At the beginning of 2019, the TVL of DeFi lending platforms (mainly MakerDAO) was $270 million. This momentum continued in 2020 as well, to the point where Compound launched its governance token, COMP which kicked off the craze and initiated the first call for liquidity mining.
By December 2021, the TVL of DeFi jumped 990x, reaching $249 billion. Some of the most significant projects that emerged are:
- Yearn Finance
As new projects launched and these early players developed, many investors have begun using the term DeFi 2.0.
So what is DeFi 2.0 all about? Is this just a new, temporary narrative or a paradigm shift? What are some of the most interesting DeFi 2.0 protocols? And what does this all mean for the already existing DeFi projects? You’ll find answers to these questions in this article.
What is DeFi 2.0
DeFi 2.0 is a movement trying to upgrade and fix the problems seen in the original DeFi wave. DeFi was revolutionary in providing decentralized financial services to anyone with a crypto wallet, but it still has weaknesses. Crypto has already seen this process with second-generation blockchains like Ethereum (ETH) improving on Bitcoin.
DeFi 2.0. needs to go beyond the previous bootstrapping mechanisms implemented by early protocols. Admittedly, high liquidity mining APYs are an intelligent customer acquisition process, but ultimately failed in the long-term success of products, native token prices would decrease as token inflation rose.
Olympus DAO is taking a different rewards route and showcasing firsthand why DeFi 2.0 can improve the overall perception of decentralized finance. Olympus DAO has implemented a protocol-controlled value that uses a bonding mechanism, which effectively works to prevent “toxic liquidity” from entering the ecosystem.
What are the limitations of DeFi?
Before going deeper into DeFi 2.0 use cases, let’s explore the problems it’s trying to resolve. Many of the issues here are similar to the problems blockchain technology and cryptocurrencies face in general:
- Scalability: DeFi protocols on blockchains with high traffic and gas fees often provide slow and expensive services. Simple tasks can take too long and become cost-inefficient.
- Oracles and third-party information: Financial products depending on external details need higher quality oracles (third-party sources of data).
- Centralization: An increasing amount of decentralization should be a goal in DeFi. However, many projects still don’t have DAO principles in place.
- Security: Most users don’t manage or understand the risks present in DeFi. They stake millions of dollars in smart contracts that they don’t fully know are safe. While there are security audits in place, they tend to become less valuable as updates occur.
- Liquidity: Markets and liquidity pools are spread across different blockchains and platforms, splitting liquidity. Providing liquidity also locks up funds and their total value. In most cases, tokens staked in liquidity pools can’t be used anywhere else, creating capital inefficiency.
DeFi 2.0 and the Quest for Sustainable Liquidity
In the context of liquidity, DeFi 2.0 refers to a few emerging DeFi projects that hope to revolutionize the common problems associated with liquidity provisioning and incentivization. They provide alternatives and supplements to the yield farming model, giving projects a way to source liquidity that can be sustained for the longer term. But how exactly do blockchain-based projects with native tokens maintain a healthy amount of liquidity that’s allocated in an ideal fashion?
OlympusDAO and Protocol-Owned Liquidity
One solution that has risen to the forefront of the DeFi community in 2021 is OlympusDAO’s bonding model, which focuses on Protocol-Owned Liquidity (POL).
Through its bonding model, OlympusDAO flips the script for yield farming on its head. Instead of renting liquidity through yield farming initiatives that expand supply, OlympusDAO uses bonds to exchange LP tokens from third parties for the protocol’s native token at a discount. This provides an advantage to the protocol, and to any project that uses the protocol (e.g. bonding-as-a-service). Through bonds, protocols can buy their own liquidity, removing the potential for liquidity exits and building up a long-lasting pool that can also generate revenue for the protocol.
On the other hand, users are incentivized to exchange their LP tokens through bonds because the protocol offers a discount on the token. For example, if the price of token X is $500 with a discount of 10%, the user can bond $450 worth of LP tokens to receive $500 in token X. The result is a net profit of $50, dependent on a short vesting schedule (normally around 5 days to a week) to help prevent arbitrageurs from extracting value.
Another crucial aspect of liquidity-focused bonds is that the bond prices change dynamically and can have a hard cap. This serves an important purpose for the protocol, allowing it to control two levers: the rate at which tokens are exchanged for liquidity and the total amount of liquidity exchanged.
If too many users are purchasing bonds, the discount rate declines and can even become negative, acting as a way to control the rate at which the protocol’s token supply is expanding. The protocol can also determine its desired liquidity amount through a hard cap, in which bonds are no longer available, further controlling supply expansion based on precisely determined parameters.
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.
Other DeFi 2.0 Advancements
Another subset of DeFi 2.0 protocols is building on top of previous yield generating mechanisms and assets to build novel financial instruments.
A prime example of this is Alchemix, a self-repaying lending platform that has a “no liquidation” design. The protocol lends out representative tokens pegged 1:1 to the collateralized asset. For example, by posting the DAI stablecoin as collateral, users are able to borrow 50% of the amount as alDAI. The underlying collateral is then deposited into yield-generating protocols so that it incrementally increases.
Through the combination of representative tokens and yield-generating collateral, Alchemix can offer a liquidation-free lending platform that enables users to spend and save at the same time—with decreasing loan principal amounts as the collateral continues to garner yield.
Abracadabra, another DeFi 2.0 protocol, employs a similar mechanism, but with a system that’s relatable to MakerDAO. Users can post yield-bearing collateral and receive the MIM stablecoin in exchange, maintaining exposure to the collateral while simultaneously garnering yield and unlocking liquidity for users.
Without the early innovations that first brought the decentralized economy to life—AMM protocols, decentralized stablecoins, and price oracles—there could be no liquidity bonding, liquidity flow mechanisms, or yield-generating collateral. From the early stages of AMM LP tokens and decentralized stablecoins to the DeFi 2.0 protocols of today, every project is a valuable iteration towards building the decentralized economy.
What are the risks of Defi 2.0, and how to prevent them?
DeFi 2.0 shares many of the same risks as DeFi 1.0. Here are some of the main ones and what you can do to keep yourself safe.
- Smart contracts you interact with could have backdoors, weaknesses, or be hacked. An audit is never a guarantee of a project’s safety either. Do as much research as possible on the project and understand that investing always involves risk.
- Regulation could affect your investments. Governments and regulators worldwide are taking an interest in the DeFi ecosystem. While regulation and laws can bring security and stability to crypto, some projects may have to change their services as new rules as created.
- Impermanent loss. Even with IL insurance, it still is a large risk for anyone who wants to get involved with liquidity mining. The risk can never be totally minimized.
- You may find accessing your funds difficult. If you are staking through a DeFi project’s website UI, it might be a good idea to locate the smart contract on a blockchain explorer as well. Otherwise, you won’t be able to withdraw if the website goes down. However, you will need some technical expertise to interact directly with the smart contract.
Top DeFi 2.0 Projects: $OHM, $TIME, $BRC
OlympusDAO is one of the first protocols that came about in this new wave of DeFi 2.0, and it has some lofty ambitions. It wants to be a trustless, decentralized crypto reserve bank backed by a basket of crypto assets.
Remember, DeFi 2.0 changes the relationship with capital holders. Instead of renting liquidity, protocols aim to own their liquidity. Users with capital sell their assets to the OlympusDAO treasury to receive discounted OHM tokens in their process called “Bonding.”
The assets in the treasury provide revenue for the protocol and increase the risk-free value for each of the tokens. Users are then incentivized to lock away the tokens that they receive through this process byways of staking (taking away sell pressure).
$OHM Token: Creation & Value
The $OHM token is trying to be both a store of value and also a unit of exchange. And through OlympusDAO, the OHM token is issued and managed based on its monetary policy.
Therefore, OHM neither wants to be a purely speculative store of value like Bitcoin nor does it want to be pegged to a certain amount like a stable coin like USDT or USDC. It sits somewhere in the middle.
Here are a few interesting points about the OHM token:
- Because OHM has a free-floating value (its price fluctuates depending on the free market) and is not pegged to the US Dollar, it avoids the monetary policies of the Federal Reserve or the US government.
- OHM is backed by assets and liquidity in the treasury. The assets that you sell to Olympus are kept in its treasury which produces revenue for the protocol and increases the risk-free value of each OHM token. See graphic below:
- As mentioned before, staking OHM tokens is incentivized due to its massive APY. Almost a whopping 7000%+ APY at the time of this writing.
Wonderland.Money: Following The White Rabbit
From the success of OlympusDAO, a bunch of forks or copies of the project’s code appeared, trying to chase the same success that Olympus had gained. Among the forks, Wonderland.Money is the most popular.
Its popularity is likely due to a couple of things:
- Although Wonderland is a fork, it was built as another part of the growing and already popular MIM ecosystem on Avalanche (using the Abracadabra protocol), which allows for different synergies than OlympusDAO.
- Avalanche is another layer 1 blockchain that offers a high throughput and low fees. Therefore, users that are sick of Ethereum gas fees are more likely to put money into Wonderland.
As explained above, since Wonderland is a fork, the protocol largely remains the same. See the quick comparison table below of the two protocols:
What’s Next For Defi 2.0: Brinc Finance
While OlympusDAO and its forks are leading the charge for Defi 2.0 currently, some innovative new protocols and assets are being developed with the same values in mind.
One of these new projects is Brinc.fi and its token $BRC.$BRC is a digital asset that can only be bought by depositing funds into a reserve i.e. a public Ethereum wallet address; one hundred percent of $BRC tokens in circulation are backed by these reserve funds. This means that every $BRC token is backed by the funds that were used to purchase them as opposed to the majority of cryptocurrencies which do not have any form of reserves or backing.
The minting, burning, and control of all $BRC tokens are completely done by smart contracts so that the token supply of $BRC is always decentralized and free from manipulation or arbitrary actions of the team behind the project.
No one, not even the founders, team, or community receives a single token without paying i.e. depositing to reserves. What makes Brinc different from all previous crypto projects is that it is providing real intrinsic value:
- Each token is backed by DAI reserves held on-chain
- The protocol generates fees on the buying and selling of BRC token supply
- The reserves (DAI) can be reinvested into third-party DeFi protocols in order to generate income and value which increases the treasury base
- DeFi 2.0 projects are incredibly appealing due to its high APY and solves some of the issues plaguing a lot of projects. The projects leading the charge are OlympusDAO and Wonderland.
- Upcoming such as Brinc.Fi seeks to improve upon DeFi 2.0, provide intrinsic value and give users of their protocol massive incentive to stake (up to 800,000%+ APY at the time of this writing!)
DeFi 2.0 ― The Next Big Trend?
“Liquidity” will have long-term growth in the future, simply because its demand is huge and real. If we take advantage of the amount of TVL locked in DeFi ecosystems, the capitalization of these group products is likely to see an even stronger increase in the future.
The remaining 2 groups are stablecoins and bonding DAO, which I personally think will be a temporary phenomenon. Because stablecoins are now too clearly dominated by Tether and there has not been much change in the mindset of the majority of users to hold stablecoins. If there is a shift, I think the trend somewhere will be towards USDC (another traditional bank-backed asset), instead of trusting a new network.
The Bonding DAO is an innovative model that uses game theory to manage the system and ensure everyone works towards a win-win for all. However, the amount of tokens held by participating individuals and organizations is not so clear, so the risk of token dump and system manipulation is still very large. And even though it is a new model, do not forget that this is still a variant of the farming model and depends a lot on the game creator.
DeFi 2.0 claims to be a solution to DeFi 1.0’s shortcomings. While both have the same goal, their protocols matter a lot in terms of their longevity. Regardless, decentralized finance is arguably a good concept, especially for the consumers, but whether DeFi 2.0 will continue to soar is something only time can tell for sure.
Disclaimer: This article is for informational purposes only and should not be considered investment advice. Crypto investment is a very risky type of investment and you should only participate with the amount of capital you can lose.