Brief content

DeFi 2.0 is a movement of projects trying to solve the problems of DeFi 1.0. DeFi aims to bring finance to the masses, but has issues with scalability, security, centralization, liquidity, and access to information. DeFi 2.0 wants to combat these problems and make things more user-friendly. If successful, DeFi 2.0 could help reduce the risk and complications that prevent crypto users from using it.

Today, we already have many use cases for DeFi 2.0. Some platforms allow you to use your LP Tokens and Profit Farm LP Tokens as collateral for a loan. This mechanism allows you to get additional value from the tokens while continuing to receive rewards.

You can also take out self-paying loans if the collateral earns interest for the lender. This interest pays off the loan without the borrower paying interest. Other use cases include insurance against compromised smart contracts and impermanent losses (IL).

A growing trend in DeFi 2.0 is the governance and decentralization of DAOs. However, governments and regulators may ultimately influence the number of projects launched. Keep this in mind when investing, as the services offered are subject to change.

Introduction

It has been almost two years since the rise of DeFi (decentralized finance) in 2020. Since then, we've had incredibly successful DeFi projects like UniSwap, the decentralization of trade and finance, and new ways to earn interest in the cryptocurrency world. But as with Bitcoin (BTC), there are still challenges to be overcome in this new area. The term DeFi 2.0 has become popular to describe the new generation of decentralized DeFi applications (DApps).

As of December 2021, we are still waiting for the full development of DeFi 2.0, but we can already see its beginnings. Find out what to look for in this article and why DeFi 2.0 is necessary to solve the unsolved problems in the DeFi ecosystem.

What is DeFi 2.0?

DeFi 2.0 is a movement that attempts to update and correct the problems identified in the original DeFi wave. DeFi has been a revolutionary technology in providing decentralized financial services to anyone with a crypto wallet, but it still has weaknesses. Cryptocurrency has already seen this process with second-generation blockchains like Ethereum (ETH) that are improved over Bitcoin. DeFi 2.0 also needs to respond to new compliance regulations such as KYC and AML that governments plan to introduce.

Let's look at an example. Liquidity Pools (LPs) have proven extremely successful in DeFi because they allow liquidity providers to earn a fee for staking pairs of tokens. However, if the token price ratio changes, liquidity providers risk losing money (permanent losses). The DeFi 2.0 protocol can protect against this with insurance and a small fee. This solution provides greater incentive for LP investment and benefits users, participants and the DeFi space in general.

What are the limitations of DeFi?

Before we delve into the use cases of DeFi 2.0, let's take a look at the problems this technology is trying to solve. Many of the issues here are similar to those faced by blockchain technology and cryptocurrencies in general:

1. Scalability: DeFi protocols on blockchains with high traffic and gas fees often provide slow and expensive services. Simple tasks can take a lot of time and become unprofitable.

2. Oracles and third-party information: Financial products that depend on external details require higher-quality oracles (third-party data sources).

3. Centralization: Increasing the degree of decentralization should be the goal of DeFi. However, many projects still do not have DAO principles.

4. Security: Most users do not realize or understand the risks inherent in DeFi. They are staking millions of dollars in smart contracts, the security of which they do not know. Although security audits are available, they usually become less valuable as updates become available.

5. Liquidity: Markets and liquidity pools are distributed across different blockchains and platforms, sharing liquidity. Providing liquidity also locks in funds and their total value. More often than not, tokens placed in liquidity pools cannot be used elsewhere, creating capital inefficiencies.

Why does DeFi 2.0 matter?

Even for holders and experienced crypto users, DeFi can be a challenge to understand. However, the technology aims to lower barriers to entry and create new earning opportunities for cryptocurrency holders. Users who may not be able to get a loan from a traditional bank can use DeFi.

DeFi 2.0 technology is important because it can democratize finance without sacrificing risk. DeFi 2.0 also tries to solve the problems mentioned in the previous section by improving the user experience. If we can do this and provide better incentives, then everyone will benefit.

Possibilities of using DeFi 2.0

We don't have to wait for DeFi 2.0 use cases. There are already projects providing new DeFi services on many networks, including Ethereum, Binance Smart Chain, Solana, and other smart contract-enabled blockchains. Here we look at some of the most common ones:

Unlocking the value of staking assets

If you ever put a pair of tokens into a liquidity pool, you got LP tokens in return. With DeFi 1.0, you can stake LP tokens with annual returns to increase your profits. Before DeFi 2.0, this was about the value extraction chain. Millions of dollars are locked up in liquidity-providing vaults, but there is potential for further improvements in capital efficiency.

DeFi 2.0 goes one step further and uses these LP tokens as collateral. This can be a crypto loan from a lending protocol or minting tokens in a process similar to MakerDAO (DAI). The exact mechanism varies from project to project, but the idea is that your LP tokens should have value unlocked for new features while generating APY.

Insurance of smart contracts

Performing enhanced due diligence on smart contracts is difficult unless you are an experienced developer. Without this knowledge, you can only partially evaluate the project. This creates a big risk when investing in DeFi projects. With DeFi 2.0, you can get DeFi insurance for certain smart contracts.

Imagine you are using a yield optimizer and have included LP tokens in its smart contract. If the smart contract is compromised, you can lose all your deposits. Project insurance can offer you a guarantee against your deposit in a profitable farm for a fee. Note that this will only work for a specific smart contract. Normally, you will not receive a payout if the liquidity pool contract is compromised. However, if a profitable farm contract is compromised but is covered by insurance, you are more likely to receive a payout.

Insurance against temporary losses

If you invest in a liquidity pool and start mining liquidity, any change in the price ratio of the two locked tokens can lead to financial losses. This process is known as volatile losses, but the new DeFi 2.0 protocols are exploring new ways to reduce this risk.

For example, imagine adding a single token in a one-way LP where you don't need to add a pair. The protocol then adds its own token as the other side of the pair. You will then receive a commission for swaps in the relevant pair, just like the protocol.

Subsequently, the protocol uses their fees to create an insurance fund to protect the deposit from the effects of non-permanent losses. If the fee is not enough to cover the losses, the protocol can create new tokens to cover them. If there are excess tokens, they can be saved for later or burned to reduce the supply.

Loans with self-repayment

As a rule, obtaining a loan is associated with the risk of liquidation and payment of interest. But with DeFi 2.0, this should not be the case. For example, imagine that you take a loan of $100 from a crypto lender. The lender gives you $100 in cryptocurrency but requires $50 as collateral. Once you provide your deposit, the lender uses it to earn interest to pay off the loan. After the lender has earned $100 with your cryptocurrency plus an additional bonus, your deposit is returned. There is also no risk of liquidation. If the security token depreciates, it simply takes longer to pay off the loan.

Who controls DeFi 2.0?

With all these features and use cases, it's worth asking who controls them? Well, blockchain technology has always had a trend toward decentralization. DeFi is no different. One of the first DeFi 1.0 projects, MakerDAO (DAI), set the standard for the mechanism. Now projects increasingly offer their community the right.

Many of the platform's tokens also work as governance tokens, giving their holders voting rights. It is reasonable to expect that DeFi 2.0 will bring more decentralization to the space. However, the role of compliance and regulation is becoming increasingly important as DeFi catches up.

What are the risks of Defi 2.0 and how to avoid them?

DeFi 2.0 has many of the same risks as DeFi 1.0. Here are some of the main ones and what you can do to protect yourself.

1. The smart contracts you interact with may have backdoors, vulnerabilities, or be hacked. An audit also never guarantees project safety. Do as much research as possible on the project and understand that investing always involves risk.

2. Regulation can affect your investments. Governments and regulatory bodies around the world are showing interest in the DeFi ecosystem. Although regulation and laws can ensure the safety and stability of cryptocurrency, some projects may have to change their services to comply with the new regulations.

3. Non-permanent losses. Even with insurance against volatile losses, this is a big risk for anyone who wants to mine liquidity. Risk can never be completely minimized.

4. You may experience difficulties accessing your funds. If you are staking through the DeFi project's website interface, it would be nice to also find the smart contract in the blockchain explorer. Otherwise, you will not be able to withdraw funds if the website goes down. However, you will need some technical knowledge to directly interact with the smart contract.

Final thoughts

Although we already have many successful projects in the field of DeFi, the full potential of DeFi 2.0 lies ahead. This topic is still difficult for most users and no one should use financial products that they do not fully understand. There is still work to be done to create a streamlined process, especially for new users. The industry has been successful in new ways to reduce risk and earn APY, but we will have to wait and see if DeFi 2.0 fully delivers on its promise.

Disclaimer: This article is for educational purposes only. This article is for educational purposes only. Binance has nothing to do with these projects and does not promote them. The information provided by Binance does not constitute investment or trading advice or recommendation. Binance is not responsible for any of your investment decisions. Please seek professional advice before taking any financial risks.