What is DeFi 2.0?

What is DeFi 2.0?

The world is ruled by financial systems and big institutions that are part of this system. But as we have seen multiple times in the past, these systems can fail or they can abuse their power as they see fit. Because of this, when blockchain started to develop, we were introduced to the newest financial system called DeFi. DeFi stands for decentralized finances and it has introduced decentralization to the financial sector.

DeFi consists of different applications that run on smart contracts and are fully or partially decentralized. DeFi, just like any other part of the blockchain, is developing day by day, and nowadays we started to move towards DeFi 2.0, which is the newer and better version of the DeFi system. But what exactly is DeFi 2.0, how did we get here, and what new possibilities does it bring to the world of decentralized finances? Let’s take a look.

Beginning of DeFi

One of the first innovations in the world of DeFi was an automated market maker, which was used to create decentralized exchanges. Uniswap was one of the first decentralized exchanges that gave users the ability to swap and trade with cryptocurrencies using their own private wallets, meaning that users did not have to give up custody over their tokens. 

This was followed by the introduction of decentralized stablecoins and different lending/borrowing platforms. With this, the world of DeFi started to develop and more and more DeFi projects started to pop up. This has created a very competitive market, with multiple projects offering similar services, and development has become a crucial part of these projects. This has created a constant development cycle, where everyone was trying to introduce new innovations or fix problems that were affecting the DeFi ecosystem. While these problems were not something major, they were still problems and flaws that needed to be addressed and fixed. Once these problems started to be fixed, we started to shift towards DeFi 2.0, but what were these problems?

Flaws of DeFi 1.0

One of the first major problems with the first iteration of the DeFi industry was the complexity behind it. DeFi consists of different blockchain products, and most of these products were designed with the thought that people who were going to use them knew a lot about blockchain. There were also big problems with UX and UI and many newcomers who decided to give DeFi a shot swiftly returned to centralized platforms which offered simplicity and ease of use. 

Another problem that plagued the DeFi ecosystem was the blockchain it was built on. Most of the DeFi projects used Ethereum as their blockchain. While this was not a huge problem at the start, as more and more projects and people started to use Ethereum, scalability came into the equation. Ethereum used to operate on a proof-of-work protocol, which is very energy-intensive, expensive, and slow. With a large demand for Ethereum transactions, gas fees started to skyrocket, and if you were not ready to pay astronomical fees, you needed to wait a very long time for your transactions to go through. Ethereum has moved to proof-of-stake protocol since some of these problems still remain with this blockchain. 

DeFi also became a nest for criminals and scammers. Since DeFi is a decentralized system, it’s easy to hide your own identity. This gave scammers a perfect hunting ground since they had a lot of freedom and the ability to remain anonymous throughout the whole process. Because of this, we also saw a huge number of pump-and-dump scams, with projects giving big hopes but ending up as scams. 

DeFi also started to suffer with low liquidities. When trading on decentralized exchanges, it’s very important that there is liquidity, otherwise, coin prices will be altered and not resemble the actual market. To combat this, decentralized exchanges started to offer incentives for those who provided liquidity for the exchanges, but this is just a bandage on the wound and does not provide long-term sustainability. 

Why DeFi 2.0?

Looking at these problems that plague the DeFi ecosystem, people started to innovate and this has created a pathway towards DeFi 2.0. While the first iteration of DeFi was not user-friendly and had many problems, it still managed to create an initial user base, which is crucial for development. Now that people are familiar with DeFi and at least have a general idea of what it stands for and what it wants to achieve, DeFi started to evolve into a more sustainable ecosystem with long-term viability.

The main problems that prevent DeFi from becoming sustainable are third-party reliance and token incentives to secure liquidity. DeFi also has no correlation with traditional finances, which makes it challenging to appeal to the masses. These are the main concerns that DeFi 2.0 aims to address. 

Solutions for DeFi 2.0

As people got more familiar with DeFi and understood what was and was not working, solutions started to be developed. New products and services entered the market, and stuff that was not working properly was adjusted and upgraded. Let’s take a look at some of these solutions.

New blockchains for scalability

As we mentioned earlier, Ethereum was and still is, the most popular blockchain when it comes to the DeFi ecosystem. But with DeFi growing, Ethereum started to show cracks in its system. It’s slow and expensive, which caused many interested people to avoid DeFi. 

But people were quick to catch onto this problem and we started to see new blockchains entering the market. BSC, Solana, and Polygon all were blockchains that addressed scalability issues and introduced faster and cheaper alternatives. For example, transactions made on the Solana network are done within seconds or minutes with fees that are always less than $1. 

Yield Farming

Yield farming was introduced a long time ago as a way to create liquidity. Users on decentralized exchanges could provide liquidity for any trading pair and in return they would earn Liquidity Provider (LP) Tokens. These users could then stake these LP tokens to earn returns, and this somewhat solved the problem. With this, people who provided liquidity did not rely only on trading fees as a way of making money, and they had other forms of income. 

This got pushed even further in DeFi 2.0, with LP tokens gaining other functionalities and their values started being unlocked. LP tokens started to be used as collaterals and depending on the project, they had different uses. Some projects used these LP tokens as collaterals for crypto lending platforms, some used them for minting new coins, and so on. This gave people a reason for providing liquidity for these decentralized projects and in return they could gain different benefits. 

DAO Developments

DeFi stands for decentralized finances, but when taking a closer look at these projects, we could see that most of them were still controlled by a group of people. Each project had people who ran everything, and while it was still decentralized, people did not feel like they had full control over their assets and future. 

Because of this, we started to see the birth of DAO projects within the DeFi ecosystem. DAO stands for Decentralized Autonomous Organization and every participant in this project has its own say. Each DAO project has what’s called governance tokens, which are tokens that represent a share of the project. People who hold these tokens can make suggestions regarding the project, it can be new services, changes to existing services, and anything else associated with the project. After this, people holding these governance tokens could vote on these changes. This has given control over the project to the community and truly embraced the DeFi spirit.

Smart Contract Advancements

Another very important development that took place in the DeFi ecosystem is the advancements of smart contracts. One clear example of this advancement benefiting the ecosystem is self-repaying loans. DeFi is known for having multiple loaning platforms, where users can loan out their cryptocurrencies for certain monthly fees. But there was one problem with this system, which was people not paying back the crypto they borrowed. While there were some mechanisms in place to protect lenders from this, it was still a risky endeavor. But with smart contract development, self-paying loans have become a reality, and now lenders don’t have to worry about these people not paying back their loans. 

Final Thoughts

As the world of cryptocurrencies grows, DeFi is destined to follow in its footsteps. Bitcoin was created with the goal of bringing decentralization to the financial sector and right now DeFi is what Satoshi Nakamoto envisioned when he created Bitcoin. More and more people start not believing in banks and traditional financial institutions, as time and time again these institutions fail to protect people's needs. 

This will fuel the DeFi development even further, and with DeFi 2.0 becoming a reality, we should expect this progress to continue. But when it comes to investing in this scene, everyone should be on high alert. Despite DeFi being a good overall ecosystem, it’s still highly volatile and filled with uncertainties. There are some DeFi projects, which are definitely investment-worthy, while others might be best to avoid. Because of this, it’s best to do thorough research into this scene and decide where to invest only after getting a clear picture of it all.

FAQs on What is DeFi 2.0

Is DeFi risky?

DeFi is most certainly an ecosystem filled with risky investments. But this is changing as time goes on. At the beginning of DeFi, it was filled with many problems and flaws that made investment into this system very difficult and risky. But as DeFi keeps advancing and we are introduced to DeFi 2.0 these risks are gradually becoming lower and lower. But this does not mean that it has become a risk-free investment space, and it’s still filled with projects that are not investment worthy. Because of this, if you are planning to invest in DeFi, it’s best to do thorough research.