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What Is DeFi 2.0 and Why Does it Matter?

DeFi 2.0 is a collection of initiatives that address the shortcomings of DeFi 1.0. DeFi's goal is to bring finance to the public, but it has battled scalability, security, centralization, liquidity, and information accessibility. DeFi 2.0 aims to address these issues and improve the user experience. If DeFi 2.0 is effective, it will assist to lessen the risks and complexity that dissuade crypto users from utilizing it.

We already have several DeFi 2.0 use cases operational. You may use your LP tokens and yield farm LP tokens as collateral for a loan on some sites. This approach allows you to extract more value from them while still getting pool benefits.


You can also obtain self-repaying loans in which your collateral earns money for the lender. This interest pays off the debt without the borrower having to pay any interest. Insurance against hacked smart contracts and temporary loss are two further use cases (IL).


DAO governance and decentralization are emerging trends in DeFi 2.0. Governments and regulators, on the other hand, may eventually influence how many projects are carried out. Keep this in mind before investing, since the services provided may need to alter.


Introduction

It has been over two years since the birth of DeFi (Decentralized Finance) in 2020. Since then, we've seen tremendously successful DeFi ventures like as UniSwap, a decentralization of trade and finance, and new methods to earn interest in the cryptocurrency sector. But, as we saw with Bitcoin (BTC), there are still issues to work out in such a young industry. As a result, the name DeFi 2.0 has gained currency to designate a new generation of DeFi decentralized apps (DApps).

We are still waiting for the full deluge of DeFi 2.0 as of December 2021, but we can already witness its beginnings. Learn what to look for in this article and why DeFi 2.0 is required to fix unresolved issues in the DeFi ecosystem.


What is DeFi 2.0?

DeFi 2.0 is a movement attempting to update and correct the issues that plagued the initial DeFi wave. DeFi was a game-changer in giving decentralized financial services to everyone with a cryptocurrency wallet, yet it still has flaws. This trend has already occurred in cryptocurrency, with second-generation blockchains such as Ethereum (ETH) outperforming Bitcoin. DeFi 2.0 will also need to respond to new compliance laws that countries want to implement, like KYC and AML.

Let's have a look at an example. Liquidity pools (LPs) have been enormously popular in DeFi because they allow liquidity providers to earn fees for staking pairs of tokens. However, if the token price ratio changes, liquidity providers risk losing money (impermanent loss). For a nominal cost, a DeFi 2.0 protocol might give insurance against this. This strategy increases the motivation to invest in LPs while also benefiting users, stakeholders, and the DeFi industry as a whole.


What are the limitations of DeFi?

Before delving more into DeFi 2.0 use cases, let's look at the issues it's attempting to fix. Many of the concerns raised here are comparable to those encountered by blockchain technology and cryptocurrencies in general:


1. Scalability: DeFi protocols on high-traffic blockchains with high gas prices sometimes deliver sluggish and costly services. Simple chores can become inefficient if they take too long.


2. Oracles and third-party information: Financial products that rely on external details require higher grade oracles (third-party sources of data).


3. Centralization: In DeFi, greater decentralization should be a goal. However, many projects continue to lack DAO principles.


4. Security: Most consumers do not manage or comprehend the hazards associated with DeFi. They put millions of dollars at risk in smart contracts that they don't fully understand. While security audits are in place, their value diminishes when changes are implemented.


5. Liquidity: Markets and liquidity pools are distributed over several blockchains and platforms, dividing liquidity. By providing liquidity, monies and their complete worth are likewise locked up. Tokens invested in liquidity pools, in most situations, cannot be utilized elsewhere, resulting in capital inefficiencies.


Why does DeFi 2.0 matter?

Even for HODLers and seasoned crypto users, DeFi can be intimidating and difficult to comprehend. However, it intends to remove entrance barriers and provide new income opportunities for cryptocurrency holders. Users who are unable to obtain a loan from a regular bank may be able to do it through DeFi.

DeFi 2.0 is significant because it has the potential to democratize banking while minimizing risk. DeFi 2.0 also seeks to address the issues highlighted in the preceding section, therefore enhancing the user experience. If we can do this while also providing greater incentives, everyone will benefit.


DeFi 2.0 use cases

We do not need to wait for DeFi 2.0 use cases. There are already initiatives on several networks offering new DeFi services, including Ethereum, Binance Smart Chain, Solana, and other smart contract enabled blockchains. We'll look at some of the most prevalent in this section:


Unlocking the value of staked funds

If you've ever bet a token pair in a liquidity pool, you've gotten LP tokens in exchange. With DeFi 1.0, you may compound your income by staking the LP tokens with a yield farm. Before DeFi 2.0, this was the end of the value extraction chain. Millions of dollars are held in vaults to provide liquidity, but there is room to increase capital efficiency even more.


DeFi 2.0 goes a step farther by using these yield farm LP tokens as collateral. This might be for a crypto loan from a lending protocol or to manufacture tokens in a MakerDAO-like procedure (DAI). The specific technique varies with every project, but the goal is that your LP tokens' value should be unlocked for new possibilities while also growing APY.


Smart contract insurance

Unless you're a seasoned developer, performing improved due diligence on smart contracts might be challenging. You can only evaluate a project partially if you don't have this information. When investing in DeFi initiatives, this poses a significant degree of risk. DeFi 2.0 allows you to receive DeFi insurance on specified smart contracts.


Assume you're utilizing a yield optimizer and have LP tokens staked in its smart contract. You might lose all of your deposits if the smart contract is breached. For a price, an insurance project can provide you with a guarantee on your deposit with the yield farm. It should be noted that this will only apply to a single smart contract. If the liquidity pool contract is breached, you will often not get a payment. However, if the yield farm contract is jeopardized but covered by insurance, you will almost certainly receive a reimbursement.


Impermanent loss insurance

If you invest in a liquidity pool and begin mining liquidity, any change in the price ratio of the two tokens you locked may result in financial losses. This is referred to as impermanent loss, however, new DeFi 2.0 protocols are looking for new ways to reduce this risk.


Consider adding one token to a single-sided LP if a pair is not required. The protocol then adds its native token to the pair as the other side. The protocol, as well as you, will thereafter get fees earned by swaps in the corresponding pair.

Over time, the procedure will utilize their fees to build up an insurance fund to protect your deposit from the impacts of temporary loss. If there aren't enough fees to cover the losses, the protocol can create additional tokens to compensate. If there are too many tokens, they can be saved for later use or destroyed to reduce supply.


Self-repaying loans

Taking out a loan often entails the risk of liquidation as well as interest payments. This does not have to be the case with DeFi 2.0. Assume you obtain a $100 loan from a cryptocurrency lender. The lender lends you $100 in cryptocurrency but asks for $50 in collateral. Once you have made your deposit, the lender will utilize it to collect interest to pay off your loan. Your deposit is reimbursed after the lender has earned $100 with your cryptocurrency plus a surcharge. There is also no danger of liquidation here. If the collateral token loses value, it just takes longer to pay off the loan.


Who's in control of DeFi 2.0?

With all of these features and use cases, it's worth wondering who is in charge of them. With blockchain technology, there has always been a decentralization movement. DeFi is no exception. MakerDAO (DAI), one of DeFi 1.0's initial initiatives, established a precedent for the movement. It's becoming more typical for projects to give their community a say.


Many platform tokens also function as governance tokens, granting holders voting rights. It's realistic to expect additional decentralization in the sector with DeFi 2.0. However, when compliance and regulation catch up with DeFi, their job is becoming more crucial.


What are the risks of Defi 2.0, and how may they be avoided?

Many of the dangers associated with DeFi 2.0 are the same as those associated with DeFi 1.0. Here are some of the most common, as well as what you can do to protect yourself.


1. Smart contracts with which you interact may contain backdoors, flaws, or be hacked. An audit is also never a guarantee of a project's safety. Conduct as much research as possible on the idea and keep in mind that investment always entails risk.


2. Regulation may have an impact on your investments. Governments and authorities all around the globe are interested in the DeFi ecosystem. While regulation and regulations can increase crypto's security and stability, certain projects may have to adjust their services when new restrictions are enacted.


3. Impermanent loss Even with IL insurance, anyone interested in liquidity mining faces significant risk. The risk can never be eliminated.


4. You may have difficulty accessing your money. If you're staking using a DeFi project's website UI, you should look for the smart contract on a blockchain explorer as well. If the website is down, you won't be able to withdraw. However, to communicate directly with the smart contract, you will need some technical knowledge.


Closing thoughts

While there are numerous successful efforts in the DeFi arena, we have yet to see DeFi 2.0's full potential. Most consumers still find the subject difficult, and no one should use financial products that they do not completely comprehend. There is still work to be done to simplify the procedure, particularly for new users. We've seen success in innovative approaches to limit risk while earning APY, but we'll have to wait and see if DeFi 2.0 lives up to its promises.