What is DeFi 2.0 and how important is it ?..

It's been almost two years since DeFi (Decentralized Finance) took off in 2020. Since then, we've seen hugely successful DeFi projects like UniSwap, decentralization of trading and finance, and new ways to make money in the crypto world. But there are still problems to be solved in such a new space, similar to what we have experienced with Bitcoin (BTC). In response to these problems, the term DeFi 2.0, which describes the next generation of DeFi decentralized applications (DApp), has become popular.

As of December 2021, DeFi 2.0 is not fully operational, but we can already see the first steps. You can find out what you can expect from DeFi 2.0 and why DeFi 2.0 is needed to solve major problems in the DeFi ecosystem in our article.

What is DeFi 2.0?

DeFi 2.0 is a movement that aims to solve the problems seen in the original DeFi and take it one step further. While DeFi has revolutionized the delivery of decentralized financial services to anyone with a crypto wallet, it also has some weaknesses. Crypto is already familiar with this process, with second-generation blockchains like Ethereum (ETH) developing Bitcoin. DeFi 2.0 will also need to comply with new compliance regulations that governments want to enforce, such as KYC and AML.

Let's go through an example. Liquidity Pools (LPs) have had great success in the world of DeFi, allowing liquidity providers to monetize transaction fees by staking token pairs. But if the rate of tokens changes, liquidity providers run the risk of losing money (temporary loss). A DeFi 2.0 protocol can offer insurance against this loss for a small fee. This solution can benefit users, stakers and the DeFi world in general by offering more incentives to invest in LPs.

What are the limitations of DeFi?

Before we talk about the usage areas of DeFi 2.0 in more detail, let's talk about the problems it tries to solve. A large part of these problems are the problems faced by blockchain technology and cryptocurrencies in general:

1. Scalability: Services offered by DeFi protocols on blockchains with high traffic and gas fees are often slow and expensive. Simple tasks can take a long time to complete and the process becomes cost-inefficient.

2. Oracles and third-party information: Financial products that need outside information need better quality oracles (third-party data sources).

3. Centralization: In DeFi, the goal should be more decentralization. However, many projects still have not adopted the DAO principles.

4. Security: Many users fail to manage or understand the risks of DeFi. Users stake millions of dollars on smart contracts that they are not entirely sure of being secure. Although security audits are in progress, the effectiveness of these audits may decrease as updates are made.

5. Liquidity: The fact that markets and liquidity pools are dispersed across different blockchains and platforms divides liquidity. Providing liquidity also causes the funds and their total value to be locked. It is often not possible to redeem tokens staked in liquidity pools elsewhere, leading to capital inefficiency.

Why is DeFi 2.0 important?

DeFi can be daunting and difficult to understand, even for experienced crypto users and those who hold their crypto long-term. But its goal is to lower the barrier to entry and create new earning opportunities for crypto holders.

DeFi 2.0 is important because it can democratize finance without increasing risk. At the same time, DeFi 2.0 also tries to provide a better user experience by trying to solve the problems we talked about in the previous section. If he can achieve this and offer better incentives, in the end, everyone can win.

DeFi 2.0 usage areas

We don't have to wait to see DeFi 2.0 usage areas. There are already projects offering new DeFi services on many different networks, including Ethereum, Binance Smart Chain, Solana, and other blockchains compatible with smart contracts. Here we will examine some of the most common of these uses:

Unlocking the value of staked funds

If you have previously staked a token pair in a liquidity pool, you received LP tokens in return. In DeFi 1.0 you can increase your yield by staking LP tokens in a yield farm. Before DeFi 2.0, what could be done in terms of value was limited to this. Millions of dollars are locked in safes that provide liquidity, but in fact, it is possible to further increase capital efficiency.

DeFi 2.0 takes this one step further and uses these yield farm LP tokens as collateral. This collateral can be used to issue tokens through a process similar to that in MakerDAO (DAI). Exactly what the mechanism will be may differ from project to project, but the main idea is that your LP tokens can be used for new opportunities while still generating returns, while remaining locked in.

Smart contract insurance

It is quite difficult to examine smart contracts in detail if you are not an experienced developer. Without this information, you can only partially evaluate a project. This creates a large amount of risk when investing in DeFi projects. With DeFi 2.0 it is possible to get DeFi insurance on certain smart contracts.

Imagine farming Yield and staking LP tokens in a smart contract. If the smart contract is breached, you may lose all your invested funds. An insurance project may offer you a guarantee for a fee for the funds you invest in the yield farm. But it should be noted that this will be for a specific smart contract. You will generally not be able to receive a payment if the liquidity pool agreement is breached. On the other hand, if the yield farm contract is violated, but you have insurance, you can most likely get paid.

temporary loss insurance

If you invest in a liquidity pool and start liquidity mining, any change in the price ratio of the two tokens you lock can cause financial loss. This process is called temporary loss, but the new DeFi 2.0 protocols are working on new methods to eliminate this risk.

For example, let's say you add a token to a one-sided LP that doesn't require you to add a token pair. The protocol then adds its native token as the other side of the pair. Both you and the protocol are then paid out of the fees charged for swapping the pair.

Over time, the protocol creates an insurance fund from the fees it earns to protect your invested funds against the effects of temporary loss. If the accumulated fees are not enough to cover the losses, the protocol may issue new tokens. Even if the amount of tokens accumulated is greater than the debt, these tokens can be stored for later or burned to reduce the supply.

Who is in control of DeFi 2.0?

With all these features and uses, you may be wondering who is in control of DeFi 2.0. Blockchain technology always tends towards decentralization. DeFi is no different. One of the first projects of DeFi 1.0, MakerDAO (DAI) has set a standard for this trend. More and more projects are now giving their community a say.

Many of the platform tokens also serve as governance tokens, offering voting rights to token holders. It is reasonable to expect DeFi 2.0 to bring more decentralization. But the role of regulatory compliance and regulation is also becoming more and more important for DeFi.

What are the risks of DeFi 2.0 and how can these risks be avoided?

DeFi 2.0 has the same risks as DeFi 1.0. The most important of these risks and what you can do to keep yourself safe are:

1. The smart contracts you interact with may have backdoors and weaknesses, or the contracts may be hacked. Audits also never guarantee the security of the project. Do as much research as possible about the project and remember that investing always poses a risk.

2. Legal regulations may affect your investments. Governments and regulators around the world have begun to consider the DeFi ecosystem as well. While regulations and laws can bring security and stability to crypto, some projects may have to make changes to their services as new rules are created.

3. Temporary loss. Even with temporary loss insurance, there is a huge risk for anyone wishing to mine liquidity. It is never possible to minimize the risk.

4. You may have difficulty accessing your funds. If you are staking from the website UI of a DeFi project, it might be a good idea to also access the smart contract via the blockchain explorer. Otherwise, you may not be able to withdraw your funds if the website is out of service. But before you can interact directly with the smart contract, you will need some technical expertise.

source: academy.binance.com