Decentralized finance, commonly known as DeFi, is one of the most successful and influential creations of the innovations made by blockchain networks in the crypto industry. The blockchain network consists of built-in smart contracts that help unlock new economic perspectives for the sector by disintermediating traditional financial services.
DeFi offers a wide range of decentralized applications for the users and ultimately helps secure multiple oracle networks such as Chainlink. Using the proven models of agreements based on financial mechanisms, the DeFi protocols are continuously evolving and growing.
Moreover, it provides multiple other advantages to the users, such as open-source development and managing their funds independently.
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There has been a significant advancement in decentralized financial projects over the past few months that led to the creation of an entirely new concept of DeFi known as DeFi 2.0. This guide article explains the reasons that led to the foundation of this new generation of DeFi. Moreover, it also elaborates on the recent financial paradigms and applications of the DeFi 2.0 protocol.
What is DeFi 2.0?
DeFi 2.0 refers to a new subset of DeFi protocols that introduced a new concept in the blockchain industry. The earlier idea of DeFi was based on different mechanisms such as lending, staking, liquidity mining, etc. However, there were multiple liquidity constraints faced by the system due to native tokens. Tackling this issue is the main aim of the DeFi 2.0 protocol.
It addresses the main issues faced by the first wave of the DeFi network, such as scalability, liquidity, security, user interface, and access to information. It is also trying to solve the security issues and is planning to introduce the AML and KYC policies as per the government requirements.
Early Developments in DeFi
A rigid foundation for the expanding DeFi economy has been kept by the early DeFi pioneers such as Compound, MakerDAO, Bancor, Aave, Uniswap, etc.
Moreover, it has also added many composable and critical money Legos to the system. The users were allowed to swap tokens without providing custody for the very first time by the early decentralized automated market makers (AMM), Bancor, and Uniswap.
The services for online borrowing and lending were provided by Compound and Aave. It allows the users to deposit their funds on-chain and get access to their capital without any permission. To buffer the volatile nature of crypto assets, the users were given decentralized stablecoins by MakerDAO to use and retain in their daily transactions.
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Using these protocols, users got access to stable pegged currencies, lending and borrowing currencies without any hurdle, and dependable exchanges. In traditional financial markets, all these three elementary features are usually available.
However, the infrastructure of decentralized services providing user control and transparency to the customers is quite different from the traditional centralized one. These services are usually offered by technological implementations integrated with the DeFi system.
Limitations of DeFi 1.0
The upgraded version of the existing DeFi model is known as DeFi 2.0. The main goal of this model is to tackle the problems faced by the users and to bring better opportunities for them in the future with new and exciting innovations. Here are a few limitations of the DeFi protocol discussed below.
One of the major problems faced by the users is the usability of a decentralized financial platform. As a significant percentage of the users are seasoned crypto experts, beginners usually find it complicated to use the DeFi platforms because of the UI and UX technicalities.
Things are made more complicated using the scalability feature of decentralized applications. Users do not have a pleasant experience when they are made to wait for verification of transactions and have to pay high transaction costs.
In addition, as the Ethereum blockchain network is used to build most of the decentralized financial solutions, this usually results in high prices and significant time delays due to a considerable number of participants on the network. Therefore, the decentralized services become unprofitable for those who earn less than a few dollars.
- Time Spans
People usually move away from decentralized applications to work on some significant profitable project. Therefore, users’ attention spans on the blockchain network are generally short.
For the blue chips of the decentralized network, yield starts declining than past experiences. This results in an absurd flow of cash, creating a farm-and-dump situation. Therefore, it contributes to inefficient usage of assets and multiple other issues.
All crypto assets require liquidity to carry out trade in the automated market makers (AMMs) and the decentralized exchanges (DEXs) without changing the price of the tokens. Although the incentives available provide a little break, small-scale investors are still a significant threat to the network as they offer situations far away from the ideal ones.
There are specific projects which still have no idea about integrating a relevant oracle and the advantages it can provide to them. Although decentralized finance still significantly uses oracles in the network, some projects refuse to use them. This resulted in multiple attacks on some projects where they had to compensate for the loss later.
What is the Main Aim of DeFi 2.0?
The new wave of decentralized finance mainly focuses on building a direct linkage between the businesses instead of being geared towards users like the previous one. As the initial setup of the DeFi protocol has provided the user base and the required essentials to the users, now the DeFi 2.0 developers can manufacture new decentralized applications and earn capital through it.
Protecting and looking after the services and activities offered in the long term is the main aim of this new wave of the decentralized protocol.
The fundamental hurdles in the sustainability of this sector are the non-existent association of decentralized finance with the traditional financial system and securing the industry’s liquidity by depending on a mediator and incentives earned through tokens. The primary issue of DeFi 2.0 is to tackle this particular issue.
A few of the founders of the DeFi 2.0 protocol strive to create methods to provide long-term liquidity to the system. One of those pioneers is Olympus DAO which is trying its best to create a decentralized reserve currency.
In addition, Olympus Pro has also been announced by Olympus DAO. It demonstrates the business-to-business goal of DeFi 2.0 that helps the DeFi protocols gain their liquidity through a bonding mechanism.
DeFi 2.0 is also helping decentralized automated organizations (DAO) by creating value mechanisms that are operated through specific protocols. Hence, it allows the DAOs to compete with the existing organizations through the innovative tools produced by DeFi 2.0 and achieve the B2B goal in its real sense.
The Innovations of DeFi 2.0 and DeFi Protocols of Second Generation
When the users and the projects got to know the limits and boundaries of the decentralized financial system, it is where the research for DeFi 2.0 started.
When the developers started figuring out the relevant solutions to each problem integrated with the DeFi protocol, it resulted in the upgradation of the market mechanism every time in the same way as required by the market. Some of the solutions proposed by DeFi 2.0 are discussed below.
- Scalability: Layer one, Layer two
A significant hurdle for the users of decentralized protocols, especially the beginners, was the interaction with the Ethereum network. However, because of the long waiting time and the high transaction costs, many users could never get a chance to experience decentralized services.
Therefore, the developers started thinking of solutions to help users interact with DeFi without facing any scalability issues. Some blockchain networks exist, such as Solana, Polygon, BSC, etc., where the users can deposit their funds and provide the required facilities. However, it should be kept in mind that the scalability solutions might disturb the upcoming market waves.
- Liquidity: Yields
The simplest way to attract more users to the DeFi protocol and to provide them the solution to their liquidity issues is by helping them earn more capital and yields.
The third-party liquidity providers operating on the automated market maker protocols have provided a temporary solution to the liquidity issue. Therefore, any person with sufficient money can provide liquidity for a pair of tokens he is trading.
Moreover, it is also possible that the teams gain enough liquidity from others theoretically rather than providing it by themselves. However, there is a possibility that the users might face a loss for swapping a new coin to earn minimal revenue as they already have a limited amount of incentives to launch liquidity.
Therefore, a sensible step was required to solve this issue that may have caused chaos otherwise. If the system lacks liquidity, the users usually refrain from using DeFi applications due to the slippage issue. The external actors do not participate in the pools and provide liquidity as the consumers participating in the transactions could not create enough fee volume.
This led to another development in the decentralized sector known as yield farming or liquidity mining. This is the practice of providing liquidity to the pools using the liquidity provider (LP) tokens. Yield farming became famous in 2020 when the DeFi protocol was getting hype.
It is a relatively more straightforward process where the users use the automated market makers protocol to provide liquidity for a specific pair of tokens. As a result, he receives an LP token in return that he then stakes to earn rewards in the form of a native token of the project.
Therefore, the disturbing situation created initially can be solved by adopting this approach as it provides a way for the external liquidity providers to offer a higher return on the token based on solid economic grounds.
In addition, there is a possibility that the liquidity providers may even earn a yield more than expected. This is because by generating an ample amount of cumulative fee with automated market makers swaps because of high liquidity, they might stake and earn more of the native tokens of the project.
For the sustenance of DeFi operations and to minimize the slippage for the users in the DeFi ecosystem, yield farming has proved itself as an effective way of generating capital in DeFi. It increased the number of DeFi protocols explaining to the users how the implementation of decentralized protocols has reduced charges for both the developers and the users.
However, one cannot deny the fact that yield farming is still a practical approach in DeFi, still has certain risks integrated with it in the long run. In addition, being a lot beneficial, sometimes yield farming might be unable to solve the liquidity problems due to certain limitations.
But the developers believe that the yield farming approach must be adopted by the DeFi projects to launch liquidity, as it is a healthy and necessary requirement in the field. However, to avoid any loss, it is recommended that the projects’ teams keep a keen eye on the supply of their tokens and tactics being implemented.
- Centralization: Decentralized Automated Organizations (DAOs)
In addition to generating money through DeFi, the users also want to become independent and self-sufficient using the DeFi services. However, some people are still trying to control the decentralized services, causing distrust among the users of DeFi.
The decentralized projects are trying to tackle the issue in the best possible manner. Decentralized automated organizations are becoming more popular these days by allowing all the participants in the project to vote for the betterment of the project.
- Capital Efficiency: The Next Interest
The total value locked (TVL) in the crypto sector is continuously increasing as DeFi projects are getting more popular these days. However, the assets being static and wasted is one of the biggest challenges that DeFi has to face. One can understand this concept through the following situation.
- Lending: As there are more lenders than borrowers in DeFi protocols, the utilization ratio is low in the DeFi protocols.
- AMM: A large quantity of DeFi liquidity is being collected through the AMMs, for they are the primary liquidity pool. However, the existing design of AMM does not allow the liquidity to get concentrated in the collection.
- Borrowing: The Agtokens earned by the users through aggregator protocols cannot be spent anywhere else.
Several initiatives have been taken by multiple DeFi projects to solve these issues. However, DeFi 2.0 tends to solve these issues by focusing on capital efficiency. It can allow the user to consume the deposited assets to their full potential, which would assist in optimizing the total value locked for the system.
Moreover, a sustainable cash flow can be created by exchanging the bonds with LP tokens, as shown by the Olympus DAO. This will provide long-term liquidity to the system by decreasing the probability of farm-and-dump situations.
Comparison Between DeFi 1.0 and DeFi 2.0
The differences between DeFi 1.0 and DeFi 2.0 protocols have been mentioned below.
- Connection Among Users
DeFi 1.0 does not provide any means of connection among the users. However, the users can develop a strong relationship with each other using the DeFi 2.0 protocol.
The first wave of DeFi comprises decentralized exchanges, lending, and stablecoin applications, decentralized trading platforms, synthetic assets, liquidity gun pool applications, and insurance projects. On the other hand, DeFi 2.0 focuses mainly on the creation of an interconnected, sustainable infrastructure, provision of liquidity incentives, and capital efficiency.
- Incentive Schemes
Using the DeFi 1.0 protocol, the users are not provided with any considerable amount of incentives. However, the attractive incentive schemes for the users in DeFi 2.0 is one of the reasons for its growing popularity.
- Governance Patterns
Being an initial stage, DeFi 1.0 does not own a good governance pattern, and the community exists in a scattered manner. On the contrary, the policy rights and governance patterns are delegated to the participants in DeFi 2.0 protocol.
- Scope for Innovations
DeFi 1.0 is a single-sided road to innovation and the development of decentralized technology. However, there is vast room for innovation and growth in the financial and technological sectors.
The main focus of the DeFi projects is to print money in exchange for tokens; however, no new ways have been found to distribute governance tokens and govern the community. DeFi 2.0 aims at connecting the users to concentrate liquidity in the pool.
The main goal is to break the previous boundaries of transactions so that the users can develop closer horizontal connections. Moreover, unlike the first wave, the DeFi 2.0 protocol also provides the authority to make decisions for all community members.
DeFi 2.0 is a significant signal of the growing popularity of decentralized services and features in the crypto space. The increasing development in the new wave has already surpassed the launching phase of the movement. They have now understood the strategies and techniques to help the DeFi 2.0 protocol grow and expand further.
The initial phase of the decentralized protocol has taught the creators a lot. They are now striving to achieve decentralization, capital efficiency, and profit maximization. DeFi 1.0 has made many mistakes initially; the protocol movement is learning in terms of technology and adoption to the governance and financial regulations.