DeFi 2.0: A beginner's guide to the second generation of DeFi protocols

Decentralized finance 2.0

One of the most influential and successful waves of blockchain-based innovation has been decentralized finance or DeFi. DeFi refers to a broad spectrum of decentralized applications that disintermediate traditional financial services and unlock whole new economic primitives and is powered by blockchains with built-in smart contract capabilities and secure oracle networks like Chainlink.

DeFi protocols are continually evolving and iterating upon proven models of financial-based agreements, fueled by their inherent advantages of permissionless composability and open-source development culture. The DeFi ecosystem advances at breakneck speed—over the last few months, a surge in liquidity-focused decentralized finance projects has ushered in a new generation of DeFi innovation known as DeFi 2.0. So, is DeFi 2.0 a thing yet? 

DeFi 2.0 is a new phrase in the blockchain world that refers to a subset of DeFi protocols built on prior DeFi breakthroughs like yield farming, lending and other things. Many on-chain systems with native tokens experience liquidity constraints, which is a crucial focus of notable DeFi 2.0 implementations. 

Before going into the usefulness and new financial paradigms the DeFi 2.0 ecosystem brings, this article explores previous breakthroughs that set the stage for the DeFi evolution, DeFi 2.0 movement and discusses the liquidity problem that DeFi 2.0 protocols seek to tackle.

Early DeFi developments

Uniswap, Aave, Bancor, MakerDAO, Compound and other early DeFi pioneers have constructed a solid foundation for the burgeoning DeFi economy, adding many critical and composable "money LEGOs" to the ecosystem.

The early decentralized automated market makers (AMMs), Uniswap and Bancor, were the first to allow users to swap tokens without giving up custody. Aave and Compound provided decentralized lending and borrowing, allowing for on-chain yield for deposits and permissionless access to operating capital.

MakerDAO provided a decentralized stablecoin for ecosystem members to retain and use in transactions, offering a buffer against the volatility of cryptocurrencies. Users gained access to dependable exchanges, frictionless lending/borrowing and stable pegged currencies through these protocols, which are three key financial primitives commonly available in traditional financial markets. 

However, in terms of transparency and user control, the infrastructure that underpins these well-known DeFi-based services is vastly different from centralized companies. DeFi innovations are built on the numerous technological implementations that underpin these decentralized services.

Limitations of DeFi 1.0

DeFi 2.0 is an improved version of the current DeFi model, aiming to fix existing flaws while leveraging strengths to provide consumers with new and exciting options on the road to financial freedom. The various limitations of DeFi 1.0 are discussed in the below sections.

The first stumbling block concerns the usability of DeFi platforms. Because the UX and UI complexity makes it difficult for newbies to use decentralized products, the vast majority of active users are seasoned crypto aficionados. People do want digital inclusion, and the ability of Defi 2.0 projects to mainstream crypto will determine the next DeFi run.

Furthermore, scalability does not make things simpler. High fees and extended wait times for approved transactions continue to strain the user experience. As we all know, most DeFi solutions are built on the Ethereum blockchain and owing to the enormous number of users on the network, there are considerable delays and transaction costs are skyrocketing. As a result, users with less than a few thousand dollars make using DeFi devices unprofitable.

People, especially in crypto, have short attention spans, and you can tell that people are moving away from DApps to pursue bigger financial prospects. Yields are not as appealing as they once were, particularly for DeFi's blue chips. This has resulted in a recurrent farm and dump scenario, resulting in unhealthy cash flow for practices and many other issues that contribute to inefficient asset use.

Furthermore, to trade in decentralized exchanges (DEXs) and AMMs without altering the token's price, all cryptos require liquidity. While incentive programs can provide temporary respite, they are far from ideal and pose a more significant underlying risk for small investors.

Oracles are frequently used in DeFi, but some projects are still unaware of their relevance and refuse to integrate with a reliable oracle. As a result, many protocols have been attacked, and they have had to pay for their losses.

The goal of DeFi 2.0

Unlike the earlier generation of DeFi apps, which were geared toward users, the newcomers have a specific business-to-business (B2B) focus. DeFi 2.0 protocols capitalize on the fact that the first generation of DeFi products successfully bootstrapped the industry by establishing an initial user base and developing the crucial DeFi primitives that future manufacturers can now employ to construct the next wave of DeFi apps. And the purpose of this new generation of DeFi protocols is to safeguard the sector's long-term viability.

The sector's reliance on third-party providers and token incentives to secure liquidity, as well as DeFi's essentially non-existent correlation with traditional finance and the global economy, are the fundamental problems now preventing the sector from becoming sustainable. The entire purpose of DeFi 2.0 and beyond is to address these issues.

Some of the DeFi 2.0 movement's pioneers are focused on developing methods for long-term liquidity. OlympusDAO, a protocol that intends to build a decentralized reserve currency, is one such pioneer. OlympusDao also announced Olympus Pro, a tool that allows other DeFi protocols to use the bonding mechanism to gain their liquidity, demonstrating DeFi 2.0's B2B focus.

Building protocol-controlled value mechanisms is another way DeFi 2.0 is expected to help decentralized automated organizations (DAOs). The new wave of DeFi products will produce valuable tools that will enable DAOs to compete with companies, reinforcing the movement's B2B focus.

DeFi 2.0 innovation and second generation DeFi protocols

If you are still wondering why DeFi 2.0 is so popular, please keep reading to find out.

DeFi 2.0 research began when users and projects understood DeFi's limits, which prompted them to find appropriate solutions. Each answer to each problem has resulted in minor upward market movements, which are exactly what the market requires.

Now let's have a look at the solutions that have helped DeFi 2.0 projects expand.

Scalability: Layer one, layer two

Interacting with the Ethereum network has been a major stumbling block for DeFi users, particularly novices. Unfortunately, most consumers have been unable to experience DeFi due to high gas prices and long wait times. DeFi, on the other hand, provides a wide range of opportunities, making it quite appealing. As a result, the question arises: How can users experience DeFi without dealing with Ethereum's scaling issues?

The cash flowed to BSC, Polygon, and Solana, which are some of the blockchains that can deliver what users require the most. The next market wave could be triggered by solutions to the scalability problem.

Liquidity: Yields

The simplest solution to the liquidity problem, or to entice additional users and capital into the DeFi market, is to assist them in earning yields. Third-party liquidity providers on AMM protocols provided a partial solution to the liquidity problem, allowing any independent person with sufficient funds to provide liquidity for a token pair.

Rather than provisioning liquidity themselves, teams might theoretically obtain sufficient liquidity from others. But, on the other hand, end-users had limited incentives to bootstrap liquidity for a new coin because doing so would entail exposing themselves to the risk of temporary loss in exchange for minimal fee revenue through swaps. They needed a compelling financial rationale to take that risk. This resulted in a chicken-and-egg problem. 

The slippage caused by swaps discourages users from engaging in a DeFi protocol's environment if there isn't enough liquidity. There isn't enough fee volume created without consumers participating in token transactions to motivate third-party actors to pool their tokens and provide liquidity. As a result, another crucial DeFi breakthrough was born. Yield farming, or the practice of bootstrapping liquidity for new DeFi protocols using liquidity provider (LP) tokens, has become the norm. So, how is yield farming going to revolutionize DeFi?

In the summer of 2020, when yield farming (also known as liquidity mining) became available, there was a rise in DeFi activity, dubbed "DeFi Summer" by blockchain specialists. The concept of yield farming is straightforward. Users offer liquidity for an exchange pair via an AMM protocol, receive an LP token in exchange, and then stake the LP token for returns in the project's native token. 

This approach addresses the chicken and egg dilemma by providing a strong economic rationale for third-party liquidity providers to supply a token's higher return. They might earn even more yield by staking and getting more of the project's native token, in addition to generating higher cumulative fees on AMM swaps due to deeper liquidity.

New DeFi protocols were able to bootstrap significant amounts of liquidity to launch and sustain operations and minimize slippage for users entering their ecosystem, thanks to the advent of yield farming. As a result, the number of DeFi protocols has increased exponentially across the board, demonstrating how yield farming has lowered the cost to entry for both users and DeFi project creators.

Yield farming has proven to be an effective means of bootstrapping funding for DeFi projects, but it is not without risks in the long run. Moreover, due to the specific limits of long-term yield farming projects, it does not fully solve the liquidity problem by itself, despite its effectiveness.

Most DeFi projects must undertake yield farming initiatives and bootstrap liquidity since it is necessary and healthy. Still, project teams must be cautious of their token supply and long-term yield farming tactics to avoid negative, long-term consequences.

Centralization: DAOs

Apart from the fact that people come to DeFi to generate money, they also come to DeFi to pursue independence and be self-sufficient. Nonetheless, a group still controls a large number of DeFi protocols, leading to a loss of faith among DeFi users.

To address this issue, DeFi projects have a propensity to prioritize the decentralized aspect. The DAO, which allows anybody to vote on the project's evolution, has exploded in popularity in recent years.

Capital efficiency: The next interest

DeFi is growing at a breakneck pace. The industry's TVL (Total Value Locked) has continued to climb. Nonetheless, one of DeFi's biggest challenges is that most assets are static and underused. To understand this, consider the following scenario:

• Lending: Currently, DeFi protocols have a low utilization ratio, meaning there are far more lenders than borrowers.

• AMM: Even though AMM is DeFi's "Liquidity Pool" and attracts a large quantity of TVL, the majority of it is not used. This is due to AMM's design, which prevents liquidity from being concentrated.

• Aggregator: Users that input assets into aggregator protocols and obtain Agtokens cannot spend those tokens anywhere else.

To solve the above issues, numerous projects, such as Olympus DAO or Abracadabra, have begun to design suitable initiatives, which are steadily becoming the trigger for the next wave of the Capital Efficiency branch.

DeFi 2.0 will be able to do the following with projects focusing on capital efficiency:

• Optimize TVL: Allow deposited assets to be used to their full potential.

• Create a sustainable cash flow: As demonstrated by Olympus DAO, the system for exchanging LP tokens for bonds reduces the frequency of farm and dump situations while also providing long-term liquidity. Therefore, maintaining a good cash flow allows projects to expand more sustainably and attract more backers.

DeFi 2.0 vs. DeFi 1.0

DeFi 1.0 and DeFi 2.0 projects have the following differences:

Most DeFi projects are currently focused on issuing tokens to "print money," and this type of DeFi project, which has not proposed new solutions in the distribution of governance tokens and community governance, as well as its launch of "mining" architecture, is frequently unsustainable.

Currency transactions are required to create a DeFi 2.0 decentralized financial system that is both sustainable and automatically distributed. Decentralized finance in the DeFi 2.0 stage is more likely to connect all community members who supply liquidity. Liquidity incentives are being pushed to connect relationships in all future transactions to build a warm, sustainable and interconnected decentralized financial architecture. 

It is committed to breaking DeFi1.0's cold transaction mode, expecting users to develop close horizontal connections while forming strong vertical ties, as it advocates for close user relationships.

Community members are given ecological governance and decision-making authority in DeFi 2.0 compared to DeFi 1.0. The entire group makes all choices. Community members rely on more than just excitement and curiosity to participate in community activities. All members are stakeholders and communities, ensuring that everyone has a voice and that truly decentralized government is realized.

The DeFi evolution continues

Whether you think of DeFi 2.0 news as a generational change in decentralized finance or just a fancy name, one thing is sure: It's another sign of the DeFi space's continuing progress. 

More importantly, the types of initiatives that make up the DeFi 2.0 movement show that we've already passed through what is perhaps the most critical stage of that evolution: the bootstrapping phase. With that out of the way, DeFi 2.0 projects now have the tools they need to keep pushing decentralized finance forward.

Developers are getting inventive when it comes to designing protocols (the concept of money lego) that maximize profit, capital efficiency, decentralization and everything else. Some tradeoffs have yet to be seen, but they do exist. For the time being, it appears like everyone is merely excited.

In a more philosophical sense, DeFi phase one taught us a lot. There have been numerous accomplishments as well as blunders. Lessons learned from a not-so-distant past. This field is maturing in terms of adoptions and technology and the decentralized ethos that people are forgetting as they combine with "the old world" — regulation, the government and traditional finance.