What is DeFi 2.0 (Decentralized Finance 2.0)?
Decentralized Finance (DeFi) has become a center of attraction since the 2020 boom. The ecosystem opened up new possibilities in the crypto space, making it possible to trade tokens on decentralized exchanges (DEXes) without going through an intermediary such as is the case with a centralized exchange. Developers can also easily create tokens and list them without having to pay or meet any listing requirements.
Through DeFi also, crypto investors could make money investing in tokens through various means including staking and providing liquidity. This is DeFi 1.0, which although brought some relief from centralized control of exchanges, has its own shortcomings.
First, DEXes rely on individuals to provide liquidity (available assets for trading). This means that individuals with large amounts of a token can easily affect the liquidity of the asset when they sell. The result is higher volatility and is one of the major differences between DeFi 1.0 and 2.0 as we will see shortly.
Secondly, people who provide liquidity can decide to quit and there will be no more liquidity for users of DEXes to trade. This is because liquidity providers only provide liquidity to earn rewards and incentives. In the event that such incentives are not paid, they may decide to withdraw their liquidity.
Another issue is that liquidity providers may suffer a phenomenon known as Impermanent Loss. This is a situation that results in a loss of tokens due to changes in the price of the tokens they provide.
As many DeFi protocols are built on the Ethereum blockchain, anyone using these protocols must have encountered the high gas fees charged for transactions. The long wait time for transactions to finalize during high blockchain traffic is also a nightmare that many wish to wake up from.
The high fees and slow transactions have also contributed immensely to reducing the scalability of protocols under this DeFi ecosystem. Consequently, the growth of the DeFi 1.0 ecosystem was limited, making it of little use to big businesses that could have adopted it. All these and more are the issues that led to the birth of DeFi 2.0.
What is DeFi 2.0?
Remember we mentioned earlier that liquidity is the reason that DeFi 2.0 was created? Liquidity is simply the amount of an asset that is available for traders to trade. If a DEX has for instance 20 ETH available to trade with USDT for example, its liquidity is said to be 20 ETH. It is important to note that the more the available liquidity for an asset the better.
Since liquidity is so important but is not guaranteed with DeFi 1.0, DeFi 2.0 seeks to fix that by having its own liquidity at the protocol level. This means that any DeFi 2.0 project has its own liquidity pool, not provided by external liquidity providers. As a result, no single individual or whale can cause major price changes in the asset by selling their portions of the liquidity.
As it removes the need for liquidity providers, it also secures the future of the DEX by ensuring that liquidity is always available. For stakers, DeFi 2.0 projects also pay significantly higher interest rates on staked tokens. An example of this is Olympus DAO which is creating its own reserve stablecoin and making a way for other protocols to use its platform for their own liquidity.
This makes DeFi 2.0 capable of creating business networks. While DeFi 1.0 was focused on individual users, DeFi 2.0 seeks to facilitate business to business (B2B) connections.
How DeFi 2.0 is solving DeFi 1.0 problems
DeFi 2.0 was created to correct the shortcomings of 1.0, but in what ways is it improving the DeFi ecosystem to enable it support businesses and make it safer to use?
DeFi 2.0 does not eliminate individual staking of tokens. It however makes it better by giving stakers more options than just earning LP tokens for staking. The earned tokens can be used as collateral for crypto loans or to mint tokens as is the case with MakerDAO.
More secure protocols
Smart contracts are what make DeFi protocols run, but they are built by human beings which means there are inherent risks when dealing with them. Auditing the smart contracts may also not bring the result that is needed, which is full security. DeFi 2.0 makes it possible to have smart contract insurance which reduces the risks in DeFi and can make it more attractive even to institutional investors.
Protecting against Impermanent Loss
Remember Impermanent loss? DeFi 2.0 has a solution to that too. We said earlier that 2.0 projects have their own liquidity pools. This makes it unnecessary to stake pairs of assets. For example instead of adding ETH/USDT pair to a pool, you can only add ETH while a protocol like Olympus DAO will provide the stablecoin which is issued by the protocol.
This way, both the liquidity provider and the protocol earn fees which the protocol later uses to build an insurance fund that will compensate liquidity providers in case of impermanent loss. If this fails, they can mint tokens to pay compensation to liquidity providers as a last resort.
These are just a few of the many benefits of DeFi 2.0. There are many others such as better scalability and better crypto loan conditions. However, DeFi 2.0 protocols are not without their shortcomings as well. For example, smart contract insurance does not guarantee that it is secure and Impermanent Loss can still occur, just that there is a backup plan to compensate in case of one.
DeFi 1.0 was a great option to centralized exchanges, but DeFi 2.0 is coming with ideas to make the ecosystem better. This will in no way alter everything that existed, but will rather build on the existing platforms to make them better. DeFi 2.0 is still in its infancy but when it blooms fully, experts believe it will make the ecosystem much more attractive to businesses which has potential to make it grow exponentially compared to DeFi 1.0.