Lately, the Crypto space has been observing more and more projects that aim to tackle the current problems of the popular Decentralized Finances. These new platforms have been given a common denominator — DeFi 2.0. The name itself is explanatory enough, as all of these platforms have in common some sort of an upgrade of the current DeFi 1.0 segment.
Since 2020, DeFi 1.0 has successfully brought crypto finances to the masses. Its numerous platforms enabled crypto users to start trading, staking, borrowing, and lending crypto assets, just to name a few. However, it has not addressed certain pain points in terms of its scalability, security, centralization, liquidity, and accessibility to information. It was these unsolved issues that brought to life a number of new projects which are striving to provide the crypto space with a better, safer, and more user-friendly experience. If successful, this will significantly strengthen the decentralization of finances all over the world.
Why should we upgrade from DeFi 1.0?
DeFi protocols have been struggling with the scalability of individual platforms. High traffic on blockchains results in higher gas fees. Services become slower and more expensive which is why they are no longer interesting to individual investors. Combined with the use of low-quality oracles, the user experience becomes weaker and weaker.
Another pain point is the de-centralization of the entire field. These Decentralized Financial services are in truth not as decentralized as they would like to be. Each platform is still governed by a group of engineers who developed its mechanisms. To achieve true de-centralization, they would need to take steps towards the DAO structure.
A major risk factor in DeFi 1.0 is its security aspect. The more crypto-savvy users are aware of the many risks and can mitigate them to a certain degree, but those who are only just embarking on their crypto journey may get entangled in situations like wrong liquidity pool estimates, compromised private keys, frontrunning attacks, rug pulls and Ponzi schemes, inefficient access control, or 51% attacks. Security audits play an important role in DeFi security but can become outdated as updates occur.
The last on our list of DeFi 1.0 obstacles is liquidity. Liquidity pools are currently structured with a couple of weak points, including funds lock-up which can result in capital inefficiency, smart contract risks, malicious actions on the part of the developers — and the most notorious of them all — impermanent loss.
Will DeFi 2.0 change the game?
The DeFi 2.0 movement is seeking to increase the quality of the user experience and the overall security aspect of decentralized financial services. Multiple protocols are already solving some of the before-mentioned risks.
DeFi 1.0 enticed its users to assist in providing liquidity for a token pair in exchange for earning yields. However, certain limitations of long-term yield farming projects arose as investors were at risk of impermanent loss. DeFi 2.0 strives to remove its reliance on subsidized liquidity and restructure it into one that is controlled by the protocol. Platforms that use the so-called “protocol-controlled liquidity” (PCV) approach acquire their own liquidity or rent it from other protocols, which means they are no longer dependent on third-party investors and mitigate the risk of impermanent loss.
Smart contract insurance
It’s hard to conduct due diligence on a protocol’s smart contracts and this lack of knowledge represents a great risk for new investors. DeFi 2.0 enables its users to take out insurance on specific smart contracts for a fee and protect their investments in case a specific smart contract or a liquidity pool contract gets hacked.
Loans typically involve liquidation risk and interest payments. But DeFi 2.0 services remove this risk. The worst-case scenario here is that the collateral token’s value depreciates, and it takes longer for the loan to be paid off. For example, if you take a loan worth $100, the lender gives you $100 of crypto but takes $50 as collateral. The lender uses your deposit for staking to earn interest with which he pays off your loan. After the lender has earned $100 with your crypto plus extra as a premium, your deposit is returned. The idea is that the borrower never actually pays the loan back, the lender is paid back in yield.
The end goal of the crypto community is complete decentralization, therefore moving to DAOs will be one of the key steps toward the crypto end game vision. As long as DeFi protocols continue to be controlled by their groups of developers, the promised transparency and security will remain dubious. DeFi 2.0 will put a lot of emphasis on transforming its protocols into DAOs where all stakeholders will be able to co-govern on every aspect of the protocol itself. This will improve transparency, security, and the overall strength of individual communities.
Unlocking the value of staked funds
DeFi 2.0 enables its investors to use their yield farm LP tokens for new opportunities, e.g., for a crypto loan from a lending protocol or to mint tokens, while still generating APY. There are numerous possibilities of how to benefit from these LP tokens which have until now just sat locked in individual protocols.
What about the risks?
Every upgrade still possesses potential risks and DeFi 2.0 is no exception. While protocols benefit greatly from security audits and the ecosystem is maturing, the crypto space still holds plenty of risks. Despite the chance to take smart contract insurance, users should be careful of “aping” into a particular protocol.
Another thing to keep in mind is the regulatory aspect of DeFi 2.0. It’s highly unlikely that governments are just going to sit back and watch billions of dollars move between traders and decentralized exchanges without taking their slice of the deal. Each participant in DeFi should follow relevant changes in their country’s regulations and taxation to avoid any financial complications in the future.
Trending DeFi 2.0 projects
Ethereum, Binance Smart Chain, Solana, and other smart contract-capable blockchains already host some interesting DeFi 2.0 protocols. Here are some projects that are trying to secure their place in the new DeFi 2.0 sphere:
- OlympusDAO ($OHM) — Decentralized reserve currency model with bonds, LP, staking, etc. More on the topic is available in the Investor’s Guide to OlympusDAO.
- Abracadabra ($MIM) — Protocol generating the Magic Internet Money (MIM) stablecoin as yield for various lending practices.
- Alchemix ($ALCX) — Low-maintenance protocol with self-repaying loans, future yield, and DAO governance.
- Algorand ($ALGO) — Layer-1 and layer-2 smart contract protocols focused on scale and blockchain interoperability.
- Avalanche ($AVAX) — Fast, low-cost programmable smart contract platform (layer 1) which supports creation of DeFi 2.0 dApps.
- Curve Finance (CRV) & Convex (CVX) — Top 3 (currently) TVL of DeFi protocols: DAO, exchange, LP, stablecoin, and more.
- MakerDAO ($MKR, $DAI) — $MKR token holders govern the DAO that regulates $DAI, the native stablecoin pegged 1:1 with the US dollar.
- Solana ($SOL) — A layer-1 smart contract platform.
- Synapse ($SYN) — Trustless cross-chain bridge and automated market-maker (AMM).
- Rarible ($RARI) — DAO governance and yield generation based on NFT sales.
- Wonderland ($TIME) — Avalanche-based reserve currency protocol with responsive APY.
- Yearn Finance ($YFI) — Yield and lending aggregator and insurance provider on the Ethereum blockchain.
What can we expect?
DeFi services have significantly influenced the financial industry. It’s exciting to imagine just what an important upgrade will bring to the table. The DeFi 2.0 movement is only getting started and we still need to wait some time to grasp its full potential. Processes will need to be simplified to attract more users who don’t possess an in-depth knowledge of decentralized finances. This could boost the growth of the crypto space considerably. Now, all we can do is wait and see if DeFi 2.0 fully delivers on its promises.
Join the GoCrypto community on Telegram!