What is DeFi 2.0?

What is DeFi 2.0?

It might feel like the birth of the decentralized finance movement happened a lifetime ago, even though the first DeFi protocols started gaining traction just over two years ago. Such is the nature of the blockchain space that things change very quickly and new  revolutionary concepts and ideas are always around the corner. In the case of DeFi we are already talking about the DeFi 2.0, with a wave of ambitious new protocols having ushered in the next phase in DeFi’s evolution.

But what is DeFi 2.0 and what does it aims to achieve? Is it really a paradigm shift or is it just a hastily put together marketing term? Let’s find out!

What is DeFi 2.0?

To understand what DeFi 2.0 is, we really need to take a closer look at DeFi, what the movement has so far achieved and what problems still need to be addressed, as well as how this new wave of DeFi protocols fits in the current ecosystem.

At the core of the vision for the various DeFi products lies the desire to provide decentralized alternatives to traditional financial instruments and markets. Projects like Compound, Aave MakerDAO and Uniswap have been able to utilize the unique properties of blockchain technology and smart contracts to bring a range of innovative financial services  and make them easily available to a wide range of users. The big goal here is to democratize finance, freeing the sector from its reliance on regulating bodies, banks and other intermediaries.

The challenge presented by that vision lies in ensuring that, even in the absence of intermediaries like banks, there can be enough liquidity to fuel properly functioning markets. That’s why DeFi protocols typically rely on liquidity mining pools, which provide the necessary assets for automated trading.

This, however, creates another problem. Since DeFi protocols need to borrow liquidity from third-party providers, they need to incentivize those providers. This happens through liquidity mining reward programs, where liquidity providers receive tokens for lending out assets. This has proven to be an effective way of acquiring liquidity quickly, but the problem is that liquidity providers are only motivated by token rewards and could leave a protocol the moment those rewards dry up.

This is one of the problems that DeFi 2.0 protocols seek to solve – as they want to put protocols in charge of their own liquidity.  But it goes beyond that.

Whereas the first  generation of DeFi apps were oriented towards the users, the new kids on the block display a clear B2B focus. DeFi 2.0 products take advantage of the fact that the first generation of DeFi products have already managed to bootstrap the industry by establishing an initial user base and creating the critical DeFi primitives that future products can now use to build the next wave of DeFi apps. And the goal of this new wave of DeFi products is to ensure that the sector is sustainable.

When we think about sustainability, the main challenges currently preventing the sector from becoming sustainable are: the sector’s reliance on third-party providers and token incentives to secure liquidity; and DeFi’s almost non existent correlation with traditional finance and the global economy. Addressing these challenges is the main goal of DeFi 2.0 and beyond.

Source: Finematics

Sustainable liquidity

Creating mechanisms for sustainable liquidity is the focus of some of the pioneers of the DeFi 2.0 movement. One such pioneer is OlympusDAO, a protocol that aims to create a decentralized reserve currency.

The protocol sells its native token OHM at a discount via what it calls a bonding mechanism, which pays out the discount to buyers over a period of five days. Users can buy OHM with single crypto assets like DAI and ETH, but also pay with liquidity provider (LP) tokens representing trading pairs that include OHM, such as OHM-DAI and OHM-WETH. This is what allows OlympusDAO to own its own liquidity. Reportedly, OlympusDAO currently owns over 99.5% of its own liquidity. 

Another mechanism that OlympusDao uses is OHM staking, which reduces the selling pressure on the token.

Demonstrating the aforementioned B2B focus of DeFi 2.0, OlympusDao recently launched a product called Olympus Pro, which allows other DeFi protocols to use the bonding mechanism to acquire their own liquidity. 

Another DeFi 2.0 project, Tokemak, approaches the problem from a different angle. In Tokemak, every crypto asset is stored in its own pool dubbed a reactor. Meanwhile, the holders of the protocol’s native token, TOKA, assume the role of  ‘liquidity directors’ and vote on where the liquidity should flow. With this design, Tokemak aims to create a decentralized market making protocol. 

Empowering DAOs

Building protocol controlled value mechanisms is one way in which DeFi 2.0 is posed to benefit DAOs, but the pioneers of the movement expect that it will not be the only one. Reaffirming the movement’s B2B focus, Scoopie Truples from Alchemix anticipates that the new wave of DeFi products will create many useful tools that will help DAOs compete with corporations.

“I think what’s going to make DAOs supercharged compared to corporations is that they will have really awesome financial tools at their fingertips that they can use to manage their firms a lot better than they could with TradFi markets”, he said in a recent episode of the Bankless podcast.

Enabling DAOs to compete effectively with traditional businesses will be a decisive step toward strengthening DeFi’s connection to the broader economy.

What is the goal of DeFi 2.0?

Ultimately, this should be DeFi 2.0’s overarching goal. Today, the DeFi space is still largely self-contained. This is not the case with traditional finance, which is mainly in service of the broader economy. Sure, the financial sector often seems to be divorced from reality, but that’s not really the case. Indeed, even the more complicated and confusing derivatives are ultimately underpinned by the global economy. 

In contrast, DeFi pretty much exists in its own bubble, which inevitably limits its reach, user base, liquidity pool and potential applications. It goes without saying that all that hinders the sector’s sustainability.

Fortunately, some of the leading DeFi 2.0 projects are realizing that decentralized finance needs to be more than just means for exchanging crypto assets. On the Bankless podcast, Carson Cook from Tokemak talked about there being several infrastructure layers stacked on top of one another, starting with electricity, then the Internet layer, then blockchain layer and, lastly, the liquidity layer . In that sense, he sees liquidity as being the “bandwidth of Web 3” and considers protocols like Tokemak to be the Web3 version of Internet service providers.

Another guest on the podcast, Zeus from OlympusDAO expressed a similar sentiment, likening liquidity to а railroads system for DeFi. Zeus also believes that the B2B focus of the new wave of DeFi products can strengthen the sector’s connection to the real world and go beyond facilitating “financial activity for the sake of financial activity”.

What are the risks of DeFi 2.0?

Risk is inherent to innovation and the DeFi and crypto space is no exception. This seems especially true in the case of DeFi 2.0, as it is being built on a foundation that has still quite a few kinks that need to be ironed out? So is DeFi 2.0 even a good idea?

The overall sentiment within the space seems to be that the potential risks pale in comparison to the benefits that could be unlocked through a successful implementation of DeFi 2.0 concepts. At the same time, this doesn’t mean that the risk factors should be simply ignored. There are ways to mitigate those risks, for example by educating users, employing rigorous smart contract  auditing procedures and making sure that failures don’t affect the broader ecosystem, to name a few.

The DeFi evolution continues

Whether you see DeFi 2.0 as a generational shift in decentralized finance or just a fancy term, one thing is undeniable – it’s another indication of the continued evolution of the DeFi space. More importantly, the types of projects comprising the DeFi 2.0 movement are proof that we are already past what’s arguably the most crucial part of that evolution – the bootstrapping phase. With that out of the way, DeFi 2.0 projects have the necessary tools to continue to push decentralized finance forward.