Introduction
Decentralized Finance (DeFi) has emerged prominently since 2020, and it has been nearly two years since then. During this period, we have witnessed the success of various DeFi projects, such as Uniswap, decentralized exchanges, and new ways to earn interest in the cryptocurrency space. Similar to the development of Bitcoin (BTC), new sectors often face numerous issues that need to be addressed. To tackle these challenges, the concept of DeFi 2.0 has gradually gained attention, becoming the next generation of decentralized applications (DApps).
As of December 2021, we have yet to see the widespread adoption of DeFi 2.0, but the trends in its development are becoming apparent. This article will explore the significance of DeFi 2.0 and why it is viewed as a necessary tool for resolving outstanding issues within the decentralized finance ecosystem.
What is DeFi 2.0?
DeFi 2.0 is an upgraded version aimed at addressing the issues present in the initial wave of decentralized finance (DeFi). While decentralized finance has provided innovative financial services for all cryptocurrency wallet users, it is not without flaws. The development of cryptocurrencies has demonstrated this, with second-generation blockchains like Ethereum (ETH) being improvements over Bitcoin. DeFi 2.0 also needs to contend with new compliance regulations imposed by governments, such as identity verification and anti-money laundering requirements.
Taking liquidity pools (LP) as an example, they have achieved significant success in the DeFi space, allowing liquidity providers to earn fees by staking tokens. However, when the price ratios of tokens fluctuate, liquidity providers may face "impermanent loss," which poses the risk of capital loss. DeFi 2.0 protocols can offer insurance against such risks, usually at a relatively low premium. This solution not only encourages more investment into liquidity pools but also benefits users, stakers, and the entire DeFi ecosystem.
What Are the Limitations of Decentralized Finance (DeFi)?
Before delving into the applications of DeFi 2.0, it is important to consider some of the issues that DeFi 2.0 aims to resolve. These problems are also prevalent in the blockchain technology and cryptocurrency sectors:
Scalability: DeFi protocols on blockchains often face network congestion and high gas fees, leading to slow service and high costs. Even simple transactions can suffer from long processing times and poor cost-effectiveness.
Oracles and Third-Party Information: Financial products that rely on external information have higher quality requirements for oracles, or third-party data sources.
Centralization: Increasing the level of decentralization should be a goal for DeFi, yet many projects still do not fully adhere to the principles of Decentralized Autonomous Organizations (DAOs).
Security: Most users lack an understanding of the risks associated with decentralized finance (DeFi) and may not be able to manage these risks. They might stake millions of dollars in smart contracts without being aware of the security of their funds. Although security audits are conducted, the results can quickly become irrelevant after system updates.
Liquidity: Markets and liquidity pools spread across different blockchains and platforms lead to fragmented liquidity. Providing liquidity means that funds and their total value need to be locked. In many cases, tokens staked in liquidity pools cannot be utilized elsewhere, resulting in inefficient capital allocation.
Why is DeFi 2.0 Important?
Even experienced cryptocurrency users can sometimes find decentralized finance (DeFi) difficult to understand and confusing. However, the goal of DeFi is to lower the barriers to entry and provide new revenue opportunities for cryptocurrency holders. Users who are unable to obtain loans from traditional banks may find opportunities to realize their dreams in decentralized finance.
Under the premise of managing risks, DeFi 2.0 is crucial for making financial services more accessible. It aims to address the user experience issues mentioned earlier. If these challenges can be successfully managed and more attractive incentives are provided, all parties involved will benefit.
Use Cases of DeFi 2.0
We do not need to wait for the use cases of DeFi 2.0 to emerge; in fact, several projects are already offering innovative DeFi services across various blockchains, including Ethereum, Binance Smart Chain, and Solana. Here are some common use cases:
Unlocking the Value of Staked Assets
If you have ever staked tokens in a liquidity pool, you typically receive liquidity provider tokens in return. In DeFi 1.0, users could utilize these tokens for liquidity mining to achieve compound returns. Before the advent of DeFi 2.0, this was the limit of on-chain value extraction. While funds provide liquidity to the market, the value locked in liquidity pools still has room for enhancement.
The innovation of DeFi 2.0 lies in using liquidity provider tokens as collateral, allowing users to obtain cryptocurrency loans from lending protocols or mint tokens through processes similar to MakerDAO (DAI). The specific mechanisms vary by project, but the goal is to unlock the value of liquidity provider tokens, generating annual yields while creating new profit opportunities.
Smart Contract Insurance
Conducting thorough due diligence on smart contracts is not easy, especially for users without a technical background. Without sufficient knowledge, project assessments may be incomplete, increasing the risks associated with investing in DeFi projects. DeFi 2.0 can provide insurance for specific smart contracts.
For instance, if you stake liquidity provider tokens in a yield optimizer, your deposits could be at risk if the smart contract encounters issues. Insurance projects offer protection for users' deposits, typically charging a fee for liquidity mining. It is important to note that this insurance only applies to specific smart contracts. If a liquidity pool contract is compromised, funds are generally unrecoverable. However, if a covered liquidity mining contract is affected, your funds may still be retrievable.
Impermanent Loss Insurance
If you invest in a liquidity pool and engage in liquidity mining, you may incur financial losses when the price ratios of the locked tokens change. This situation is known as "impermanent loss," and new DeFi 2.0 protocols are exploring ways to mitigate this risk.
For example, if you add a certain token to a single-sided liquidity pool without providing a token pair, the protocol will automatically add its native token to the opposite side. This way, both users and the protocol can earn transaction fees from the respective token pair exchanges.
Subsequently, the protocol will use these fees to establish an insurance fund to protect users' deposits from impermanent loss. If the fees are insufficient to cover the losses, the protocol will mint new tokens to compensate. If the number of tokens exceeds what is needed, they can be stored or burned to reduce supply.
Self-Repaying Loans
Traditional loans often involve liquidation risks and interest payments, but in DeFi 2.0, these concerns can be alleviated. For instance, if a borrower obtains a $100 loan from a lender, the lender provides $100 worth of cryptocurrency and requires the borrower to supply $50 as collateral. The borrower deposits the collateral, and the lender uses the interest earned from this collateral to repay the loan. The borrower’s deposit is returned after the lender earns $100 plus additional profits, eliminating liquidation risk. Even if the collateral depreciates, the repayment period for the loan is merely extended.
Who Controls DeFi 2.0?
With the aforementioned features and use cases, who is in control of it all? The decentralized trend of blockchain technology is not going to stop, and decentralized finance (DeFi) is no exception. The pioneering project in DeFi 1.0, MakerDAO (DAI), has set standards for future developments. Currently, an increasing number of projects are empowering communities with more decision-making power.
Many platform tokens also serve as governance tokens, granting holders voting rights. We have reason to believe that DeFi 2.0 will further enhance the decentralization of this field. However, as decentralized finance evolves, the importance of regulatory compliance will also become more pronounced.
What Are the Risks of DeFi 2.0? How to Mitigate Them?
The risks faced by DeFi 2.0 are similar to those in DeFi 1.0. Here are some key risks and their mitigation measures:
Smart Contract Security: Smart contracts may contain backdoors, vulnerabilities, or be subject to hacking. Although audits can reduce risks, they do not guarantee the security of a project. Users should conduct thorough research and recognize that investing always carries risks.
Regulatory Impact: Governments and regulatory agencies are closely monitoring the decentralized finance (DeFi) ecosystem. While regulatory frameworks can enhance the safety and stability of cryptocurrencies, certain projects may need to adjust their services according to new regulations, potentially impacting individual investments.
Impermanent Loss Risk: Despite impermanent loss insurance, risks still exist for users wanting to participate in liquidity mining. Risks cannot be entirely eliminated, so careful assessment is necessary.
Withdrawal Difficulties: If staking must be conducted through the website interface of a DeFi project, it is advisable to use a blockchain explorer to identify the smart contract. If the website malfunctions, staked funds may be inaccessible. Users need some technical knowledge to interact directly with smart contracts.
Conclusion
Although many successful projects have emerged in the decentralized finance (DeFi) space, we have yet to see the full potential of DeFi 2.0. For most users, this field remains complex and difficult to understand. Investors should avoid putting money into financial products they do not fully comprehend, and there is still much work to be done to create simplified processes suitable for new users. We have observed some new methods that can achieve returns while lowering risks, but whether DeFi 2.0 can fully deliver on its promises remains to be seen.
Risk Warning
While the cryptocurrency market offers significant growth potential and innovation opportunities, it also carries a high level of market risk and price volatility. The value of crypto assets can fluctuate dramatically in a short period, potentially leading to substantial financial losses for investors. Additionally, the cryptocurrency market faces multiple risk factors, including technical risks, legal and regulatory uncertainties, cybersecurity threats, and market manipulation. We strongly advise users to conduct thorough research and due diligence before making any investment decisions and to consult professional financial advisors. All investment decisions are made at the user’s own risk. Thank you for your trust and support of Venkate!
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