DeFi, or Decentralized Finance, is a powerful blockchain-powered innovation that disintermediates traditional financial services. DeFi protocols are constantly evolving, and the existing models of agreements in the financial services domain are undergoing continuous improvements.
This has led to the creation of DeFi 2.0, which is an umbrella term for the new generation of decentralized finance platforms and functions. DeFi 2.0 protocols are made keeping in view the existing flaws and limitations in DeFi models, which are mostly associated with liquidity, scalability, and security.
The DeFi ecosystem was created by the pioneers of DeFi protocols such as Compound, Uniswap, and MakerDAO. These platforms introduced decentralized stablecoin and laid the foundation for the thriving DeFi ecosystem. The DeFi 2.0 ecosystem promotes an open-source development culture and transparency by eliminating the need for a central administrator.
What is DeFi 2.0?
One of the distinguishing financial elements of Web 3.0 is the concept of Decentralized Finance (DeFi). By DeFi solutions, we mean the programs and functions that work in a financial system that is no longer based on the centrality of its traditional intermediaries, such as banks, etc.
Rather, it is organized and built on new technologies capable of disintermediating the exchange of information and finances between multiple subjects. Underlying DeFi is blockchain technology, on which new paradigms are being studied and developed with the aim of revolutionizing traditional finance and the global economy.
DeFi 2.0 protocols
DeFi 2.0 protocols are built based on the concepts like yield farming and lending which are the prior DeFi breakthroughs. The DeFi pioneers were able to access dependable exchanges through these DeFi protocols.
DeFi 2.0 provides better protection from financial losses and unlocks greater value from stakes funds. Also, DeFi 2.0 offers greater scalability by leveraging a variety of blockchains.
DeFi 2.0 Products
A product's ability to be available free of charge without any intervention from governments, internet infrastructure providers, or even the program developers is an excellent litmus test for determining whether a product is decentralized or not.
Another critical component in DeFi 2.0 products is the automated self-executing programs called smart contracts. Their main purpose is the fast and transparent execution of financial agreements on the blockchain. Using smart contracts managed on a distributed ledger makes it possible for the software to continue to be accessible to anyone. All users need are resources and knowledge to engage in a smart contract.
Application of Blockchain Technology in the Financial Services Industry
Blockchain, the technology behind the digital currency Bitcoin, has been a source of inspiration for most DeFi solutions and projects. Public blockchains allow anyone to access the history of transactions, which means that it is not controlled by one centralized source.
This is important because centralized systems and human gatekeepers can limit the speed and complexity of transactions while also providing users with less direct control over their money.
By extending the use of blockchain beyond simple money transfers and to more complex uses in the financial sector, DeFi projects are revolutionizing how the client’s data is managed and how the transactions are handled.
For instance, the blockchain technology used in DeFi can be used to put the client’s information on the blockchain so that various financial companies can access it for their know-your-customer (KYC) processes. This will save resources for both the client and the financial institutions since they would not have to go through the KYC process for every new financial account.
DeFi 1.0 vs DeFi 2.0: What’s the difference?
In DeFi 1.0, the structure of the model is quite complex, which makes it difficult for new members to use the products of decentralized nature. Hostile user interface and scalability challenges impacted how early DeFi protocols worked as the Ethereum blockchain powered most solutions. DeFi 2.0 has resolved this problem by enhancing the user experience (UX), thus allowing everyone with a computer or smartphone to navigate the applications easily.
Furthermore, DeFi 2.0 protects users from the risk of temporary losses, such as impermanent losses caused because of the volatility of a trading pair. Eventually, the second generation of DeFi also mitigates the risks associated with lending processes and eliminates the interest payable on loans.
The huge gas fees and long hours of waiting to transact in the DeFi 1.0 space further add to the already-mentioned problems. DeFi 2.0 has reduced the costs involved in executing transactions by lowering gas fees and improving the transaction processing speed. Furthermore, DeFi 2.0 promises a reliable supply of liquidity through the introduction of liquidity pools (LPs) which provide incentives to the liquidity providers.
DeFi 2.0 aims to give more decision-making authority and ecological governance to the community members as compared to DeFi 1.0.
The problems of DeFi 1.0
Difficulty in attracting liquidity, high volatility, and lack of regulation are some of the problems associated with DeFi 1.0. Furthermore, the more massive a platform becomes, the most vulnerable it gets to security challenges.
DeFi 1.0 relies heavily on liquidity mining funded by the users. In DeFi 1.0, there is always a risk of impermanent loss for the investors due to the general uncertainty and volatility of the token price.
Furthermore, capital allocation is inefficient, resulting in long-term consequences in yield farming. Therefore, it becomes extremely difficult to retain long-term investors in the project, thus increasing the chance for financial risks.
There needs to be a long-term reward mechanism to attract liquidity in a sustained matter, like providing the investors with liquidity provider tokens.
In this way, people will actually take an interest in the project and not focus on the collection of tokens only. This is also not a long-term solution considering that people remove their capital as soon as they find a better project. Security
A hacker getting unauthorized access to the DeFi applications can result in a major loss of funds. Unlike traditional finance, DeFi 1.0 lacks any consumer safeguards. DeFi can be heavily used in money laundering and fraud because it is unregulated. Since most users don’t understand these risks, sending security updates on smart contracts is the only option left to safeguard people from cyber criminals.
Another problem with DeFi 1.0 is scalability. This issue is found on its most extensive Layer 1 network, Ethereum. High gas fees and long waiting times due to the excessive traffic contribute further to this problem because it strains the user experience.
One of the problems with DeFi 1.0 is the delay in transactions and network congestion due to the massive traffic of the DeFi protocol on the Blockchain. This is where the oracles have to play their part. Oracles are middleware entities that link smart contracts to resources outside of their native blockchains.
Apart from prioritizing the transactions and catering to the needs of smart contract developers, oracles can also function as autonomous auditors.
Without secure oracle networks, DeFi 1.0 protocols are unable to use any off-chain data. The DeFi 1.0 “oracle problem” refers to the conflict between authenticity, security, and trustworthiness in third-party oracles.
Many DeFi 1.0 projects don’t follow the principles set by the Decentralized Autonomous Organizations (DAOs). These principles follow the bottom-up management approach of decision-making to ensure decentralization.
To ensure higher scalability and security, the DeFi 1.0 project must compromise with decentralization. This creates a dilemma and leads to a loss of faith among the DeFi users considering that the decentralization aspect is not prioritized.
Innovation in DeFi 2.0
Decentralized finance has been providing services for the cryptocurrency ecosystem for many years. However, its boom began in 2021, thanks to various lending platforms and decentralized exchanges that managed to unify this system to make it grow despite the problems.
Therefore, despite having used a system with an imminent need for improvements, everything indicates that its growth will continue to be exponential for the second generation.
Yield farming is a practice of bootstrapping liquidity for new DeFi protocols. It allows yield farm LP tokens to be used as collateral for loans. This eliminates the usual slippage in pricing and is a good way to attract liquidity.
In these second-generation projects, popularity can be generated from the improvements implemented within DeFi, such as the liquidity mining system.
By gaining investors' confidence, they can request loans with lower collateral and may be audited to ensure the safety of the funds. And for those concerned about volatility, it will mostly be arranged to add long-term liquidity through the use of a stablecoin.
A long-term issue with yield farming is that it is very difficult to retain users. As soon as they find a better option, they will move their entire capital to other protocols.
Decentralized autonomous organizations
Decentralized Autonomous Organizations (DAOs) play a great role in improving the DeFi models. They present a fresh perspective on the legitimacy of governance. It enforces the decentralized aspect of DeFi 2.0 by allowing anybody to vote on the project's evolution.
Layer 1 & Layer 2 blockchains
A growing number of DeFi protocols are available on the Layer 1 and Layer 2 blockchains. Innovations are being made in Layer 1 & Layer 2 blockchains by making advancements in cross-chain bridging and blockchain scaling.
The protocols are easily deployed on Ethereum Layer-2 solutions like Arbitrum, Optimism, and Starknet and Layer-1 networks like Avalanche, Solana, and Gnosis Chain, etc.
Layer 2 blockchains offer increased privacy as opposed to Layer 1.
The goal of DeFi 2.0
The goal of DeFi 2.0 is to turn people away from the traditional financial system by democratizing finance and making DeFi products as user-friendly as possible.
DeFi 2.0 removes the intermediaries and third parties from the financial services. Another goal of DeFi 2.0 is to remove any shortcomings that were present in DeFi 1.0.
These shortcomings include elements of centralization, confusing interfaces, unattractive liquidity, and capital inefficiency. DeFi 2.0 provides enhanced user experience, greater scalability, better protection, improved capital efficiency, and excellent value from staked funds.
Investing in DeFi 2.0
Investment opportunities offered by DeFi 2.0 come with a much broader scope. DeFi 2.0 simplifies the processes on the front end and adds a layer of complexity to the use cases for DeFi. Before choosing a DeFi project, it is imperative to ensure that it complies with your financial expectations and goals.
While investing in DeFi can generate handsome profits, it is also risky and requires utmost vigilance. Seeking professional advice before investing in such a venture is the way to go.
DeFi 2.0 provides additional incentives through yield farming by allowing yield farm LP tokens to be used as collateral for loans. This type of investment involves using DeFi to maximize the returns that are usually calculated in APY. For instance, in “farming.” the investors might shift from one loan platform to another for better returns.
Users can generate passive income for themselves by staking tokens earned through locking up crypto holdings. They can earn block rewards by becoming a validator on a blockchain network that uses proof-of-stake as its consensus mechanism.
DEX stands for Decentralized exchanges. It involves crypto transactions without involving any third-party organizations. This type of trading is much cheaper as compared to traditional centralized exchanges.
Although DEX Trading is decentralized in nature, it occurs in highly regulated environments because of the local laws of different states and countries. DEX trading also supports margin trading, which involves trading a financial asset using borrowed funds from a broker.
This type of DeFi 2.0 investment is also known as liquidity provision. In this investment, crypto enthusiasts earn rewards for lending their assets to liquidity pools in decentralized exchanges.
These rewards are based on the share of lenders in the liquidity pool. The amount is derived from the trading fees which the traders pay who are swapping the tokens.
In this type of DeFi 2.0 investment, DeFi loans are offered in exchange for interest payments. Lending tokens can offer peace of mind to both the borrowers and lenders considering the DeFi 2.0 self-repaying loans. Moreover, lending platforms can also help in improving capital efficiency.
In this article, we have attempted to cover all the aspects pertinent to what DeFi 2.0 is. In a nutshell, we have concluded that it offers a much better user interface and scalability than DeFi 1.0. Also, it offers good liquidity options for crypto exchanges and provides much easier ways to manage smart contracts.