What Is DeFi 2.0 and Why Does it Matter?

 TL;DR

DeFi 2.0 is a movement of projects improving on the problems of DeFi 1.0. DeFi aims to bring finance to the masses but has struggled with scalability, security, centralization, liquidity, and accessibility to information. DeFi 2.0 wants to combat these and make the experience more user-friendly. If successful, DeFi 2.0 can help reduce the risk and complications that discourage crypto users from using it.

We already have a variety of DeFi 2.0 use cases working today. Some platforms allow you to use your LP tokens and yield farm LP tokens as collateral for a loan. This mechanism lets you unlock extra value from them while still earning pool rewards.

You can also take out self-repaying loans where your collateral generates interest for the lender. This interest pays off the loan without the borrower making interest payments. Other use cases include insurance against compromised smart contracts and impermanent loss (IL).

A growing trend in DeFi 2.0 is DAO governance and decentralization. However, governments and regulators may eventually affect how many projects are run. Keep this in mind when investing, as offered services might have to change.

Introduction

It's been almost two years since DeFi's (Decentralized Finance) rise in 2020. Since then, we've had incredibly successful DeFi projects like UniSwap, a decentralization of trading and finance, and new ways to earn interest in the crypto world. But just like we experienced with Bitcoin (BTC), there are still problems to solve in such a new field. As a response, the term DeFi 2.0 has become popular to describe a new generation of DeFi decentralized applications (DApps).

As of December 2021, we're still waiting for the full flood of DeFi 2.0, but we can already see its beginnings. Understand what to look out for in this article and why DeFi 2.0 is needed to solve outstanding problems in the DeFi ecosystem.

What is DeFi 2.0?

DeFi 2.0 is a movement trying to upgrade and fix the problems seen in the original Defi wave. DeFi was revolutionary in providing decentralized financial services to anyone with a crypto wallet, but it still has weaknesses. Crypto has already seen this process with second-generation blockchains like Ethereum (ETH) improving on Bitcoin. DeFi 2.0 also will need to react to new compliance regulations that governments plan to introduce, such as KYC and AML.

Let's look at an example. Liquidity pools (LPs) have proved hugely successful in DeFi, as it allows liquidity providers to earn fees for staking pairs of tokens. However, if the price ratio of the tokens changes, liquidity providers risk losing money (impermanent loss). A DeFi 2.0 protocol could provide insurance against this for a small fee. This solution provides a greater incentive to invest in LPs and benefits users, stakers, and the DeFi space as a whole.

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, Binance 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.

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. 

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.