DeFi 2.0

What is DeFi 2.0

The benefits of DeFi provide consumers with more ubiquitous financial tools than the walled gardens of traditional finance. But having said that, the early days of its ecosystem have resulted in numerous flaws, such as impermanent losses and flaws in liquidity mining, requiring many users to compromise on risk. This is where DeFi 2.0 comes in.

Essentially, like any technological iteration (not just blockchain), DeFi 2.0 is a movement focused on improving on the shortcomings of its predecessors. While the DeFi 101 article below will present more detailed insights, the main differences between DeFi 1.0 and DeFi 2.0 focus on liquidity, scalability, security, and centralization.

Why this matters:

At the risk of generalization, a common aspect of any successful business or service (regardless of industry) is that it helps create (or reinforce) a path of least resistance for the end user.

For example, Amazon helps customers save time by automatically delivering products. Uber and Airbnb help simplify and save the cost and effort of transportation, lodging, and more.

One could argue from a macro and micro perspective that the purpose of DeFi is similar, to lower the barriers to entry into competing financial solutions. For example, people who often struggle to get loans can find unbiased alternatives through MakerDAO or Compound.

However, the current need to benefit from core DeFi-centric activities such as lending, staking or yield farming remains relatively daunting for the average user. However, by simplifying the user experience, providing stronger incentives, aligning with updated regulations, and alleviating the level of uncertainty in the web3 market, DeFi 2.0 can help its rich platform and resources go further on its broader journey, To secure and democratize finance. safely.

Disadvantages of DeFi 1.0:

To better understand the relevance of DeFi 2.0, we can explore some of the more common problems it tries to solve.

Liquidity: Providing liquidity to pools requires locking funds and their total value. While fragmented across different blockchains and markets, this financial rigidity often leads to capital inefficiencies.

Liquidity mining: Many DeFi protocols lack long-term, practical incentives for liquidity providers beyond distributing LP tokens. As it stands, a common problem with liquidity providers is that they often withdraw their allocated resources and rewards once they are eligible or a more competitive protocol with a higher APY emerges. Such sales of the protocol’s native tokens, which are regularly and capitulated in the market, often result in supply dilution.

Scalability: DeFi platforms that experience a lot of network activity often suffer from data congestion. These bottlenecks slow down transactions and make network fees like gas (in the case of Ethereum) increasingly expensive.

Security: While smart contracts are regularly audited, routine upgrades and changes to the software often result in outdated and redundant information, even from reliable DeFi security firms like certik. Given the highly technical nature of these systems, most DeFi users still do not understand how to safely manage risk or objectively verify the security of the network as they hold (lock) large amounts of funds.

Centralization: Consistent with the issues outlined by the blockchain trilemma, many DeFi platforms sacrifice decentralization for higher levels of scalability and security.

Oracles: Financial services that rely on external or off-chain information require higher quality third-party data sources (oracles) than those currently available on web3.

DeFi 2.0 projects:

DeFi’s total value locked (TVL) increased dramatically from $667 million in December 2019 to over $100 billion in December 2021.

While the overall movement has largely accelerated due to the rise of services such as UniSwap (2018), MakerDAO, and Compound, several more significant projects that have emerged during this period include:

While each of these respective platforms has helped facilitate various technological improvements, the incentives surrounding activities such as liquidity mining have still not proven sustainable. In response to the industry's ongoing shortcomings, Olympus DAO is one of the first DeFi 2.0 solutions to offer different paths through its unique binding mechanism.

What is Olympus DAO:

Launched in May 2021, Olympus is a decentralized reserve currency protocol based on the OHM token, backed by a basket of assets from the Olympus Treasury. The project's goal is to build a policy-controlled monetary system that uses its associated OlympusDAO to help manage the performance of OHM tokens. Olympus Treasury holds a range of assets including DAI, FRAX, LUSD, ETH, and LP tokens like SushiSwap’s OHM/DAI.

OlympusDAO Binding - An Example of DeFi 2.0

As mentioned earlier, the core and competitive focus of Olympus is its unique way of bonding. While also used as a method to manage the performance of OHM tokens, Olympus' bond structure does not follow the same approach as traditional finance.

In traditional markets, a bond is a type of loan. When companies or entities need more capital, they may issue bonds to finance fixed-term loans. During this period, the company or bond issuer pays investors a certain amount of interest, called a coupon, on selected dates (usually quarterly).

There are many types of bonds, including government bonds, corporate bonds, municipal bonds, and pledged bonds. Because bonds are debt, investors still have inherent risks—usually credit risk and interest rate risk. Bonds can default if the issuer fails to repay the debt. Therefore, the greater the risk to the bond issuer (borrower), the higher the interest rate required.

The combination with Olympus differs by reflecting the structure of the discounted token sale. Instead of earning interest, the investor sells the asset to the Olympus treasury for OHM at a discount.

The combination with Olympus differs by reflecting the structure of the discounted token sale. Instead of earning interest, the investor sells the asset to the Olympus treasury for OHM at a discount. This process also involves a typical vesting period of about five days. Investors also don't get any return on their discounted OHM unless staked or through a bigger price appreciation in the market.

As the bond sales generate profits for the Treasury, Olympus can accumulate more liquidity in the OHM SushiSwap pool over time — known as "protocol-owned liquidity." Users in the Olympus ecosystem can choose from a range of strategic bond types based on ROI. These include DAI keys, wETH keys, FRAX keys, OHM-FRAX LP keys and OHM-DAI LP keys.

The protocol owns and manages more than 99% of the liquidity in OHM-DAI bonds, according to Olympus’ website and data analytics firm Messari. Since such structures are internally controlled and managed at a high level through DAOs, they mitigate OHM's capital inefficiencies and instability.

Risks of OlympusDAO:

Olympus claims that their protocol-owned liquidity and bond-as-a-service protocol services will help alleviate (or even solve) the problems of liquidity mining today. However, this is not without risk. For example, as protocols continue to have more token liquidity, they gain more centralized control and can manipulate the price of OHM accordingly.

OlympusDAO price drops and losses

As the OlympusDAO protocol is still in its infancy, broader market volatility can quickly affect investor sentiment and support, especially in terms of OHM’s price and stability. This was evidenced by the recent drop in the cryptocurrency market throughout January 2022 after the Federal Reserve announced that it would raise interest rates. As a result, the market sell-off has caused Olympus to drop more than 50% since Jan. 10.

That said, the recent price drop in OHM has also been shared among projects using similar token economics. For example, Wonderland (TIME) has fallen more than 30% in recent weeks. On Ethereum, Redacted Cartel, a fork backed by Olympus-DAO, has also been affected since its launch in mid-December.

In conclusion, despite how attractive or complex protocols and services like OlympusDAO may sound, it is important to understand that extreme price volatility is standard in any growth phase.

Advantages and benefits of DeFi 2.0:

Broader flexibility for staking assets: A standard feature of many DeFi protocols is that when users stake token pairs in liquidity pools, they will receive an LP token in return. The DeFi 1.0 ecosystem allows users to further increase their returns by staking LP tokens in yield farms. However, there isn't much beyond these core value propositions, which has resulted in millions of dollars being locked up in various vaults to help provide liquidity for its protocol.

DeFi 2.0 helps to add more utility and incentives by using yield farm LP tokens as collateral for loans, or minting other tokens like MakerDao (DAI). While the process varies by platform, in DeFi 2.0, LP tokens can unlock their value to find new opportunities while still generating APY.

Smart contracts covered by insurance:

While DeFi operates on transparent and open-source infrastructure, due diligence and risk analysis of the protocol can be difficult for those with limited technical experience. DeFi 2.0 alleviates market ambiguity by providing users with smart contract insurance. In the past, someone took a risk before staking their LP tokens on yield farms because if the aforementioned smart contracts were compromised, they could lose all of their funds.

With DeFi 2.0, insurance programs can guarantee deposits on yield farms for a fee. While risk exposure has improved, the overall details of these insurance platforms are not perfect and rely heavily on specific smart contracts. For example, if the liquidity pool contract is compromised but the yield farm contract is not, the insurance company will not cover the loss.

With the rapid development of DeFi 2.0, users do not need to wait to access these solutions or find practical use cases.

Impermanent loss insurance:

Typically, for users who invest in liquidity pools and engage in liquidity mining, any change in the price ratio of the two tokens locked can result in financial losses. DeFi 2.0 is actively creating ways to mitigate these risks.

With DeFi 2.0, users can use the protocol to create token pairs. In this case, someone can add one token to the single-sided LP and the protocol also adds its native token as the other side of the pair. Both the protocol and the user will then receive fees from their respective pairs of exchanges.

Over time, the protocol uses the fees incurred to build an insurance fund to protect deposits from potential permanent loss. If the loss assesses the amount of fees rising in the insurance fund, the protocol can mint new tokens to cover the balance. The protocol can also destroy excess to reduce supply or store it for later use.

Self-payment loan:

Typically, loan users face liquidation risk and high repayment rates. DeFi 2.0 helps overcome these pitfalls by offering self-paying loans. In a self-paying loan structure, the lender can repay the loan over time using the interest earned on the collateral deposited. The deposited collateral is returned to the borrower after the lender receives the total loan amount plus an additional premium. Self-payment loans also have no liquidation risk. If the collateralized tokens depreciate, the time required to pay the loan will be extended accordingly.

Prominent risks of DeFi 2.0 and how to prevent them:

Despite being a step forward, DeFi 2.0 still carries many of the same risks as DeFi 1.0.

The more common risks are:

Compromised smart contracts:

Auditing can never guarantee the security of smart contracts. Therefore, it is important that users do as much layered due diligence and research on the protocol as possible before investing.

Changing regulations:

As government and regulator interest in DeFi grows, projects and platforms may need to adjust rules and services to accommodate newer regulations and industry standards. While it can help provide greater stability and security, it also changes the level of support and compromises the degree of decentralization involved.

Impermanent loss:

While DeFi 2.0 offers better safety nets like the insurance structures mentioned above, there is still significant risk to anyone opting for liquidity mining due to market volatility.

Rigid user experience: If a DeFi project's website goes down (for whatever reason), users won't be able to withdraw their staked assets unless they have the technical expertise to interact directly with smart contracts. To prevent this, it is recommended that users also locate smart contracts on the blockchain browser for reference.

In conclusion

With the rapid development of DeFi 2.0, users do not need to wait to access these solutions or find practical use cases. Projects like Ethereum, Binance Smart Chain, Solana, and other competitive emerging blockchains are all starting to offer the aforementioned services in their networks. Having said that, it is advisable to do as much research as possible as investing in web3 always involves risk.