Summary
DeFi 2.0 is a series of projects that aim to improve the problems of DeFi 1.0. Decentralized finance (DeFi) aims to provide financial services to the public, but has been plagued by problems such as scalability, security, centralization, liquidity, and information accessibility. DeFi 2.0 hopes to overcome these problems and make the user experience more humane. Once successfully overcome, DeFi 2.0 can reduce the risks of using cryptocurrencies, prevent them before they happen, and eliminate the concerns of cryptocurrency users.
There are already various DeFi 2.0 use cases in the market. Some platforms allow users to use liquidity provider tokens and liquidity mining provider tokens as loan collateral. This mechanism can not only release additional value of the token, but also continue to earn mining pool rewards.
You can take out a self-repaying loan while the collateral continues to earn interest for the lender. The interest is enough to repay the loan without the borrower having to pay additional interest. Other use cases include insurance against compromised smart contracts and impermanent loss (IL).
In DeFi 2.0, DAO governance and decentralization have become a trend. However, the actions of governments and regulators will eventually affect the scale of running projects, so please keep this in mind when investing, as the services provided may have to be adjusted.
Introduction
Decentralized Finance (DeFi) emerged in 2020, and it has been almost two years since then. During this period, we have witnessed the great success of various DeFi projects, such as Uniswap, the decentralization of trading and finance, and a new way to earn interest in the cryptocurrency field. Similar to the development of Bitcoin (BTC), new fields always face problems that need to be solved. In order to deal with these problems, the concept of DeFi 2.0 has gradually gained attention and become the next generation of DeFi decentralized applications (DApps).
As of December 2021, we have not yet seen the full popularity of DeFi 2.0, but its development trend has begun to emerge. Read this article to learn how to view DeFi 2.0 and why DeFi 2.0 is a necessary means to deal with the unresolved issues in the decentralized financial ecosystem.
What is DeFi 2.0?
DeFi 2.0 is an evolution that aims to address the issues that existed in the initial wave of decentralized finance (DeFi). Decentralized finance (DeFi) provides innovative decentralized financial services to all cryptocurrency wallet users, but it is not perfect. Cryptocurrencies have witnessed this process, and second-generation blockchains such as Ethereum (ETH) are the result of Bitcoin's improvement. DeFi 2.0 will also need to respond to the new compliance regulations that governments plan to introduce, such as identity verification and anti-money laundering regulations.
Let's look at an example. Liquidity pools (LPs) have been a huge success in the decentralized finance (DeFi) space, where liquidity providers earn fees by staking token pairs. However, once the token price ratio changes, liquidity providers are at risk of losing funds, i.e., suffering from "impermanent loss". DeFi 2.0 protocols can provide insurance against such risks at a low premium. This solution not only encourages more investment into liquidity pools, but also benefits users, stakers, and the entire decentralized finance (DeFi) space.
What are the limitations of decentralized finance (DeFi)?
Before we delve into the use cases of DeFi 2.0, let’s first explore the problems that DeFi 2.0 is trying to solve. Many of the problems mentioned here are also common in the field of blockchain technology and cryptocurrency:
1. Scalability: DeFi protocols in blockchains often have network congestion and high fuel costs, which results in slow and expensive services. Even simple tasks take too long and are less cost-effective.
2. Oracles and third-party information: Financial products that rely on external information have higher requirements on the quality of oracles, that is, third-party data sources.
3. Centralization: Improving decentralization should be a goal of decentralized finance (DeFi). However, many projects still do not have complete DAO principles.
4. Security: Most users neither manage the risks of decentralized finance (DeFi) nor even understand what risks exist. They stake millions of dollars in smart contracts without knowing whether their funds are safe. Although there are security audits, as long as updates occur, the security audits are almost useless.
5. Liquidity: Markets and liquidity pools across various blockchains and platforms disperse liquidity everywhere. Providing liquidity means that funds and their total value need to be locked up. In most cases, tokens staked in liquidity pools cannot be used elsewhere, resulting in inefficient capital allocation.
Why is DeFi 2.0 important?
Even experienced cryptocurrency users and holders may find decentralized finance (DeFi) difficult to understand and daunting. However, decentralized finance aims to lower the barrier to entry and bring new income-generating opportunities to cryptocurrency holders. Users who cannot obtain loans from traditional banks may be able to make their dreams come true through decentralized finance (DeFi).
DeFi 2.0 is crucial to making finance accessible to the public while keeping risks under control. DeFi 2.0 strives to solve the problems mentioned in the previous section, that is, to improve user experience. If it can be successfully solved and more attractive incentives are provided, all parties will be happy.
DeFi 2.0 Use Cases
We don’t have to wait for DeFi 2.0 use cases to emerge. In fact, there are already projects providing novel DeFi services on a variety of networks, including: Ethereum, Binance Smart Chain, Solana, and other blockchains that support smart contracts. Here are the most common use cases:
Unlocking the value of pledged funds
If you ever stake a token pair to a liquidity pool, you will receive liquidity provider tokens in return. With DeFi 1.0, users can stake liquidity provider tokens to liquidity mining and let profits continue to compound. Before the birth of DeFi 2.0, this was the limit of extracting value on the chain. Millions of dollars worth of funds are locked in machine gun pools to provide liquidity to the market, however, the efficiency of capital allocation still has the potential to be further improved.
DeFi 2.0 is taking a step forward by using liquidity provider tokens as collateral in liquidity mining. This allows for crypto loans from lending protocols or minting tokens in a process similar to MakerDAO (DAI). The exact mechanism varies from project to project, but the goal is to unlock the value of liquidity provider tokens, both to generate annualized returns and to seek new opportunities for profit.
Smart Contract Insurance
It is not easy to conduct in-depth due diligence on smart contracts unless you are an experienced developer. Without this knowledge, the project evaluation will be incomplete. As a result, the risk of investing in DeFi projects will be very high. With DeFi 2.0, DeFi insurance can be obtained for specific smart contracts.
Let's say you use the Yield Optimizer and stake your liquidity provider tokens in its smart contract. If the smart contract is compromised, all your deposits could be lost. Insurance programs protect user deposits and only charge a fee from liquidity mining. Note that this is limited to specific smart contracts. If the liquidity pool contract is compromised, the funds are usually irrecoverable. However, if the insured liquidity mining contract is compromised, it may be possible to recover the funds.
Impermanent loss insurance
If you invest in a liquidity pool and start liquidity mining, you will suffer financial losses if the price ratio of the two locked tokens changes. This process is called "impermanent loss", and the new DeFi 2.0 protocol is exploring new ways to reduce this risk.
For example, if you add a token to a one-way liquidity pool, you don’t need to add a token pair, the protocol will add its native token to the other side of the token pair. In this way, both the user and the protocol will receive payment for the corresponding token pair exchange.
The protocol then uses these fees to build an insurance fund to protect user deposits from impermanent loss. If this fee is not enough to cover the loss of funds, the protocol will mint new tokens to cover the loss. If there are excess tokens, they can be stored for later use or destroyed to reduce the supply.
Self-repaying loan
Loans usually involve liquidation risk and interest payments. But with DeFi 2.0, there is no need to worry about this. For example, suppose a borrower takes out a loan worth $100 from a crypto lender. The lender provides $100 in crypto but requires the borrower to post $50 as collateral. The borrower provides a deposit, and the lender uses the interest earned on the deposit to repay the loan. Once the lender has earned $100 and an additional premium using the borrower's crypto, the borrower's deposit is returned in full. There is no liquidation risk involved. Even if the token collateral depreciates, it will just take longer to repay the loan.
Who controls DeFi 2.0?
DeFi 2.0 has all these features and use cases, but who is in control of it all? The trend of blockchain technology decentralization will not stop, and decentralized finance (DeFi) is no exception. MakerDAO (DAI), one of the first projects in DeFi 1.0, set the standard for subsequent development. At present, it is increasingly common for projects to give the community a voice.
Many platform tokens also serve as governance tokens, and holders will have voting rights. We have reason to believe that DeFi 2.0 can make the field more decentralized. However, in order to adapt to the development of decentralized finance (DeFi), compliance supervision will also play an increasingly important role.
What are the risks of DeFi 2.0? How to prevent them?
DeFi 2.0 faces roughly the same risks as DeFi 1.0. Here are some of the main risks and measures to ensure the safety of your personal funds:
1. Smart contract interactions may have backdoors, weak links, or be attacked by hackers. Audits also cannot guarantee that projects are completely safe. Users should research projects as comprehensively as possible and understand that there are always risks in investing.
2. Regulation may affect personal investment. Governments and regulators are paying close attention to the decentralized finance (DeFi) ecosystem. Although regulations guarantee the security and stability of cryptocurrencies, some projects still need to change their service content according to new regulations.
3. Impermanent loss. Even with impermanent loss insurance, there are still huge risks for users who want to get involved in liquidity mining. Risks can never be completely avoided.
4. Difficulty accessing personal funds. If you need to stake through the DeFi project's website UI, it is recommended to use a blockchain browser to locate the smart contract. Otherwise, if the website fails, the staked funds will not be withdrawn. However, direct interaction with smart contracts requires some technical expertise.
Summarize
While there are already many successful projects in the decentralized finance (DeFi) space, we have yet to see DeFi 2.0 reach its full potential, and the subject remains complex and incomprehensible to most users. And you really shouldn’t invest in financial products you don’t fully understand. There is also a long way to go to create a simplified process for new users. We have seen some new ways to earn annual returns while reducing risk. However, it remains to be seen whether DeFi 2.0 can fully deliver on its promise.
Disclaimer: This article is for educational purposes only. Binance is not affiliated with or endorses these projects. The information provided through the Binance platform does not constitute investment or trading advice or recommendations. Binance is not responsible for any of your investment decisions. Please seek professional advice before taking financial risks.