TL;DR (SUMMARY)
DeFi 2.0 is a movement made up of projects that present improvements to the problems in DeFi 1.0. DeFi aims to bring finance to the general public, but has had problems with scalability, security, centralization, liquidity, and information accessibility. DeFi 2.0 aims to combat these problems and make the experience more user-friendly. If successful, DeFi 2.0 could help reduce the risk and complications that discourage cryptocurrency users from using it.
Currently, we already have several DeFi 2.0 use cases that work. Some platforms allow you to use your LP tokens and yield farming LP tokens as collateral for a loan. This mechanism allows you to release additional value from these tokens, while also earning rewards from the pools.
You can also obtain self-repaying loans, in which your collateral generates interest for the lender. This interest pays off the loan without the borrower having to make any interest payments. Another use case is insurance to protect smart contracts that are compromised, and insurance against impermanent loss (IL).
An increasingly popular trend in DeFi 2.0 is governance through DAOs and decentralization. However, governments and regulators could eventually alter the way many projects are managed. Keep this in mind when investing, as the services offered could change due to obligation.
Introduction
It's been almost two years since the rise of DeFi (Decentralized Finance) in 2020. Since then, we have witnessed incredibly successful DeFi projects like UniSwap, which represents the decentralization of trading and finance, as well as new ways to generate interest on the world of cryptocurrencies. But just as we experienced with Bitcoin (BTC), there are still problems to be solved in such a new field. In response, the term DeFi 2.0 has been popularized to describe a new generation of DeFi decentralized applications (DApps).
As of December 2021, we are still waiting for the tide of DeFi 2.0 to arrive, although we can already see its beginnings. Discover in this article the things you should pay attention to and why DeFi 2.0 is necessary to solve the pending problems of the DeFi ecosystem.
What is DeFi 2.0?
DeFi 2.0 is a movement that tries to update and solve the problems seen in the original DeFi wave. DeFi was revolutionary in offering financial services to anyone with a cryptocurrency wallet, but it still has weaknesses. Cryptocurrencies have already gone through a similar process with second-generation blockchains like Ethereum (ETH), which represent an improvement over Bitcoin. DeFi 2.0 will also need to react to new regulatory compliance standards that governments plan to implement, such as KYC and AML.
Let's look at an example. Liquidity pools (LPs) have proven to be very successful in DeFi, as they allow liquidity providers to earn fees for staking token pairs. However, if the price relationship between the two tokens changes, liquidity providers risk losing money (impermanent loss). A DeFi 2.0 protocol could offer protection against it in exchange for a small fee. Such a solution would offer a greater incentive to invest in LPs and would benefit users, stakers and the DeFi sector as a whole.
What are the limitations of DeFi?
Before we look into the use cases of DeFi 2.0 in detail, let's first look at what problems it is trying to solve. Many of these problems are similar to those faced by blockchain technology and cryptocurrencies in general:
1. Scalability: DeFi protocols on blockchains with high traffic and high gas fees often offer slow and expensive services. Simple tasks can take a long time and be unprofitable.
2. Oracles and third-party information: Financial products that depend on external details need higher quality oracles (third-party data sources).
3. Centralization: One of the goals of DeFi should be increasing decentralization. However, many projects still do not have DAO-based principles implemented.
4. Security: Most users do not manage or understand the risks present in DeFi. They stake millions of dollars in smart contracts whose security they do not know. Although security audits are done, they tend to lose value as updates are made.
5. Liquidity: Liquidity markets and pools are distributed across different blockchains and platforms, which causes liquidity to be divided. Providing liquidity also locks the funds and their total value in deposit. In most cases, tokens staked in liquidity pools cannot be used anywhere else, resulting in capital deficiency.
Why DeFi 2.0 is important?
Even for HODLers and expert cryptocurrency users, DeFi can be overwhelming and difficult to understand. However, it is proposed to reduce entry barriers and create new earning opportunities for cryptocurrency holders. Users who might not get a loan through a traditional bank could get one with DeFi.
DeFi 2.0 is important because it can democratize finance without making any trade-offs on risk. DeFi 2.0 also tries to solve the problems noted above, which would improve the user experience. If we can achieve this and offer better incentives, then everyone can win.
DeFi 2.0 Use Cases
We don't have to wait for DeFi 2.0 use cases to emerge. There are already projects offering new DeFi services on many networks, including Ethereum, Binance Smart Chain, Solana, and other smart contract-capable blockchains. Next, we will see some of the most common:
Unlock the value of staked funds
If you have ever staked a token pair in a liquidity pool, you will have received LP tokens in exchange. In DeFi 1.0, LP tokens can be staked through yield farming to generate profits from your profits. Before the existence of DeFi 2.0, this was all the chain could offer in terms of value extraction. Millions of dollars are locked in deposits in vaults that provide liquidity, but there is still room to further improve capital efficiency.
DeFi 2.0 goes a step further and uses these yield farming LP tokens as collateral. It could be for a cryptocurrency loan from a lending protocol, or for minting tokens in a process similar to MakerDAO (DAI). The exact mechanism varies depending on the project, but the idea is that your LP tokens should release their value to access new opportunities while still generating APY.
Insurance for smart contracts
Expanding due diligence on smart contracts is difficult unless you are a very experienced developer. Without this knowledge, you can only partially evaluate a project. This creates a lot of risk when investing in DeFi projects. With DeFi 2.0, it is possible to obtain DeFi insurance for specific smart contracts.
Imagine you are using a yield optimizer and you are staking LP tokens in its smart contract. If the security of the smart contract is compromised, you could lose your entire deposit. An insurance project can offer you a guarantee for your deposit in yield farming in exchange for a commission. Please note that this will only be for a specific smart contract. Generally, you will not receive compensation if the security of the liquidity pool contract is compromised. However, if the security of the yield farming contract is compromised, and you have insurance coverage, then you will likely receive compensation.
Insurance against non-permanent loss
If you invest in a liquidity pool and start liquidity mining, any change in the price rate of two tokens that you have locked in escrow may lead to financial losses. This process is known as non-permanent loss, but new DeFi 2.0 protocols are exploring methods to mitigate such risk.
For example, imagine adding a token to a one-sided LP where a pair does not need to be included. The protocol then adds its native token as the opposite side of the pair. And you will receive commissions paid from the swaps in the respective pair, and so will the protocol.
Over time, the protocol uses its fees to build an insurance fund that protects your deposit against the effects of non-permanent loss. If there are not enough fees to offset losses, the protocol will be able to mint new tokens to cover them. If there are excess tokens, they can be stored for another time or burned to reduce the supply.
Self-repaying loans
Normally, obtaining a loan carries a risk of settlement and payment of interest. However, with DeFi 2.0, this does not have to be the case. For example, imagine you get a $100 loan from a cryptocurrency lender. The lender gives you $100 in crypto, but requires $50 as collateral. Once you provide the deposit, the lender uses it to generate interest that pays your loan. As soon as the lender earns $100 on your cryptocurrencies plus an extra bonus, your deposit is returned to you. There is also no risk of liquidation. If the token acting as collateral loses value, it will simply take more time to repay the loan.
Who controls DeFi 2.0?
With all of these features and use cases, it's worth asking who controls them. There has always been a trend towards decentralization in blockchain technology. And DeFi is no exception. One of the first DeFi 1.0 projects, MakerDAO (DAI), set a standard for the movement. Nowadays, it is increasingly common for projects to allow their communities to give their opinion.
Many platform tokens also function as governance tokens that grant their holders voting rights. It is reasonable to expect that DeFi 2.0 will bring more decentralization to the sector. However, the role of regulations and compliance is becoming increasingly important as DeFi catches up.
What are the risks of DeFi 2.0 and how can they be prevented?
DeFi 2.0 shares many of the same risks with DeFi 1.0. Here are some of the main ones and what you can do to stay protected.
1. The smart contracts you interact with could have security holes (backdoors), vulnerabilities, or be hacked. And an audit is never a guarantee of the safety of a project. Research the project as much as you can and be aware that investing always carries risk.
2. Regulation could affect your investments. Governments and regulators around the world are taking an interest in the DeFi ecosystem. While regulations and laws can bring security and stability to the crypto environment, some projects may be forced to change their services as new rules are created.
3. Non-permanent loss. Even with impermanent loss (IL) coverage, this loss is still a significant risk for anyone who wants to engage in liquidity mining. The risk cannot be completely eliminated.
4. You may find it difficult to access your funds. If you're staking through the UI of a DeFi project's website, it might be a good idea to locate the smart contract in a block explorer. Otherwise, you will not be able to make withdrawals if the website stops working. However, to interact directly with the smart contract, you will need to have some technical experience.
Conclusions
Although there are already many successful projects in the DeFi sector, the full potential of DeFi 2.0 remains to be seen. The topic is still complicated for most users, and no one should use financial products without fully understanding them. There is still work to be done in terms of creating a streamlined process, especially for new users. We've seen successes in new ways to reduce risk and generate APY, but we'll still have to wait to see if DeFi 2.0 delivers on all its promises.
Disclaimer: This article is for educational purposes only. Binance has no relationship with nor does it endorse these projects. The information provided through Binance does not constitute investment or trading advice or recommendations. Binance is not responsible for your investment decisions. Seek professional advice before taking on financial risks.