What is DeFi 2.0 and why is it important?

DeFi 2.0 is a movement made up of projects that present improvements to the problems in DeFi 1.0. DeFi aims to bring finance closer to the general public, but has had problems with scalability, security, centralization, liquidity, and accessibility to information. DeFi 2.0 aims to combat these issues and make the experience more user-friendly. If successful, DeFi 2.0 could help reduce the risk and complications that discourage crypto users from using it.

Currently, we already have several working DeFi 2.0 use cases. Some platforms allow you to use your LP tokens and yield farming LP tokens as collateral for a loan. This mechanism allows you to release additional value from these tokens, while earning rewards from the pools.

You can also get self-repaying loans, in which your collateral earns interest for the lender. This interest pays off the loan without the borrower having to make the interest payment. Another use case is insurance to protect smart contracts from being compromised, and insurance against non-permanent loss (IL).

An increasingly popular trend in DeFi 2.0 is DAO governance and decentralization. However, governments and regulators could eventually alter the way many projects are managed. Keep this in mind when investing, since the services offered could change by obligation.

Almost two years have passed since the rise of DeFi (Decentralized Finance) in 2020. Since then, we have seen incredibly successful DeFi projects like UniSwap, which represents the decentralization of trading and finance, as well as new ways to generate interest in the world of cryptocurrencies. But just as we experienced with Bitcoin (BTC), there are still problems to be solved in such a new field. In response, the term DeFi 2.0 has been popularized to describe a new generation of DeFi decentralized applications (DApps).

As of December 2021, we are still waiting for the DeFi 2.0 tide to roll in, although we can already see its beginnings. Find out in this article the things you should pay attention to and why DeFi 2.0 is necessary to solve the pending problems of the DeFi ecosystem.

What is DeFi 2.0?

DeFi 2.0 is a movement that tries to update and solve the problems seen in the original DeFi wave. DeFi was revolutionary in offering financial services to anyone with a cryptocurrency wallet, but it still has weaknesses. Cryptocurrencies have already gone through a similar process with second-generation blockchains like Ethereum (ETH), which represent an improvement over Bitcoin. DeFi 2.0 will also need to react to new regulatory compliance rules that governments plan to implement, such as KYC and AML.

Let's see an example. Liquidity Reserves (LPs) have proven to be very successful in DeFi, as they allow liquidity providers to earn fees for staking pairs of tokens. However, if the price ratio between the two tokens changes, liquidity providers risk losing money (impermanent loss). A DeFi 2.0 protocol could offer protection against it for a small fee. Such a solution would offer a greater incentive to invest in LPs and would benefit users, stakers and the DeFi sector as a whole.

What are the limitations of DeFi?

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

1. Scalability: Blockchain DeFi protocols with high traffic and high gas fees often offer slow and expensive services. Simple tasks can take a long time and be unprofitable.

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

3. Centralization: One of the goals of DeFi should be ever-increasing decentralization. However, many projects still do not have DAO-based principles implemented.

4. Security: Most users do not manage or understand the risks present in DeFi. They stake millions of dollars in smart contracts whose security they do not know. While security audits are done, they tend to lose value as updates are made.

5. Liquidity: The markets and liquidity pools are distributed by different blockchains and platforms, which causes the liquidity to be divided. Providing liquidity also locks the funds and their full value into escrow. In most cases, tokens staked in liquidity pools cannot be used anywhere else, leading to capital deficiency.

Why is DeFi 2.0 important?

Even for experienced cryptocurrency HODLers and users, DeFi can be overwhelming and difficult to understand. However, it aims to lower the barriers to entry and create new earning opportunities for cryptocurrency holders. Users who might not get a loan through a traditional bank could get one with DeFi.

DeFi 2.0 is important because it can democratize finance without compromising risk. DeFi 2.0 also tries to fix the issues noted above, which should improve the user experience. If we can pull that off and offer better incentives, then everyone can win.

DeFi 2.0 Use Cases

We do not have to wait for DeFi 2.0 use cases to appear. There are already projects offering new DeFi services on many networks, including Ethereum, Binance Smart Chain, Solana, and other smart contract-capable blockchains. Next, we will see some of the most common:

Release the value of staked funds

If you have ever staked a token pair in a liquidity pool, you will have received LP tokens in return. In DeFi 1.0, LP tokens can be staked by yield farming to generate profit from your profits. Before the existence of DeFi 2.0, this was all the chain could offer in terms of value extraction. Millions of dollars are locked up in vaults that provide liquidity, but there is still room to further improve capital efficiency.

DeFi 2.0 goes one step further and uses these LP tokens from yield farming as collateral. It could be for a cryptocurrency loan from a lending protocol, or to mint tokens in a MakerDAO (DAI)-like process. The exact mechanism varies from project to project, but the idea is that your LP tokens should unlock their value so you can access new opportunities while still generating APY.

Insurance for smart contracts

Expanding due diligence on smart contracts is difficult unless you are a very 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 becomes possible to obtain DeFi insurance for specific smart contracts.

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Imagine that you are using a yield optimizer and you have staked LP tokens in your smart contract. If the security of the smart contract is compromised, you could lose your entire deposit. An insurance project can offer you a guarantee for your yield farming deposit in exchange for a commission. Please note that this will only be for a specific smart contract. Generally, you will not receive compensation if the security of the liquidity pool contract is compromised. However, if the security of the yield farming contract is compromised, and you have insurance coverage, then you will likely receive compensation.

Insurance against non-permanent loss

If you invest in a liquidity pool and start liquidity mining, any change in the price rate of two tokens you have locked in escrow can lead to financial loss. This process is known as non-permanent loss, but newer DeFi 2.0 protocols are exploring methods to mitigate such risk.

For example, imagine adding a token to a one-sided LP where you don't need to include a pair. The protocol then adds its native token as the opposite side of the pair. And you will receive commissions paid from the swaps on the respective pair, and so will the protocol.

Over time, the protocol uses its fees to build up an insurance fund to protect your deposit against the effects of non-permanent loss. If there are not enough fees to make up for the losses, the protocol will be able to mint new tokens to cover them. If there is an excess of tokens, they can be stored for another time or burned to reduce the supply.

Self-repaying loans

Normally, obtaining a loan carries a risk of liquidation and the payment of interest. However, with DeFi 2.0, this does not have to be the case. For example, imagine you get a $100 loan from a cryptocurrency lender. The lender gives you $100 in crypto, but requires $50 as collateral. Once you contribute the deposit, the lender uses it to generate interest that pays off your loan. As soon as the lender earns $100 from your crypto plus an extra bonus, your deposit is returned to you. There is also no liquidation risk. If the token acting as collateral loses value, it will simply take more time to repay the loan.

Who controls DeFi 2.0?

With all these features and use cases, it's worth asking who controls them. There has always been a trend towards decentralization in blockchain technology. And DeFi is no exception. One of the first DeFi 1.0 projects, MakerDAO (DAI), set a standard for the movement. These days, it's increasingly common for projects to let their communities have a say.

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

What are the risks of DeFi 2.0 and how can they be prevented?

DeFi 2.0 shares with DeFi 1.0 many of the same risks. Here are some of the main ones and what you can do to stay protected.

1. The smart contracts you interact with could have security holes (backdoors), vulnerabilities or be hacked. And an audit is never a guarantee of the safety of a project. Research the project as much as you can and be aware that investing always carries risk.

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

3. Non-permanent loss. Even with coverage against non-permanent losses (IL), this loss is still a significant risk for anyone who wants to participate in liquidity mining. The risk cannot be completely eliminated.

4. Accessing your funds may be difficult for you. If you are staking through the UI of a DeFi project website, it might be a good idea to locate the smart contract on a block explorer. Otherwise, you will not be able to make withdrawals if the website stops working. However, to interact directly with the smart contract, you will need to have some technical expertise.