The growth of the DeFi sector throughout 2020 and 2021 saw an explosion of new projects for lending, asset trading, and profitable liquidity mining. The opportunity to make lots of money has attracted more and more day traders to these DeFi projects, who become extremely short-term stakeholders, selling immediately after making a profit. As a result, the price of DeFi tokens, which help provide the funds needed for projects’ sustainable development, fluctuate drastically, meaning that a project may have lots of liquidity one day, and none the next. This principal problem has led to the search for ways to improve the way existing DeFi protocols operate, leading to the emergence of DeFi 2.0 solutions, which we will take a closer look at in this blog post.
Existing limitations of DeFi 1.0
The DeFi sector was created to provide alternatives to the traditional centralized financial industry. Using blockchain technology and smart contracts, projects such as Compound, Uniswap, and Yearn Finance have provided decentralized financial services to a wide range of users without governments, banks, payment systems, and other intermediaries. Despite its rapid development, DeFi is still in its infancy, with the benefits of using these platforms counterbalanced with some prominent issues which are yet to be satisfactorily resolved. These include:
Scalability
Most dApps are currently deployed on the Ethereum blockchain, which is experiencing well-known scalability issues, low throughput due to high user flow, and rising gas fees. All this makes it difficult to use DeFi products and prohibitive for users making smaller-scale transactions.
That being said, the Ethereum Virtual Machine, which provides distributed computational power to interpret and validate smart contracts, is being built into or made compatible with other blockchain networks. This has given developers the ability to create and execute smart contracts that are fully compatible with Ethereum but on a much more scalable and cost-effective network. Read about EVM scalability solutions for DeFi development in our recent blog.
UX and UI complexity
The next barrier is directly related to the usability of DeFi platforms. It is difficult for beginners to use decentralized products due to the complexity of the UX and UI. As with any other sector, “people ignore design that ignores people”, so the majority of users continue to be experienced cryptocurrency users.
Smart contract vulnerability
The vulnerability in smart contracts development is another area of concern. If a contract is deployed in an ecosystem with a vulnerability in the code, it could lead to hacks and lost funds.
Centralization
Another problem with the DeFi sector is that it’s not always centralized. New projects give developers a high degree of confidence to quickly respond to issues and fix them. This leads to situations where the dApps are actually centralized, and risks of abuse of users’ funds, even if the project team is trustworthy.
Liquidity
As we mentioned above, the main challenge for DeFi projects, considering the absence of third parties, is to provide liquidity for sustainable market performance. Liquidity in cryptocurrency means how quickly an asset can be bought or sold without affecting its market price. DeFi protocols need liquidity for trading, lending, insurance, and other financial services, which is why liquidity mining was introduced.
What is liquidity mining?
Liquidity mining (also known as yield-farming) is a way to earn by locking up cryptocurrency to receive rewards. In simple terms, this is similar to the usual bank deposit; you put a certain amount of money in your account and earn interest. However, unlike with conventional currencies, you lock the DeFi project’s coins and receive a reward, thereby providing liquidity to increase the entire project’s TVL (Total Value Locked).
The main challenge for DeFi projects is to provide sustainable liquidity for the ecosystem’s continued operation and development. A common practice when deploying a DeFi project is to attract investors to grow TVL through generous rewards, airdrops, and other economic incentives. Unfortunately, most users are short-term speculators who want to earn quickly and then withdraw their funds in search of more lucrative opportunities.
Analysis by the blockchain analytics platform Nansen shows that 42% of yield farmers exit within 24 hours, and 16% within 48 hours. By the third day, 70% of these users leave the smart contract. The diagram below gives a further detailed breakdown.
DeFi 2.0 solutions
All of the above risks and problems are gradually being addressed thanks to the new generation of solutions referred to as DeFi 2.0. Let’s take a look at what this new movement brings to the table.
Insurance for smart contract vulnerability
While smart contract audits are a good way to protect your application against breaches, there is also now insurance for certain smart contracts. With DeFi 2.0 projects, you can get a guarantee on your deposit for a certain fee at a yield farm for a specific smart contract. If the smart contract is violated but is covered by insurance, you will receive a payment.
DAO as a solution to the centralization problem
To solve the problem with centralization, some projects choose DAOs as a form of organization for further governance and development. The project, which is initially controlled by the development team, becomes governed by the community. Each participant—owning a share of management tokens, participates in the development of the project, suggests changes, or voting for other participants’ ideas. This approach makes the project truly decentralized. The most famous DAO project in the DeFi 2.0 industry is Olympus DAO, which we will talk about in more detail below.
Liquidity solution
To combat liquidity loss, some DeFi projects solve the problem by gradually unlocking tokens in accordance with a certain schedule; however, these are only temporary measures in the fight against the utility token price decline, liquidity retention, and TVL fall. DeFi 2.0 projects are changing the existing yield-farming protocols and tokenomics, as well as providing new approaches to attract and keep funds in the long run.
Olympus DAO’s solution to unstable liquidity
Olympus DAO has introduced one of the most promising liquidity control concepts, using the bond mechanism as an alternative to liquidity mining. Olympus launched in March 2021 with the OHM token. OHM’s price is backed by assets in the Olympus Treasury. Each OHM is backed by 1 DAI, and its offer is governed by the protocol. When 1 OHM trades below 1 DAI, the protocol buys and burns OHM, decreasing token supply to raise its price.
One of the innovations Olympus has introduced is the bond mechanism. Olympus uses OHM as liquidity bonds and uses DAI and other LP (liquidity pool) tokens as reserve bonds. Since the price of OHM is above 1 DAI, bond sales are profitable for the protocol, and the Treasury uses the profit to produce more OHMs, some of which are distributed to users and some of which are used to accumulate POL (Protocol Owned Liquidity). Thanks to this model, the protocol controls 99.99% of OHM-DAI liquidity, earning commissions on its own.
The Olympus DAO project has gone much further with the introduction of a new, unique bonding-as-a-service product called OlympusPro. For a 3.3% commission of payments in the project’s own token, Olympus will implement this mechanism for you. When users buy bonds through Olympus Pro, it allows the protocols to accumulate liquidity to ensure durability and price stability for all participants. This mutually beneficial approach has already generated interest from several blockchains.
Other DeFi 2.0 projects to watch out for
Besides Olympus DAO, there are other DeFi 2.0 projects that address issues found in DeFi 1.0. Let’s take a look at some services that are creating new DeFi trends.
Convex Finance
Convex Finance is a decentralized staking service that allows Curve’s DEX liquidity providers to increase profits without blocking tokens in the liquidity pool. An increase in income is possible by providing an additional locking of CRV tokens (the native exchange token) received for providing liquidity. This approach allows you to increase profitability by 1.5-2.5%.
Thanks to the Convex Finance service, users can bypass the system and receive income from exchange commissions without locking tokens. It is enough to add Curve LP tokens (for example, cCRV or tCRV) to the pool and at the same time earn on Curve commissions and receive an additional percentage of staking. The reward is generated through staking the liquidity provider’s tokens.
Osmosis
A similar approach to staking is offered by the Osmosis project, an AMM (Automated Market Maker) exchange, where users place funds in liquidity pools with the OSMO government token. At the same time, they can receive staking income. Users place funds in pools with the OSMO token. The exchange has an incentive module that rewards users for long-term liquidity.
DeFi 2.0 – the megatrend set to grow in 2022
Unlike DeFi 1.0, which attracted users with fast and high profitability but could not keep them, DeFi 2.0 projects are designed to make them stay. New technologies have been created to overcome most of the major challenges that are encountered when using DeFi Dapps. The DeFi sector has experienced impressive growth of hundreds of billions over the past year, thanks to the emergence of new projects. DeFi 2.0 will fix network flaws and other projects will appear with new unique solutions for liquidity mining, governance, scaling solutions, and integration between new ecosystems.
The DeFi sector has not yet revealed its full potential, but even in its present form, offers an array of financial operations that are surpassing what can be done in the world of centralized finance. Yield mining, insurance, crowdfunding, lending platforms, DeFi wallets, and other decentralized solutions are possible in the DeFi sector without third-party involvement. Entrust the development of any services that take your business into a decentralized future to the team of professionals from INC4. With a free consultation, we will show you the best ways to grow your business in the world of decentralized finance through blockchain development.
