DeFi describes blockchain applications that use smart contracts to remove intermediaries from traditional financial transactions. This makes financial services more accessible, gives users greater control over their money, and creates faster, cheaper, and more sophisticated ways of facilitating transactions.
But while the field has been rapidly progressing since its inception in 2020, there are plenty of challenges yet to be solved.
Here, we’ll dive into how the next generation of DeFi apps—DeFi 2.0—are tackling these issues and helping us achieve the DeFi vision.
So, what is DeFi 2.0?
DeFi 2.0 describes the next generation of DeFi projects built on the foundation created by the first gen of DeFi apps. DeFi 1.0 apps were all focused on attracting new users. DeFi 2.0 apps are more collaborative and focus on creating capital efficiencies, which should make these apps safer, easier, and more attractive to use.
However, technically there isn’t a “line in the sand” that separates DeFi 1.0 from DeFi 2.0. These terms refer more to “a moment in time”, with DeFi 1.0 referring to protocols launched in 2020 or earlier.
The problems DeFi 2.0 projects try to solve
DeFi 1.0 protocols have helped create solid infrastructure, but also leave much on the table for DeFi 2.0 projects to improve upon, including stablecoin vulnerabilities, liquidity incentives, impermanent loss, and security & privacy.
Here, we’ll go over these issues and how innovative DeFi 2.0 projects are tackling them.
#1 Stablecoin vulnerabilities
Stablecoins are vital for the functioning of a healthy DeFi ecosystem, and often seen as the backbone of the cryptocurrency market as they provide investors price parity (usually to the US dollar) and a more secure way of generating higher yields on crypto assets.
However, despite their name, many stablecoins have shown to not always be that stable. They can lose value and depeg because of regulatory crackdowns, security risks, and the assets backing the stablecoin losing value. The recent $40 billion UST / Luna crash is a telling example.
How DeFi 2.0 addresses stablecoin vulnerabilities
DeFi 2.0 protocols are now tasked with addressing these threats, with many new projects innovating around algorithmic stablecoins and decentralized reserve currencies.
An example is Olympus DAO, that aims to create a fully decentralized reserve currency that is not pegged to any fiat currency, but instead employs a mechanism that ensures one OHM (the native coin) always equals at least one dollar. Olympus DAO achieves this by overcollateralizing and burning OHM once its value drops below $1, causing it to increase in value.
#2 Liquidity incentives
A big challenge for DeFi 1.0 protocols is attracting liquidity, as without liquidity, these protocols are near useless. That’s why they offer incentives to provide liquidity to the platform by offering high yields in return, essentially “buying liquidity”.
However, this model has proved unsustainable. Liquidity providers readily move elsewhere as soon as another platform offers higher yields, resulting in a race to the bottom where DeFi protocols start issuing more and more tokens to attract liquidity providers, diluting the value of their token.
How DeFi 2.0 creates better liquidity incentives
Some DeFi 2.0 projects are tackling the liquidity issue through what’s called “owned liquidity”. Here, DeFi platforms offer liquidity providers to buy rather than lend their tokens at a discount, in return for other tokens that the platform can use to create liquidity.
In this way, the protocol owns their liquidity so it won’t leave the protocol as soon as a liquidity provider leaves. It also creates greater commitment on behalf of liquidity providers as they’ll have a greater stake in the platform. Owned liquidity essentially aligns the interests of the platform and the liquidity provider.
The pioneer in this field is the aforementioned Olympus DAO, but we can expect other DeFi protocols to follow suit.
Other DeFi 2.0 projects are providing alternatives to the yield farming model that allow projects a way to source liquidity in a more sustainable way.
An example is Tokemax, a DeFi 2.0 project that provides liquidity for DeFi platforms with token reactors—specialized token pools for assets provided by users on Tokemax. These users can choose to deposit their assets into their Token Reactor of choice, allowing them to choose the platforms they provide liquidity for.
#3 Impermanent loss
Impermanent loss is a common issue with DeFi 1.0 projects and protocols. Users must provide liquidity by pairing their tokens 1:1, resulting in a loss when token prices diverge relative to each other. If you want to understand why this happens, read this article by Binance Academy.
As you can imagine, impermanent loss is a real risk in the volatile world of crypto where prices are continuously fluctuating.
How DeFi 2.0 mitigates impermanent loss
Many DeFi 2.0 protocols are overcoming impermanent loss by offering sophisticated liquidity strategies.
An example is liquidity providers being able to add just one token rather to a pool, with the protocol adding their native token as the other side of the pair. Both the liquidity provider and the protocol will be paid fees generated by swaps in the pool, which the protocol can use to build an insurance fund that can further protect liquidity providers against impermanent loss.
Ondo Finance is one of the DeFi 2.0 platforms offering investors both higher risk, higher yield and lower risk, lower yield options by using multiple strategies to mitigate the effects of impermanent loss.
#4 Security and privacy risks
In DeFi 1.0 (and most 2.0 protocols), information on the blockchain is visible to all. This means anyone—good or bad—can see every transaction or computation performed. Exposing users’ information including their balances, purchases, and transactions with other wallets to the world.
Not only does this create major privacy concerns—imagine everyone knowing everything you’ve ever bought!—it also creates the opportunity for front-running, which costs the DeFi industry billions of dollars a year.
And introduces many security concerns. By using chain analysis, online hackers can hunt for wallets with valuable assets and link these to real-world identities, putting their owners at risk of targeted scams, hacks, and even physical attacks and robberies.
How DeFi 2.0 addresses security and privacy risks
So how does DeFi 2.0 solve these issues? The answer is composable privacy, i.e. privacy that can be adjusted to suit the needs of a DeFi platform.
DeFi projects can achieve this by using layer 1 solutions like Secret Network, a permissionless blockchain that features privacy-preserving smart contracts. Inputs, outputs, and state are encrypted by default, allowing builders to create DeFi apps that keep user data encrypted—and safe—on-chain. Because data is not publicly accessible, this also eliminates the risk of front-running.
Shade Protocol is an example of a DeFi 2.0 protocol that uses Secret Network to build an array of privacy-preserving DeFi applications that allow users to swap tokens, borrow, lend, vote, and transact, while keeping their financial details hidden on-chain.
Where DeFi 2.0 is heading next
These are just a few examples of how DeFi 2.0 is improving on the foundation DeFi 1.0 apps created. There are many more exciting things being developed in the DeFi 2.0 space like self-repaying loans (check out Alchemix!) and capital efficiency enhancing solutions like Convex Finance.
The next step—DeFi 3.0—is all about bringing these projects to the “real world” (consumers) and connecting it to real-world assets. In the meantime, by building bridges between DAOs, DeFi 2.0 projects are helping to build stronger communities, and in turn stronger dApps.
If this article got you excited about DeFi 2.0 and ready to jump in, keep in mind that DeFi, like any innovation, comes with its risks and rewards. Many DeFi 2.0 platforms—unlike established DeFi 1.0 ones—still need to stand the test of time. That’s why we advise you to only invest what you can lose and always Do Your Own Research before jumping onto a new, promising DeFi platform.