionality they seek most urgently. It’s possible that finding a solution to the scalability problem will set off the next wave in the market.
Liquidity: Yields
Assisting users in increasing their yields is the most straightforward approach to resolving the liquidity issue or luring additional users and capital into the decentralized finance market.
Third-party liquidity providers on AMM protocols provided a partial solution to the liquidity problem by allowing any independent person who possessed sufficient funds to provide liquidity for a token pair. This enabled a wider variety of people to participate in the market.
Teams have the potential to obtain sufficient liquidity from third parties rather than provisioning it themselves, according to one theoretical framework.
On the other hand, end-users had limited incentives to bootstrap liquidity for a new coin because doing so would involve exposing themselves to the risk of temporary loss in exchange for minimal fee revenue through swaps. This meant that the incentive to bootstrap liquidity for a new coin was limited.
In order for them to take that risk, they required a compelling financial rationale. This led to a predicament where the chicken came before the egg.
Users are dissuaded from participating in the environment of a DeFi protocol when there is insufficient liquidity due to the slippage that is caused by swaps.
If users don’t get involved in token transactions, there won’t be enough of a fee volume generated to encourage third-party actors to pool their tokens and provide liquidity in the market.
As a direct consequence of this, yet another significant advance in DeFi research was made. The practice of yield farming, also known as the bootstrapping of liquidity for new DeFi protocols using liquidity provider (LP) tokens, has become the standard.
The question now is, how exactly will yield farming bring about a revolution in DeFi?
The increase in activity surrounding DeFi was given the moniker “DeFi Summer” by blockchain experts after it occurred during the summer of 2020, which was when yield farming, also known as liquidity mining, became available.
The idea behind yield farming is not difficult to understand. Users stake their LP tokens for returns in the project’s native token by offering liquidity for an exchange pair through an AMM protocol. In exchange for their liquidity offering, they receive an LP token.
This approach addresses the chicken and egg dilemma by providing a strong economic rationale for third-party liquidity providers to supply a token’s higher return.
They could potentially earn an even higher yield by staking and acquiring a greater quantity of the project’s native token. In addition, as a result of the deeper liquidity, they could generate a higher cumulative fee for AMM swaps.
The development of yield farming made it possible for new DeFi protocols to bootstrap significant amounts of liquidity, which allowed them to launch and maintain operations while simultaneously minimizing slippage for users entering their ecosystem.
As a consequence of this, the number of DeFi protocols has increased exponentially across the board. This is evidence that yield farming has reduced the barrier to entry for users as well as those who are creating DeFi projects.
The use of yield farming as a means of bootstrapping funding for DeFi projects has been shown to be an effective method, but in the long run, it does not come without risks.
In addition, because long-term yield farming projects are subject to certain constraints, it is not possible for it to solve the liquidity problem all by itself, despite the fact that it is effective.
Because it is both necessary and healthy, the majority of DeFi projects are required to engage in yield farming initiatives and bootstrap liquidity. However, in order to avoid unfavourable long-term consequences, project teams need to exercise extreme caution regarding their token supply and farming strategies that produce long-term yields.
Centralization: DAOs
People come to DeFi for a variety of reasons, the most common of which is to make money, but others include the desire to pursue independence and become self-sufficient. Despite this, a group still controls a significant portion of the DeFi protocols, which has caused users of DeFi to lose faith in the technology.
In order to solve this problem, DeFi projects frequently place emphasis on the decentralized nature of their solutions. In recent years, there has been a meteoric rise in the popularity of the DAO. This decentralized autonomous organization (DAO) lets anybody vote on the development of the project.
Capital efficiency: The next interest
The size of the DeFi community is rapidly expanding. The total value locked in by the industry, also known as TVL, has been steadily increasing. Despite this, one of the most difficult problems that DeFi faces is the fact that the majority of its assets are unused and stagnant. Consider the following scenario in order to comprehend this point:
• Lending At the moment, the DeFi protocols have a low utilization ratio, which indicates that there are a great number of lenders relative to the number of borrowers.
• AMM: Despite the fact that AMM is DeFi’s “Liquidity Pool” and pulls in a substantial amount of TVL, the vast majority of it is not put to any productive use. This is due to the design of the AMM, which prevents a concentration of liquidity from taking place.
• Users who feed assets into aggregator protocols in order to obtain Agtokens are unable to spend those tokens anywhere else.
Numerous projects, such as Olympus DAO or Abracadabra, have begun to design suitable initiatives in order to address the problems that have been outlined above. These initiatives are gradually becoming the catalyst for the subsequent wave that the Capital Efficiency department will produce.
The following is an example of what DeFi 2.0 will be able to accomplish with projects that prioritize the effective use of capital:
• Optimize TVL: Allow deposited assets to be used to their full potential.
• Generate a sustainable flow of cash: The method of exchanging LP tokens for bonds, which Olympus DAO demonstrated, decreases the frequency of farm-and-dump situations while also providing long-term liquidity. The system accomplished this. As a result, keeping a healthy cash flow enables projects to grow in a more environmentally friendly manner and attracts a greater number of backers.
DeFi 2.0 vs. DeFi 1.0
The following are some of the distinctions between the DeFi 1.0 and DeFi 2.0 projects:
The vast majority of decentralized finance initiatives are currently centered on the issuance of tokens to “print money.” However, this kind of decentralized finance initiative is frequently unsustainable because it has not proposed any novel solutions for the distribution of governance tokens and community governance, nor has it launched an architecture for “mining.”
Currency transactions are necessary for the development of a decentralized financial system that is both sustainable and capable of performing automatic distribution on the DeFi 2.0 platform.
When decentralized finance reaches the DeFi 2.0 stage, it will be much more likely to connect all members of the community who supply liquidity.
To construct a warm, sustainable, and interconnected decentralized financial architecture, liquidity incentives are being pushed to connect relationships in all future transactions. These transactions will take place in the future.
It is dedicated to breaking the cold transaction mode of DeFi1.0 and expects users to develop close horizontal connections while simultaneously forming strong vertical ties. Additionally, it advocates for close user relationships.
In comparison to DeFi 1.0, DeFi 2.0 grants community members the authority to make ecological governance decisions and gives them a voice in decision-making.
The decisions are made collectively by the whole group. Participation in community activities requires more than merely excitement and curiosity on the part of the members of the community.
The fact that all members are also communities and stakeholders helps to ensure that everyone is heard and that a truly decentralized government structure is established.
The DeFi evolution continues.
Whether you think of DeFi 2.0 news as a generational change in decentralized finance or just a fancy name, one thing is sure: It’s another sign of the DeFi space’s continuing progress.
More importantly, the different kinds of initiatives that make up the DeFi 2.0 movement show that we have already passed what is perhaps the most crucial stage of that evolution: the bootstrapping phase. This is evidenced by the fact that we have already passed this stage.
Now that that obstacle has been cleared, the DeFi 2.0 projects have access to the tools they require to continue advancing the cause of decentralized finance.
When it comes to designing protocols (the concept of money lego), developers are getting more creative all the time. These protocols are designed to maximize profit, capital efficiency, decentralization, and everything else.
Although not all of the tradeoffs have been uncovered yet, there are some. At this point, it looks like everyone is simply excited. This is the current state of affairs.
The first phase of DeFi taught us a lot, particularly in a philosophical sense. There have been a great number of successes, but there have also been a great number of failures.
The experiences and education gained from relatively recent times. This industry is maturing in terms of adoptions and technological advancements, as well as the decentralized philosophy that people forget as they combine it with “the old world,” which consists of regulation, the government, and traditional finance.
