DeFi 2.0 includes more efficient use of capital, liquidity stabilization mechanisms, and long-term user incentives.

The criteria for membership in DeFi 2.0 are not clearly defined. This category contains at least a few dozen projects. Olympus DAO, Abracadabra Money, Alchemix, Tokemak, and others are among them.

What problems does DeFi 2.0 address?

However, as the field has evolved, structural flaws such as low scalability and high fees, volatility of liquidity and revenue, security issues with smart contracts, and centralization have become apparent. DeFi 2.0 projects seek to solve these problems by employing new principles and approaches.

Long-term liquidity.

Most DeFi-protocols entice investors by providing 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, through which rewards are paid to liquidity providers, puts pressure on its price. The yield will eventually fall, raising the prospect of a mass “exodus” of capital and its migration to another protocol.

DeFi 2.0 tries to address this issue by establishing a protocol reserve fund, or treasury, which is used to earn money in popular DeFi applications. Furthermore, DeFi 2.0 projects provide “liquidity as a service” (LaaS) to other DeFi services with the help of treasuries. The end result should be the creation of a permanent revenue stream that eliminates excessive yield through the issuance of a management token.

Impermanent losses

Investors who provide liquidity to DeFi-protocol pools in the form of pairs of crypto-assets face the risk of Impermanent Loss on a regular basis (IL). These arise as a result of changes in the relative exchange rates of the two assets in the pool, which significantly reduces the expected return on investment and makes this type of investment less appealing.

Although some popular AMM-DEXs provide their own solutions to reduce the impact of IL (for example, Balancer pools use an arbitrary asset share ratio), only DeFi 2.0 services have attempted to radically solve this problem by using one-way pools.

Centralization

Many DeFi services were developed by anonymous teams who made all project development decisions. This increases the likelihood of intentional or unintentional management errors that harm the project’s well-being and the safety of private investments.

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

While the transition to DAOs was slow and optional in DeFi 1.0, it is now an industry standard in DeFi 2.0. In general, handing over management to the community is a sign of a project’s maturity when the team has implemented all of the intended functionality and has been successful in attracting users and liquidity.

History and great examples of DeFi 2.0

The majority of the second generation of decentralized finance began in 2021. That is when the term DeFi 2.0 was coined. Let’s take a look at some of the most prominent second-generation DeFi protocol representatives.

Olympus DAO (OHM)

Launched in the spring of 2021 on the Ethereum network. It intends to create a decentralized reserve currency backed by its own reserve fund (treasury).

The main way to fund the Olympus DAO treasury is to sell OHM control tokens via a “bonding” mechanism. Users can buy short-term bonds (bonds) with a variety of crypto-assets (DAI, ETH, etc.) and receive OHM tokens at a small discount within five days.

OHM token stacking relieved seller pressure. And, at the start of the project, the stacking yield exceeded 200,000% p.a (taking into account the automatic re-stacking every 8 hours).

To improve protocol stability, the team gradually reduced the yield of OHM token-stacking. At the same time, Olympus Pro, a LaaS product, was released, allowing other DeFi-protocols to use the binding mechanism to obtain their own liquidity. In this way, a source of income for the protocol was created at the expense of the treasury, independent of the influx of new investors.

Olympus DAO had more than $860 million in blockchain assets (TVL) and a $4.3 billion OHM token capitalization at the height of its popularity in November 2021. This success spawned a slew of imitators who used the Olympus DAO source code to launch their own versions.

As of June 2022, OHMfork and DeFi Llama services have over 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 in an exit scam.

Abracadabra Money (SPELL)

It was launched in May 2021, initially only on the Ethereum network, but it now works in popular EVM-compatible networks such as Arbitrum, Fantom, Avalanche, and BNB Smart Chain. The protocol enables the conversion of crypto-assets (including treasury tokens from yEarn Finance, Curve, and SushiSwap) into the algorithmic Magic Internet Money (MIM) stablecoin. MIM is traded on numerous decentralized and centralized exchanges, allowing investors to easily exchange it for other stabelcoins. As a reward for liquidity providers, the project accumulates SPELL management tokens, gradually reducing the reward. Abracadabra employs Olympus Pro to stabilize liquidity by purchasing bonds at a discount in order to build treasury reserves. SPELL is used in GAO votes. Furthermore, SPELL holders who are locked in staking receive a portion of Abracadabra’s fees and commissions.

Alchemix (ALCX)

It is a decentralized lending platform that was launched in February 2021 on the Ethereum blockchain. It enables 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.

When a DAI stablecoin deposit was made, the first version of the Alchemix protocol allowed for the creation of a synthetic alUSD stablecoin. Later, USDT, USDC, ETH, and other assets were added as collateral for loans. The Loan-to-Value (LTV) parameter is set at 50% for all assets. As a result, 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, which was launched on the Ethereum blockchain in August 2021, focuses on long-term liquidity and security issues “Losses that are volatile It accepts deposits as a credit protocol, but each crypto-asset is assigned to a separate pool known as a wallet “reactor.

TOKE management token holders vote on how each reactor’s liquidity is used. TOKE payments encourage people to vote. Third-party DeFi services can borrow the protocol’s accumulated liquidity, paying fees as it is used. These fees are paid to the Treasury (Tokemak Treasury).

The goal is to eventually reach a point where the protocol will no longer require external liquidity.

Risks and drawbacks of DeFi 2.0

While DeFi 2.0 has its benefits, it still has many of the risks associated with decentralized finance, such as human error, errors and vulnerabilities in smart contracts, and the possibility of asset price manipulation due to faulty price oracles.

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

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

Specific DeFi 2.0 risks include the fact that most such projects begin with a traditional liquidity mining mechanism, with the hope of eventually transitioning to a stable model with their own treasury. The growth of treasury income, on the other hand, is heavily dependent on the overall market situation in the DeFi industry. As a result, self-sufficiency in liquidity for DeFi 2.0 protocols may be an unattainable goal at a time of declining market activity.

The prospects of DeFi 2.0

During 2021, as the crypto market’s capitalization and number of users increased, DeFi 2.0 projects demonstrated their ability to attract users and capital through a variety of innovative solutions. However, the bearish trend in the stock and cryptocurrency markets, which began in 2022 as a result of events in the global economy and politics, brought TVL and the capitalization of all projects in this segment to an end.

The impending “cryptozyma” will be a litmus test for the entire DeFi industry. It is difficult to predict which of the existing DeFi 2.0 projects will be able to thrive in the new environment and which will fade away. In any case, regardless of market conditions, interesting approaches to attracting liquidity and users that have already proven to be effective will be used in the future.