DeFi 1.0 faced several issues in its mission to make finance accessible to everyone, such as scalability, security, centralization, liquidity, and access to information. The DeFi 2.0 movement aims to improve these areas and provide a more user-friendly experience. If successful, DeFi 2.0 could make using crypto less complicated and risky, encouraging more people to adopt it.
Numerous DeFi 2.0 use cases are already operational. For instance, certain platforms allow you to utilize your LP tokens and yield farm LP tokens as collateral for a loan, enabling you to unlock additional value from them while also earning pool rewards. You can also obtain self-repaying loans where your collateral generates interest for the lender, paying off the loan without the borrower making interest payments. Insurance against compromised smart contracts and impermanent loss (IL) are other DeFi 2.0 use cases.
The decentralization and DAO governance trend is growing in DeFi 2.0. However, government and regulatory bodies might eventually affect how numerous projects are operated. Therefore, consider this while investing, as provided services may have to change.
In 2020, DeFi or Decentralized Finance emerged, and since then, successful projects like UniSwap have brought decentralization to trading and finance while introducing new ways to earn interest in the crypto industry. However, like Bitcoin (BTC), the new field has its challenges. To address these challenges, a new generation of DeFi decentralized applications (DApps) has emerged, and it's called DeFi 2.0. Although we are still waiting for the full effect of DeFi 2.0, we can already observe its beginnings as of December 2021. This article highlights the need for DeFi 2.0 to solve outstanding issues in the DeFi ecosystem and provides insights on what to expect.
What Is DeFi 2.0?
In response to the issues that arose with DeFi 1.0, a new movement called DeFi 2.0 has emerged to improve and fix the shortcomings of the original DeFi wave. Although DeFi made decentralized financial services accessible to anyone with a crypto wallet, it still had some weaknesses that needed addressing. Second-generation blockchains like Ethereum have already undergone this process of improvement, with DeFi 2.0 aiming to follow suit. Additionally, governments plan to introduce new compliance regulations such as KYC and AML, which DeFi 2.0 will also need to adapt to.
Consider the success of liquidity pools (LPs) in DeFi, as they enable liquidity providers to earn fees by staking token pairs. Unfortunately, if the token price ratio fluctuates, liquidity providers can incur losses in what is known as "impermanent loss". However, a DeFi 2.0 protocol can offer coverage against impermanent loss for a modest fee, resulting in a stronger incentive to invest in LPs, and ultimately benefiting DeFi users, stakers, and the ecosystem at large.
What Are the Limitations of DeFi?
Exploring the issues that DeFi 2.0 aims to address is important before delving into its use cases. Many of the problems are similar to those faced by blockchain technology and cryptocurrencies in general. These problems include:
- Scalability: DeFi protocols running on blockchains with high traffic and gas fees often provide slow and expensive services. This makes simple tasks slow and cost-inefficient.
- Oracles and third-party information: Financial products relying on external details need high-quality oracles (third-party sources of data).
- Centralization: Many DeFi projects lack DAO principles, even though an increasing amount of decentralization is necessary.
- Security: Many users don't understand or manage the risks present in DeFi. They stake millions of dollars in smart contracts that they don't know are safe. Although security audits are in place, they become less valuable as updates occur.
- Liquidity: Markets and liquidity pools are distributed across different blockchains and platforms, splitting liquidity. Providing liquidity locks up funds and their total value. In most cases, tokens staked in liquidity pools cannot be used elsewhere, creating capital inefficiency.
What's the Advantage of DeFi 2.0?
DeFi, despite being popular among experienced crypto users, can be challenging to comprehend. Nonetheless, its goal is to offer new income opportunities and lower the entry barriers for cryptocurrency holders. For people who may not qualify for a loan from a traditional bank, DeFi could be a viable alternative.
DeFi 2.0 is significant because it can democratize finance while maintaining risk management. It also aims to address the issues highlighted earlier, resulting in a better user experience. If DeFi 2.0 succeeds in this and provides improved incentives, it would be beneficial for everyone involved.
DeFi 2.0 Use Cases
Let's take a look at some of the most common DeFi services offered by projects across various smart contract-capable blockchains, such as Ethereum and Solana
Unlocking the Value of Staked Funds
Before DeFi 2.0, staking LP tokens in a liquidity pool to earn yields was the primary method of generating profits. Millions of dollars have been locked in vaults providing liquidity, but capital efficiency could be further enhanced. DeFi 2.0 uses yield farm LP tokens as collateral for crypto loans from lending protocols or to mint tokens, like in the MakerDAO (DAI) process. The specific mechanism varies by project, but the concept is to unlock the value of LP tokens for new opportunities while still earning APY.
Smart Contract Insurance
Evaluating smart contracts is challenging for non-technical users, which poses significant investment risk in DeFi projects. DeFi 2.0 offers a solution by providing DeFi insurance on specific smart contracts. For instance, when using a yield optimizer and staking LP tokens in its smart contract, there is a risk of losing all deposits if the contract is compromised. However, insurance projects can offer guarantees for a fee, but only for a specific smart contract. It's essential to note that a payout is unlikely for compromised liquidity pool contracts, but if the yield farm contract is compromised and covered by insurance, you'll likely receive compensation.
Impermanent Loss Insurance
DeFi 2.0 is exploring ways to mitigate the risk of impermanent loss, which may lead to financial losses when investing in a liquidity pool and liquidity mining. One method is by using a single-sided LP, where one token is added, and the protocol adds their native token as the other side of the pair. This generates fees from swaps in the respective pair, which are shared between you and the protocol. The protocol uses its share of fees to build an insurance fund to secure your deposit against impermanent loss. If the fees are insufficient, the protocol can mint new tokens to cover the losses. Excess tokens can be stored for later or burned to reduce supply.
In DeFi 2.0, taking out a loan does not involve liquidation risk or interest payments as is typical with traditional loans. An example of this is when a crypto lender gives a $100 crypto loan and requires $50 as collateral. The lender then uses the collateral deposit to earn interest and pay off the loan. When the lender has earned $100 plus a premium with the crypto, the deposit is returned, and there is no liquidation risk. In the event of a decline in the value of the collateral token, the loan repayment is only delayed.
Who Controls DeFi 2.0?
Decentralization is a key trend in blockchain technology, and it's no different with DeFi. MakerDAO (DAI) was one of the first DeFi 1.0 projects to set the standard, and now it's increasingly common for DeFi projects to offer their community a say. Governance tokens are often used as platform tokens, which give their holders voting rights. With DeFi 2.0, it's reasonable to expect more decentralization, although compliance and regulation are becoming more important as they catch up with DeFi.
What Are the Risks of Defi 2.0?
To ensure safety when investing in DeFi 2.0, it's important to be aware of the risks involved. Here are some of the main risks and what you can do to protect yourself.
- The smart contracts that you interact with could be hacked or have vulnerabilities, despite undergoing audits. Therefore, it's vital to conduct thorough research on the project before investing and to understand that there's always a risk associated with investing.
- Government regulations could have an impact on your investments. As DeFi continues to gain global attention, regulators and governments are becoming more involved in the ecosystem. While regulation can bring security and stability to crypto, it may also require some projects to modify their services to comply with new rules.
- Impermanent loss is a significant risk for anyone interested in liquidity mining, even with insurance. Unfortunately, the risk cannot be entirely eliminated.
- Accessing your funds may also be difficult, particularly if you're staking through a DeFi project's website UI. In this case, it's advisable to locate the smart contract on a blockchain explorer to enable withdrawals in the event of a website shut down. However, it's essential to have some technical expertise to interact directly with the smart contract.
Despite the success of current DeFi projects, the full potential of DeFi 2.0 is still to be realized. The topic can be complex for users, and investing in financial products that aren't fully understood should be avoided. There is a need for a more straightforward process, particularly for new users. Although new approaches to minimize risk and earn APY have been successful, the extent to which DeFi 2.0 will deliver on its commitments remains to be seen.