What is DeFi 2.0?

1. What problems does DeFi 2.0 solve?

2. DeFi 2.0’s emergence history and prominent representatives

3. Risks and drawbacks of DeFi 2.0

4. Outlook for DeFi 2.0

Main

• DeFi 2.0 is the second generation of decentralized finance, with projects that address the problems of the “first version.” This includes more efficient use of capital, liquidity stabilization mechanisms and long-term incentives for users.

• The criteria for belonging to DeFi 2.0 are not strictly defined. At least several dozen projects fall into this category. Among them are Olympus DAO, Abracadabra Money, Alchemix, Tokemak, and others.

• DeFi 2.0 protocols build their services on existing DeFi infrastructure, including decentralized exchanges with automatic market maker technology (AMM-DEX) and lending protocols secured against crypto assets.

What problems does DeFi 2.0 solve?

Today, decentralized finance remains one of the main trends in the crypto-industry. However, as DeFi has evolved, the structural weaknesses of the field have become apparent – low scalability and high fees, volatility of liquidity and revenue, security issues with smart contracts, and centralization. DeFi 2.0 projects seek to use new principles and approaches to solve these problems.

• Long-term liquidity

Most DeFi-protocols attract investors by offering them incentives in the form of native project tokens. The “liquidity mining” mechanism works well in the short term, but the accelerated issuance of the token, by which rewards are paid to liquidity providers, creates pressure on its price. Sooner or later, yields are reduced, creating risks of a massive “exodus” of capital and its migration to another protocol.

DeFi 2.0 tries to solve this problem by forming a protocol reserve fund, or treasury, which are used to earn money in popular DeFi applications. In addition, with the help of treasuries, DeFi 2.0 projects provide “liquidity as a service” (LaaS) to other DeFi services. The end result should be the creation of a permanent revenue stream that allows for the elimination of too high a return through the issuance of a management token.

• Non-permanent losses

Investors who provide liquidity to DeFi-protocol pools in the form of pairs of crypto-assets constantly face the risk of Impermanent Loss (IL). These arise from changes in the relative exchange rates of the two assets in the pool, which significantly reduces the expected return on investment and worsens the attractiveness of this type of investment.

Although some popular AMM-DEXs offer their own solutions to reduce the impact of IL (e.g., Balancer pools use an arbitrary ratio of asset shares), only DeFi 2.0 services have attempted to radically solve this problem with one-way pools.

• Centralization

Many DeFi services were created by anonymous teams that made all decisions about project development. This opens up a wide space for fraud, and also increases the likelihood of intentional or accidental management errors that harm the well-being of the project and the safety of private investment.

The answer to these challenges has been the proliferation of DAOs – decentralized, autonomous organizations whose members decide most of the tactical and strategic issues of project development through on-the-chain voting.

While for DeFi 1.0 the transition to DAOs was rather slow and not mandatory, for DeFi 2.0 it is initially an industry standard. As a rule, handing over management to the community is a sign of a project’s maturity, when the team has implemented all the intended functionality and has been successful in attracting users and liquidity.

DeFi 2.0’s emergence history and prominent representatives

Most of the representatives of the 2nd generation of decentralized finance started during 2021. That’s when the term DeFi 2.0 itself came into use. Let’s take a look at some of the most prominent representatives of the second generation DeFi protocols.

Olympus DAO (OHM)

Launched in the spring of 2021 on the Ethereum network. Aimed at creating a decentralized reserve currency, secured by its own reserve fund (treasury).

The main way to fill the Olympus DAO treasury is by selling OHM control token through a “bonding” mechanism. Users can buy short-term bonds (bonds) with a number of crypto-assets (DAI, ETH, etc.), within five days receiving OHM tokens at a small discount.

Sellers’ pressure was reduced by stealing OHM tokens. And at the start of the project, the profitability of the stacking exceeded 200,000% p.a. (including automatic re-stacking every 8 hours).

To increase the stability of the protocol, the team gradually reduced the yield of OHM token-stacking. At the same time, the LaaS product Olympus Pro was launched, which allows other DeFi-protocols to use the binding mechanism to obtain their own liquidity. In this way, a source of revenue for the protocol, independent of the influx of new investors, was created at the expense of Treasury funds.

At the peak of its popularity in November 2021, Olympus DAO’s blockchain assets (TVL) exceeded $860 million and OHM’s token capitalization was $4.3 billion. This success spawned a wave of copycats who used the Olympus DAO source code to launch copies.

As of June 2022, OHMfork and DeFi Llama services have more than 130 Olympus DAO forks in all popular blockchains. Most of them differ from OlympusDAO only in name and native token stacking yields, but they are run by anonymous developers, which increases the risk of losing funds. Dozens of such projects have already ended up with exit scams.

Abracadabra Money (SPELL)

Launched in May 2021, initially only on the Ethereum network, but today it works on popular EVM-compatible networks including Arbitrum, Fantom, Avalanche and BNB Smart Chain. The protocol allows the conversion of crypto-assets (including treasury tokens from yEearn Finance, Curve and SushiSwap) into the algorithmic Magic Internet Money (MIM) stablecoin. MIM is traded on many decentralized and centralized exchanges, so investors can easily exchange it for other stabelcoins. As an incentive for liquidity providers, the project accrues SPELL management tokens, gradually reducing the reward. Abracadabra uses Olympus Pro to stabilize liquidity by buying bonds at a discount to build treasury reserves. SPELL is used in GAO votes. In addition, SPELL holders who are locked into the stack receive a share of Abracadabra’s commissions and fees.

Alchemix (ALCX)

This is a decentralized credit platform launched in February 2021 on the Ethereum blockchain. It allows users to take out “self-liquidating” loans secured by crypto-assets by issuing highly liquid synthetic tokens. Debt positions are automatically repaid with revenue generated through integration with yield aggregator yEarn Finance and the Aave and Compound credit protocols.

The first version of the Alchemix protocol allowed the minting of a synthetic alUSD staplecoin when a DAI staplecoin deposit was made. Later, USDT, USDC, ETH and other assets were added as collateral for loans. For all assets, the Loan-to-Value (LTV) parameter is 50%. That is, you can borrow up to half of the deposited collateral.

The management of the platform is gradually transferred to Alchemix DAO, to which 10% of the protocol’s revenues are allocated. ALCX management token holders can vote to fund projects that expand the use of alUSD.

Tokemak (TOKE)

This project, launched in August 2021 on the Ethereum blockchain, focuses on addressing long-term liquidity and “volatile losses.” It accepts deposits as a credit protocol, but distributes each crypto-asset to a separate pool called a “reactor.”

TOKE management token holders vote on how to use liquidity from each reactor. Voting is incentivized by TOKE payments. Third-party DeFi services can borrow the accumulated liquidity in the protocol, paying fees as it is used. These fees go to the treasury (Tokemak Treasury).

The plan is to eventually reach a level at which the protocol will no longer need to draw liquidity from the outside.

Risks and drawbacks of DeFi 2.0

While DeFi 2.0 has its advantages, it still shares many of the risks inherent in decentralized finance, including human error, errors and vulnerabilities in smart contracts, and the possibility of asset price manipulation due to incorrect price oracles.

Smart contracts that are not properly audited have already caused serious financial losses in DeFi 2.0. For example, in June 2021, shortly after the launch of support for the synthetic asset alETH, which is tied to the ETH price, there was an incident in the Alchemix protocol. Due to an error in the logic of the smart contract, several users inappropriately received a total of 4,300 ETH ($6.5 million at the time).

In addition, for projects that support algorithmic stablecoins (such as MIM and alUSD), there is a risk of losing the fiat currency peg due to manipulation or market conditions.

Specific DeFi 2.0 risks include the fact that most such projects initially use a classic liquidity mining mechanism, hoping to transition over time to a stable model with their own treasury. However, the growth of treasury income largely depends on the overall market situation in the DeFi industry. Therefore, at a time of declining market activity, self-sufficiency in liquidity for DeFi 2.0 protocols may be an unattainable goal.

Outlook for DeFi 2.0

During 2021, while the capitalization and number of users of the crypto market grew, DeFi 2.0 projects showed their ability to attract users and their capital through a number of innovative solutions. However, the bearish trend in the stock and cryptocurrency markets, which began in 2022 due to events in the global economy and politics, collapsed TVL and the capitalization of all projects in this segment without exception.

The coming “crypto winter” will be a test of strength for the entire DeFi industry. It is hard to say which of the existing DeFi 2.0 projects will be able to survive in the new conditions, and which will leave the scene. In any case, interesting approaches to attracting liquidity and users, which have already proven themselves well, will be used further, regardless of the market conditions.