The evolution of the blockchain industry has been nothing short of excellence since the inception of Bitcoin. Cryptocurrency has opened up the world to amazing innovations in different fields.
DeFi stands for decentralized finance, and it refers to financial applications built on blockchain technology. These applications allow people to borrow, lend, and trade in a trustless manner.
DeFi allows anyone to get involved in various financial opportunities on an open-source and decentralized blockchain network. Although the early DeFi generation experienced a massive breakthrough, there has been a challenge with scalability, decentralization, security, liquidity, and accessibility to information. Here is where the DeFi 2.0 comes in.
This article explores DeFi's meaning, what you need to know about the early generation of DeFi, and the latest DeFi 2.0 trends, goals, use cases, and why you should care about them.
Decentralized Finance (DeFi) 1.0
Decentralized finance projects are all the rage in today's financial world. Decentralized exchanges (DEX) and lending and borrowing protocols are the major trends allowing investing and yield generating without compromising on privacy.
At its core, DeFi uses blockchain technology to create financial products that are more secure, efficient, and transparent than those offered by traditional financial institutions.
There are thousands of DeFi projects available today that allow users to trustlessly access financial services on various blockchain platforms. With new projects emerging daily, upgrades to the DeFi ecosystem are crucial.
DeFi 2.0 refers to another wave of products enhancing DeFi sector by focusing more on security, interoperability, insurance, and liquidity while maintaining decentralisation!
Early Developments of DeFi
DeFi is still in its early stages of development. There are a lot of innovative projects and startups working on various aspects of DeFi, from lending and borrowing platforms to trading and tokenization protocols.
Some projects listed below laid the groundwork for DeFi’s rapid growth.
This is one of the most popular DApps on the Ethereum network. UniSwap is an early decentralized exchange (DEX) that introduced the automated market maker (AMM) system that enables users to swap one token for another.
The Uniswap’s AMM introduced a bonding curve aggregating individual positions into one pool which automatically rebalances based on the X * Y = K formula. In return, liquidity providers get a commission on every transaction carried out on the platform.
Ethereum's MakerDAO allows users to create stablecoins called DAI. MakerDAO is arguably the biggest DeFi project, with a Total Value Lock (TVL) of over 15 billion and a market value of over 2 billion.
It is a DeFi crypto lending credit platform that gives out loans to members at fixed interest rates. Here's how it works; if a user wants to borrow crypto, they would have to deposit ETH into a Maker smart contract, after which the smart contract creates a Collateralized Debt Position (CDP).
Whenever ETH or any other supported crypto is locked in the platform as collateral, MakerDAO mints a decentralized stablecoin—DAI.
Aave is a decentralized lending and borrowing protocol that gives users access to crypto loans at both fixed and variable interest rates. It enables lenders to lock up their crypto assets as loans and earn a yield.
By way of summary, these protocols offer users trustless exchange, lending/borrowing, and algorithmic stablecoin services, hence enhancing key financial operations in the conventional financial markets.
What Are the Limitations of DeFi?
However, as usual, the new innovations don’t come without challenges.
Ethereum supports most DeFi protocols; however, the high number of users on the network can slow down transaction speed and increase transaction costs.
2. Oracles (Third-party Data Source)
Oracles are third-party services that allow blockchain smart contracts to send and receive external data, i.e. the price of an asset. That said, oracles are vulnerable to attacks as they are not secured by the blockchain's consensus mechanism. The attacks were carried out where bad actors exploited oracles in order to manipulate the platform and redeem funds that didn’t belong to them.
Decentralization is pivotal to DeFi, but not all projects manage decentralization well. Some individuals influence the decision-making and operations of certain DeFi projects, which may increase the possibility of fraud.
While some projects have adopted the Decentralized Autonomous Organization (DAO) structures to work towards decentralization, it could be argued that this setup is decentralized enough, with DAOs facing centralization challenges on their own.
4. Lack of Insurance and Security
Unlike centralized finance, there're very little insurance products in DeFi. Insurance protects investors’ investments in case of hacks or other unpleasant events. Therefore, investors often end up staking large sums in DeFi protocols without sufficient safety controls in place.
Liquidity is a major challenge in all financial markets, and DeFi is no exception. In most cases, tokens staked in protocol's liquidity pools can only be used in that pool, which often results in capital inefficiency
What Is DeFi 2.0 and Why It Is Important?
DeFi 2.0 is a trend that aims to provide additional liquidity, scalability, and insurance by building on top of DeFi 1.0 projects. It addresses the first DeFi protocol's liquidity constraints, such as temporary liquidity mining and sustainable long-term liquidity.
DeFi 2.0 has become the standard for developing next-generation decentralized applications (DApps). This is evident in its widespread adoption in new projects.
DeFi 2.0 makes finance more accessible with minimized risks. It also lowers boundaries, enabling crypto users to use DeFi more easily and potentially earn more money.
The Goal of DeFi 2.0
DeFi 2.0 projects take advantage of the fact that the first generation of DeFi services started the movement and created an early user base, hence providing the crucial DeFi foundation for future waves of DeFi apps to be built on.
In addition, DeFi 2.0’s role has been to save DeFi protocols from liquidity providers and token rewards to secure liquidity in the protocol.
Most of the DeFi 2.0 project's forerunners are working intently to enhance liquidity supply long-term, and a few examples of these DeFi 2.0 projects are OlympusDAO, Convex Finance, and Abracadabra.
The concept of OlympusDAO allows DeFi protocols to own their liquidity via so-called discounted bonding curves. This solution provides for greater sustainability of DeFi projects given that many of them suffer from mindless liquidity mining incentives offered across the industry which often make investors switch projects depending on the current liquidity programs in place.
Convex is a protocol based on Curve—a stablecoin exchange. This DeFi 2.0 platform enables Curve crypto holders and liquidity providers to earn extra interest from the exchange's trading fees, hence providing additional liquidity and incentives on top of the Curve’s DeFi 1.0 solution.
Abracadabra Money is a lending protocol that uses interest-bearing tokens (IB tokens) as collateral to borrow a USD-pegged stablecoin called MIM. This is another novel approach to algorithmic stablecoin creation that uses DeFi 1.0 tokens as a base layer. The protocol supports multiple blockchains, including Ethereum, Avalanche, and Binance Smart Chain (BSC).
DeFi 2.0 Use Cases
There are many successful and evolving DeFi 2.0 projects running on different blockchain networks, with a few examples listed above. Next, let’s look at even more use cases of DeFi 2.0 .
Smart Contracts Covered by Insurance
DeFi is inherently open-source and transparent. However, carrying out due diligence and risk analysis of DeFi platforms’ smart contracts is difficult without sound knowledge and technical experience.
DeFi 2.0 strives to alleviate this uncertainty by offering smart contracts insurance for its users. With DeFi 2.0 insurance projects like Nexus Mutual, crypto users’ safety comes first as their DeFi deposits are covered by investors willing to take on protocol risks in return for a premium.
Mitigation of Impermanent Loss
Typically, when a user provides liquidity to liquidity pools, it accepts that upon price changes their holdings will get re-balanced, hence they will automatically incur an impermanent loss. However, this problem is tackled by DeFi 2.0 projects using different rules and mechanisms.
With DeFi 2.0, users collaborate with the protocol to create a liquidity pool. Thanks to this they don’t need to provide both currencies to the pool which saves them from an impermanent loss. This is how it works in detail:
- Users do not need to add a token pair.
- Users can add a token to a single-sided liquidity pool (LP), while the protocol then adds another token to make a token pair.
DeFi 2.0’s Alchemix helps overcome liquidation risks and high-interest rates on crypto loans by offering self-repaying loans. In this self-repaying loan system, the interest earned on the lender's deposited collateral can pay off the loan. Once the lender’s collateral yielded enough returns to pay off the loan, the collateral can be returned to the borrower. It’s essentially a novel concept of borrowing money from your future self.
The Future Prediction of DeFi 2.0
Undoubtedly, the new DeFi trend has offered ups and downs. However, one thing we can be sure about is that DeFi space is experiencing continuous progress in terms of technology and adoption.
DeFi is arguably the future of finance, as it solves some critical problems of traditional financial systems. Notable upgrades like the DeFi 2.0 bring them closer to achieving this goal - perhaps it is about time we start guessing what will DeFi 3.0 be about?
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