How DeFi 2.0 is reshaping the current model and tackling the challenges of existing DeFi protocols?
What’s exciting about the crypto-verse is that it keeps reinventing itself and novel concepts emerge to tackle the shortcomings of the existing projects.
DeFi (Decentralized Finance) has undergone exponential growth since summer 2020 with a Total Value Locked of $105.69 Billion, as per Defipulse.com.
DeFi’s steady growth in the past year can be contributed to multiple factors:
a. Investors are captivated by DeFi to make profits,
b. Pursue financial freedom,
c. Breakaway from traditional financial institutions.
Many different protocols like SushiSwap, Aave, Uniswap, etc. are providing a variety of services with a few things in common like lending, liquidity pools, incentives, governance tokens, etc.
But this model has shortcomings like excessive yield farming or liquidity mining. To fix these limitations, projects have made some important changes that address the pain points of the traditional model that existing DeFi projects face.
This new wave is titled DeFi 2.0. So, let’s dig deeper to understand what this means for the DeFi space?
Since DeFi began gaining popularity in summer 2020, it has managed to attract users by rewarding them with high yields through yield farming. When tokens are launched, they need liquidity to trade in DEXs (Decentralized Exchanges) and AMMs (Automated market makers) without affecting the token’s price while also attracting investors. Without significant liquidity in the protocol, there will be rapid pumps and dumps — things that aren’t what investors look for in their crypto investment.
But the main challenge for the DeFi protocols has been to maintain long-lasting liquidity in a sustainable way. The usual route is to allocate native tokens into the liquidity mining incentives. This lets the protocol grow rapidly as capital flows into the project.
Although many investors join the liquidity pool eyeing the high Annual Percentage Yield (APY) attached to it, these aren’t loyal believers, and a majority will move to another protocol when a higher incentive is offered — thereby creating a selling pressure for the native token.
As a way around, some protocols add a vesting period of five days or so to their liquidity mining rewards, but this just delays the problem rather than solving it.
Yield farming has managed to attract a staggering amount of money into these protocols, but over time there have been multiple downsides to it:
a. When the majority of farmers start dumping their rewards, strong sell pressure is generated. While it might be logical for investors who would move on to the next project, which offers better yields, this isn’t good news for the protocol itself and believers as the price of the native token drops significantly.
b. Once the yields become lower than competitor projects, liquidity leaves the protocol leaving the token holders with low-priced tokens.
To tackle these challenges, other alternatives are emerging, and projects using them have come to be known as DeFi 2.0.
The DeFi sector is reinventing itself and introducing new solutions to solve the obstacles of the first generation DeFi projects by altering the protocol design and tokenomics. Players like OlympusDAO, Tokemak, Alchemix, Abracadabra, and Curve are altering the game forever and are among the top names in the space.
These new breed of projects under DeFi 2.0 are finding ways to create a balance between liquidity mining incentives without the epic upswing and sudden, steep collapse of most yield-farming schemes.
DeFi projects opt for Protocol-Controlled Liquidity (PCV), where they accumulate funds to support their protocol rather than borrowing it from users by enticing them with high incentives.
OlympusDAO needs to be credited for introducing the innovation of ‘Bonding’ in DeFi. Users who set aside crypto as collateral, receive OHM tokens at a discount, and OlympusDAO will utilize this collateral as reserve assets. To determine the relative value of OHM to that asset, the protocol will adjust the supply by either minting more OHMs or burning them. Simply put, the protocol incentivizes users to sell their Liquidity Protocol tokens to the protocol in exchange for discounted OHM.
A DeFi primitive designed to generate sustainable liquidity, Tokemak aims to create more sticky liquidity. Each asset on the platform has its own pool called a Reactor, and TOKE is used to direct liquidity to these pools. Liquidity Providers supply only one token to the dedicated Reactor, and TOKE holders become Liquidity Director. These LDs decide where the liquidity should flow, thereby creating incentives for LPs and LDs.
After ETH and USDT genesis pools, the Tokemak community has begun voting on which reactors should be initiated. Once voted, these assets will be paired with the assets in the genesis pool and deployed across DeFi.
With the new breed of protocols seeking solutions to long-lasting liquidity mining, it will be interesting to see other protocols alter their product design and tokenomics.
DeFi 2.0 might be a meme on social media pages, but the concept is here to stay as it aims to make liquidity mining sustainable. As more innovations like bonding come into crypto, it will grow the DeFi space, and existing protocols can adapt from the newer ones. And lastly, newer concepts like DeFi 2.0 can help infuse fresh excitement into crypto and attract more investment in these projects.
Which DeFi 2.0 projects do you find interesting? Comment below.