DeFi 2.0: A Beginner’s Guide to DeFi Protocols’ Second Generation

Finance 2.0 is decentralized finance.

Decentralized finance, or DeFi, has been one of the most influential and successful waves of blockchain-based innovation. DeFi refers to a broad range of decentralized applications that disintermediate traditional financial services and enable the development of entirely new economic primitives. It is powered by blockchains with built-in smart contract capabilities and secure oracle networks such as Chainlink.

DeFi protocols are constantly evolving and iterating on proven financial-based agreement models, fueled by their inherent advantages of permissionless composability and open-source development culture. The DeFi ecosystem is evolving at breakneck speed—in recent months, a surge in liquidity-focused decentralized finance projects has heralded a new generation of DeFi innovation known as DeFi 2.0. So, is DeFi 2.0 available yet?

DeFi 2.0 is a new term in the blockchain world that refers to a subset of DeFi protocols that are based on previous DeFi breakthroughs such as yield farming, lending, and other things. Many on-chain systems that use native tokens face liquidity issues, which is a key focus of notable DeFi 2.0 implementations.

Before delving into the DeFi 2.0 ecosystem’s utility and new financial paradigms, this article examines previous breakthroughs that set the stage for the DeFi evolution, the DeFi 2.0 movement, and the liquidity problem that DeFi 2.0 protocols seek to address.

Early developments in DeFi

Uniswap, Aave, Bancor, MakerDAO, Compound, and other early DeFi pioneers have laid a solid foundation for the burgeoning DeFi economy, introducing many critical and interchangeable “money LEGOs” into the ecosystem.

Uniswap and Bancor were the first decentralized automated market makers (AMMs) to allow users to swap tokens without giving up custody. Aave and Compound enabled decentralized lending and borrowing, enabling on-chain yield for deposits and permissionless access to operating capital.

MakerDAO provided a decentralized stablecoin for ecosystem members to keep and use in transactions, acting as a hedge against cryptocurrency volatility. Through these protocols, users gained access to dependable exchanges, frictionless lending/borrowing, and stable pegged currencies, which are three key financial primitives commonly available in traditional financial markets.

However, in terms of transparency and user control, the infrastructure that underpins these well-known DeFi-based services differs markedly from that of centralized corporations. The numerous technological implementations that underpin these decentralized services serve as the foundation for DeFi innovations.

DeFi 1.0’s Restrictions

DeFi 2.0 is an improved version of the current DeFi model that aims to address existing flaws while capitalizing on strengths to provide consumers with new and exciting options on the path to financial freedom. The following sections go over the various limitations of DeFi 1.0.

The first roadblock is the usability of DeFi platforms. Because the complexity of the UX and UI makes it difficult for newcomers to use decentralized products, the vast majority of active users are seasoned crypto enthusiasts. People want to be included in the digital world, and the ability of Defi 2.0 projects to mainstream crypto will determine the next DeFi run.

Furthermore, scalability does not simplify things. High fees and lengthy wait times for approved transactions continue to wreak havoc on the user experience. Most DeFi solutions, as we all know, are built on the Ethereum blockchain, and due to the massive number of users on the network, there are significant delays and transaction costs are skyrocketing. As a result, users with less than a few thousand dollars find it unprofitable to use DeFi devices.

People have short attention spans, especially in crypto, and you can tell that people are moving away from DApps to pursue larger financial opportunities. Yields aren’t as appealing as they used to be, especially for DeFi’s blue chips. This has resulted in a recurring farm and dump scenario, resulting in poor cash flow for practices and a slew of other issues that contribute to inefficient asset utilization.

Furthermore, all cryptos require liquidity in order to trade on decentralized exchanges (DEXs) and AMMs without changing the token’s price. While incentive programs can provide short-term relief, they are far from ideal and pose a greater underlying risk to small investors.

Oracles are commonly used in DeFi, but some projects are still unaware of their importance and refuse to integrate with a trustworthy oracle. As a result, many protocols have been attacked, and their losses have had to be borne.

DeFi 2.0’s goal is to

Unlike the previous generation of DeFi apps, which were geared toward users, the newcomers are geared specifically toward business-to-business (B2B). DeFi 2.0 protocols take advantage of the fact that the first generation of DeFi products successfully bootstrapped the industry by establishing an initial user base and developing critical DeFi primitives that future manufacturers can now use to build the next wave of DeFi apps. And the goal of this new generation of DeFi protocols is to ensure the long-term viability of the sector.

The sector’s reliance on third-party providers and token incentives to secure liquidity, as well as DeFi’s essentially non-existent correlation with traditional finance and the global economy, are the fundamental issues that are currently preventing it from becoming sustainable. DeFi 2.0 and beyond are entirely dedicated to addressing these issues.

Some of the DeFi 2.0 movement’s forefathers are working on methods for long-term liquidity. One such pioneer is OlympusDAO, a protocol that aims to create a decentralized reserve currency. OlympusDao also announced Olympus Pro, a tool that enables other DeFi protocols to gain liquidity through the bonding mechanism, demonstrating DeFi 2.0’s B2B focus.

Another way DeFi 2.0 is expected to assist decentralized automated organizations is through the development of protocol-controlled value mechanisms (DAOs). The next wave of DeFi products will create valuable tools that will allow DAOs to compete with corporations, reinforcing the movement’s B2B focus.

DeFi 2.0 innovation and DeFi protocols of the second generation

If you’re still curious about why DeFi 2.0 is so popular, keep reading to find out.

DeFi 2.0 research began when users and projects became aware of DeFi’s limitations, prompting them to seek appropriate solutions. Each solution to each problem has resulted in minor market upticks, which is exactly what the market requires.

Now, let’s take a look at the solutions that have aided the growth of DeFi 2.0 projects.

Layer one and layer two scalability

Interacting with the Ethereum network has proven to be a major stumbling block for DeFi users, especially newcomers. Unfortunately, due to high gas prices and long wait times, most consumers have been unable to experience DeFi. DeFi, on the other hand, offers a diverse set of opportunities, making it very appealing. As a result, the question arises: How can users enjoy DeFi without having to deal with Ethereum’s scaling issues?

The funds were transferred to BSC, Polygon, and Solana, which are some of the blockchains capable of providing what users require the most. The next market wave could be triggered by scalability solutions.

Yields: Liquidity

The most straightforward solution to the liquidity issue, or to entice more users and capital into the DeFi market, is to assist them in earning yields. Third-party liquidity providers on AMM protocols offered a partial solution to the liquidity issue, allowing any independent person with sufficient funds to provide liquidity for a token pair.

Teams could theoretically obtain sufficient liquidity from others rather than provisioning it themselves. End-users, on the other hand, had few incentives to bootstrap liquidity for a new coin because doing so would expose them to the risk of temporary loss in exchange for minimal fee revenue via swaps. To take that risk, they needed a compelling financial justification. This created a chicken-and-egg situation.

If there isn’t enough liquidity, the slippage caused by swaps discourages users from participating in a DeFi protocol’s environment. Without consumers participating in token transactions, there isn’t enough fee volume to motivate third-party actors to pool their tokens and provide liquidity. As a result, yet another critical DeFi breakthrough was created. Yield farming, or the practice of using liquidity provider (LP) tokens to bootstrap liquidity for new DeFi protocols, has become the norm. So, how will yield farming revolutionize DeFi?

When yield farming (also known as liquidity mining) became available in the summer of 2020, there was an increase in DeFi activity, dubbed “DeFi Summer” by blockchain experts. The concept of yield farming is simple. Users provide liquidity for an exchange pair using an AMM protocol, receive an LP token in exchange, and stake the LP token for returns in the project’s native token.

This method solves the chicken and egg problem by providing a compelling economic reason for third-party liquidity providers to supply a token’s higher return. They could earn even more yield by staking and receiving more of the project’s native token, as well as higher cumulative fees on AMM swaps due to increased liquidity.

Because of the advent of yield farming, new DeFi protocols were able to bootstrap significant amounts of liquidity to launch and sustain operations while minimizing slippage for users entering their ecosystem. As a result, the number of DeFi protocols has grown exponentially across the board, demonstrating how yield farming has reduced the barrier to entry for both users and DeFi project developers.

Yield farming has proven to be an effective means of bootstrapping funding for DeFi projects, but it is not without risks. Furthermore, despite its effectiveness, it does not fully solve the liquidity problem due to the specific limits of long-term yield farming projects.

Most DeFi projects must engage in yield farming and bootstrap liquidity because it is both necessary and healthy. To avoid negative long-term consequences, project teams must be cautious of their token supply and long-term yield farming tactics.

DAOs (Decentralized Autonomous Organizations)

People come to DeFi not only to make money, but also to gain independence and self-sufficiency. Nonetheless, a small group continues to control a large number of DeFi protocols, causing DeFi users to lose faith.

DeFi projects have a proclivity to prioritize the decentralized aspect in order to address this issue. The DAO, which allows anyone to vote on the evolution of the project, has grown in popularity in recent years.

The next topic of interest is capital efficiency.

DeFi is expanding at breakneck speed. The industry’s TVL (Total Value Locked) has risen further. Nonetheless, one of DeFi’s most significant challenges is that the majority of assets are static and underutilized. Consider the following scenario to better understand this:

  • Lending: DeFi protocols currently have a low utilization ratio, which means that there are far more lenders than borrowers.
  • AMM: Despite the fact that AMM is DeFi’s “Liquidity Pool” and attracts a large amount of TVL, the vast majority of it is not used. This is due to the design of AMM, which prevents liquidity concentration.
  • Aggregator: Users who input assets into aggregator protocols and receive Agtokens are unable to spend those tokens elsewhere.

To address the aforementioned issues, numerous projects, such as Olympus DAO or Abracadabra, have begun to design appropriate initiatives, which are steadily becoming the catalyst for the next wave of the Capital Efficiency branch.

With projects focusing on capital efficiency, DeFi 2.0 will be able to do the following:

TVL should be optimized by allowing deposited assets to be used to their full potential.

Create long-term liquidity: As demonstrated by Olympus DAO, the system for exchanging LP tokens for bonds reduces the frequency of farm and dump situations while also providing long-term liquidity. As a result, maintaining a positive cash flow allows projects to grow more sustainably and attract more investors.

DeFi 2.0 in comparison to DeFi 1.0

The following distinctions exist between the DeFi 1.0 and DeFi 2.0 projects:

DeFi 2 0 Vs DeFi 1 0
DeFi 2.0 in comparison to DeFi 1.0 –

Most DeFi projects are currently focused on issuing tokens to “print money,” and this type of DeFi project is frequently unsustainable because it has not proposed new solutions in the distribution of governance tokens and community governance, as well as its launch of “mining” architecture.

Currency transactions are required to build a DeFi 2.0 decentralized financial system that is both sustainable and distributed automatically. In the DeFi 2.0 stage, decentralized finance is more likely to connect all community members who supply liquidity. To build a warm, sustainable, and interconnected decentralized financial architecture, liquidity incentives are being pushed to connect relationships in all future transactions.

As it advocates for close user relationships, it is committed to breaking DeFi1.0’s cold transaction mode, expecting users to develop close horizontal connections while forming strong vertical ties.

In DeFi 2.0, as opposed to DeFi 1.0, community members are given ecological governance and decision-making authority. All decisions are made by the entire group. To participate in community activities, residents rely on more than just excitement and curiosity. Every member is a stakeholder and a community, ensuring that everyone has a voice and that true decentralized government is realized.

The evolution of DeFi continues.

Whether you consider DeFi 2.0 news to be a generational shift in decentralized finance or simply a fancy name, one thing is certain: it’s yet another sign of the DeFi space’s ongoing progress.

More importantly, the initiatives that comprise the DeFi 2.0 movement demonstrate that we have already passed through what is possibly the most critical stage of that evolution: the bootstrapping phase. With that out of the way, DeFi 2.0 projects now have the tools they need to continue pushing the envelope of decentralized finance.

Developers are becoming more creative in terms of designing protocols (the concept of money lego) that maximize profit, capital efficiency, decentralization, and everything else. Some tradeoffs have yet to be discovered, but they exist. For the time being, it appears that everyone is simply ecstatic.

In a broader sense, DeFi phase one taught us a lot. There have been numerous successes as well as mistakes. Lessons from the not-too-distant past This field is maturing in terms of adoption and technology, as well as the decentralized ethos that people are forgetting as they merge with “the old world” — regulation, government, and traditional finance.

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