The Importance of DeFi 2.0: What Is It?

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DeFi 2.0 is a collection of initiatives that seek to address the shortcomings of DeFi 1.0. DeFi aspires to bring finance to the public, but has encountered difficulties with scalability, security, centralization, liquidity, and information accessibility. DeFi 2.0 intends to address these issues and improve the user experience. If DeFi 2.0 is successful, it will assist to lessen the risks and difficulties that deter crypto consumers from utilizing it.

We already have a number of DeFi 2.0 application cases in operation. You can use your LP tokens and yield farm LP tokens as collateral for loans on some platforms. This approach allows you to acquire additional value from them while collecting pool benefits.

You can also obtain self-paying loans, in which your collateral generates interest for the lender. The debt is paid off without the borrower paying any interest payments. Other applications include insurance against tainted smart contracts and temporary loss (IL).

DAO governance and decentralization are growing trends in DeFi 2.0. Governments and regulators, on the other hand, may eventually influence how many initiatives are implemented. Keep this in mind when investing because the services provided may need to change.

Decentralized Finance (DeFi)

It has been over two years since the birth of DeFi (Decentralized Finance) in 2020. Since then, there have been tremendously successful DeFi ventures such as UniSwap, a decentralization of trade and finance, as well as innovative ways to attract attention to the crypto sector. As with Bitcoin (BTC), however, there are still issues to resolve in such a novel industry. In response, the name DeFi 2.0 has gained popularity to designate a new generation of decentralized DeFi apps (DApps).

As of December 2021, we are still awaiting the full influx of DeFi 2.0, but its beginnings are already visible. Learn what to look out for in this article and why DeFi 2.0 is necessary to resolve unresolved issues in the DeFi ecosystem.

What is DeFi 2.0?

What is DeFi 2.0?
What is DeFi 2.0?

DeFi 2.0 is an initiative that seeks to improve upon and address the issues of the first DeFi wave. DeFi was groundbreaking in that it made decentralized financial services available to anybody with a cryptocurrency wallet, yet it still has flaws. Second-generation blockchains like Ethereum (ETH) have already improved on Bitcoin in the crypto space, illustrating this trend. In addition, DeFi 2.0 will have to respond to new compliance rules like KYC and AML that countries intend to implement.

Let’s examine an illustration. Due to DeFi’s ability to pay liquidity providers for staking token pairings, liquidity pools (LPs) have been a resounding success. Liquidity providers, however, run the danger of going out of business if the tokens’ price ratio changes (impermanent loss). For a modest cost, a DeFi 2.0 protocol may offer protection against this. This strategy helps users, stakeholders, and the DeFi market as a whole while increasing the motivation to invest in LPs.

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What are the limitations of DeFi?

Before going deeper into DeFi 2.0 use cases, let’s explore the problems it’s trying to resolve. Many of the issues here are similar to the problems blockchain technology and cryptocurrencies face in general:

1. Scalability: DeFi protocols on blockchains with high traffic and gas fees often provide slow and expensive services. Simple tasks can take too long and become cost-inefficient.

2. Oracles and third-party information: Financial products depending on external details need higher quality oracles (third-party sources of data).

3. Centralization: An increasing amount of decentralization should be a goal in DeFi. However, many projects still don’t have DAO principles in place.

4. Security: Most users don’t manage or understand the risks present in DeFi. They stake millions of dollars in smart contracts that they don’t fully know are safe. While there are security audits in place, they tend to become less valuable as updates occur.

5. Liquidity: Markets and liquidity pools are spread across different blockchains and platforms, splitting liquidity. Providing liquidity also locks up funds and their total value. In most cases, tokens staked in liquidity pools can’t be used anywhere else, creating capital inefficiency.

Why does DeFi 2.0 matter?

Even for HODLers and experienced crypto users, DeFi can be daunting and challenging to understand. However, it aims to lower barriers to entry and create new earning opportunities for crypto holders. Users who might not get a loan with a traditional bank might do with DeFi.

DeFi 2.0 matters because it can democratize finance without compromising on risk. DeFi 2.0 also attempts to solve the problems noted in the previous section, improving the user’s experience. If we can do this and provide better incentives, then everyone can win.

DeFi 2.0 use cases

We don’t have to wait for DeFi 2.0 use cases. There are already projects providing new DeFi services across many networks, including Ethereum, BNB Smart Chain, Solana, and other smart contract capable blockchains. Here we’ll look at some of the most common:

Unlocking the value of staked funds

If you’ve ever staked a token pair in a liquidity pool, you will have received LP tokens in return. With DeFi 1.0, you can stake the LP tokens with a yield farm to compound your profits. Before DeFi 2.0, this was as far as the chain goes for extracting value. Millions of dollars are locked in vaults providing liquidity, but there is potential to further improve capital efficiency.

DeFi 2.0 takes this a step further and uses these yield farm LP tokens as collateral. This could be for a crypto loan from a lending protocol or to mint tokens in a process similar to MakerDAO (DAI). The exact mechanism changes by project, but the idea is that your LP tokens should have their value unlocked for new opportunities while still generating APY.

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Smart contract insurance

Doing enhanced due diligence on smart contracts is difficult unless you’re an experienced developer. Without this knowledge, you can only partially evaluate a project. This creates a large amount of risk when investing in DeFi projects. With DeFi 2.0, it’s possible to get DeFi insurance on specific smart contracts.

Imagine you’re using a yield optimizer and have staked LP tokens in its smart contract. If the smart contract is compromised, you could lose all your deposits. An insurance project can offer you a guarantee on your deposit with the yield farm for a fee. Note that this will only be for a specific smart contract. Typically you won’t get a payout if the liquidity pool contract is compromised. However, if the yield farm contract is compromised but covered by the insurance, you will likely get a payout.

Impermanent loss insurance

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

For example, imagine adding one token to a single-sided LP where you don’t need to add a pair. The protocol then adds their native token as the other side of the pair. You will then receive fees paid from swaps in the respective pair, and so will the protocol.

Over time, the protocol uses their fees to build up an insurance fund to secure your deposit against the effects of impermanent loss. If there are not enough fees to pay off the losses, the protocol can mint new tokens to cover them. If there is an excess of tokens, they can be stored for later or burned to reduce supply.

Self-repaying loans

Typically, taking out a loan involves liquidation risk and interest payments. But with DeFi 2.0, this doesn’t need to be the case. For example, imagine you take a loan worth $100 from a crypto lender. The lender gives you $100 of crypto but requires $50 as collateral. Once you provide your deposit, the lender uses this to earn interest to pay off your loan. After the lender has earned $100 with your crypto plus extra as a premium, your deposit is returned. There’s no risk of liquidation here either. If the collateral token depreciates in value, it just takes longer for the loan to be paid off.

Who’s in control of DeFi 2.0?

With all these features and use cases, it’s worth asking who controls them? Well, there has always been a decentralization trend with blockchain technology. DeFi is no different. One of DeFi 1.0’s first projects, MakerDAO (DAI), set a standard for the movement. Now, it’s increasingly common for projects to offer their community a say. 

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

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

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

1. Smart contracts you interact with could have backdoors, weaknesses, or be hacked. An audit is never a guarantee of a project’s safety either. Do as much research as possible on the project and understand that investing always involves risk.

2. Regulation could affect your investments. Governments and regulators worldwide are taking an interest in the DeFi ecosystem. While regulation and laws can bring security and stability to crypto, some projects may have to change their services as new rules as created.

3. Impermanent loss. Even with IL insurance, it still is a large risk for anyone who wants to get involved with liquidity mining. The risk can never be totally minimized.

4. You may find accessing your funds difficult. If you are staking through a DeFi project’s website UI, it might be a good idea to locate the smart contract on a blockchain explorer as well. Otherwise, you won’t be able to withdraw if the website goes down. However, you will need some technical expertise to interact directly with the smart contract.

Closing thoughts

While we already have many successful projects in the DeFi space, we’re yet to see the full potential of DeFi 2.0. The topic is still complicated to most users, and no one should use financial products they don’t fully understand. There is still work to be done in creating a simplified process, especially for new users. We’ve seen success in new ways to reduce risk and earn APY, but we’ll have to wait and see if DeFi 2.0 fully delivers on its promises.

Disclaimer: This article is for educational purposes only. Teach Tactic has no relationship to these projects, and there is no endorsement for these projects. The information provided through Teach Tacti does not constitute advice or recommendation of investment or trading. Teach Tacti does not take responsibility for any of your investment decisions. Please seek professional advice before taking financial risks.

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