Over the past 2-3 years, Decentralized Finance (DeFi) has emerged as a popular alternative to the much more rigid traditional financial systems. Running on top of blockchain technology, DeFi opened up banking to anyone with internet access. DeFi Web 2.0 applications enabled individuals or entities to transfer money without going through a central authority or intermediaries such as exchanges and banks.
Smart contracts running on the blockchain have in-built business rules that ensure the transactions are being processed safely, transparently, and efficiently. Due to the dependency on smart contracts, most DeFi applications were built on top of the Ethereum blockchain, which offers extensive support for smart contracts.
DeFi opens up multiple avenues for its users to make good returns. One such popular investment strategy is DeFi Yield farming. Here the user lends or stakes their cryptocurrency tokens in a decentralized exchange and gets rewarded in the form of transaction fees or interest. This is similar to earning interest on a savings account in a traditional bank but here the returns can be much higher even though they are riskier and tend to be quite volatile.
That being said, DeFi 1.0 is not without its set of limitations. First, the protocol’s dependence on Ethereum meant that they had to encounter long-running transactions along with high fees. This also meant the protocol was not going to be very scalable in its current form. Second, these protocols relied on users to deposit their crypto assets to increase their liquidity. But this was easier said than done as it required the users to lock up their funds for some time which was not very efficient.
There were also no attractive incentives for liquidity providers to keep continuing their investments. This slowly led to the sale of the protocol’s native tokens thereby reducing its supply. Third, the security and safety of the assets were also under question. Smart contracts could be hacked if written inefficiently and there was no insurance cover against the assets. Finally, the user interfaces of DeFi applications were considered too complex making navigation extremely tough for the average user.
The DeFi 2.0 ecosystem was born more out of the need to sort out the issues in DeFi 1.0. It aims to democratize finance and ensure financial stability without compromising on risk. DeFi Web 2.0 also promises to bring in a lot of innovation and improvements, especially in areas of usability, security, and scalability, which we will briefly describe below –
Ethereum 1.0 has the problem of scalability due to its time-consuming consensus algorithm ad high transaction fees. As an alternative, other blockchains such as Polkadot, Solana, and Cardano (also called “Ethereum killers”) can be used in the DeFi space as they are known to perform much faster than Ethereum. Ethereum 2.0 has also been recently released with a new consensus algorithm that guarantees much higher speeds than in Ethereum 1.0.
The user experience of current DeFi 1.0 applications has not been good except for seasoned crypto players. DeFi Web 2.0, which wants to take DeFi to the masses, has been working on making the UI much more intuitive and easier to use for everyone by bringing in layer-2 and layer-3 services for various operations such as yield farming and lending.
Centralization Through DAO
Even though the goal of DeFi was to be fully decentralized, it was not fully realizable in the real world as some of the existing DeFi solutions were under the control of certain groups. The DeFi Web 2.0 projects have introduced Decentralized Autonomous Organizations (DAOs) to mitigate this issue.
DAOs are entities that have no central authority and are governed by the entire user community based on a set of rules coded onto the blockchain in the form of smart contracts. All members get to vote on any decision with regard to the functioning of the DAO. DAOs help to bring more decentralization in the organization as the governance is done by the entire user community and not by any specific groups.
Security Through Insurance
DeFi 2.0 allows users to get insurance on smart contracts. Smart contracts are susceptible to external hacks, especially if poorly written, leading to a loss of all funds on the smart contract. Having insurance on the smart contract provides some risk coverage for the user’s deposits in exchange for a small fee.
Higher Yields and Self-Repaying Loans
In DeFi 1.0, users could earn returns by staking their tokens in the liquidity pool. But in DeFi web 2.0 they could also use the tokens as collateral for loans. The added advantage here was the collateral could also be used to earn further yields and pay off the loan. The lender gets back his money with interest and the borrower also gets back his collateral. In this way, DeFi web 2.0 protocols help users maximize their staked assets’ returns.
Protection Against Impermanent Loss
Impermanent loss occurs during liquidity mining whenever there is a change in the price ratio of tokens in the liquidity pool. DeFi 2.0 protocols have made some breakthroughs in resolving and mitigating this risk.
For example, in one approach, whenever a user adds a token to the liquidity pool, the protocol would also add a native token to pair with it. Now, both the user and the protocol will collect fees earned from swaps in the token pair. The fees earned by the protocol can then be used to provide insurance against impermanent loss.
DeFi 1.0 has been groundbreaking in the world of finance and has brought in many revolutionary features, along with some undesirable flaws. DeFi web 2.0 promises to raise the bar even higher by aggressively addressing those flaws and delivering more simplified, secure, and innovative solutions to the Fintech space in the coming days.