DeFi is a permissionless and decentralised financial system that allows anyone with an internet connection to participate in financial services anonymously and with transparency. A large part of this involves the idea of utilising crypto to earn a good yield that greatly exceeds the returns given to us by banks in TradFi (traditional finance).
Note: Going forward, this borrowing and lending aspect of DeFi will be our focus
DeFi 1.0
DeFi 1.0 can be described as the first wave of disruption to traditional finance, with activities such as borrowing, lending, and trading becoming decentralised and more capitally efficient. This initial wave of DeFi serves as the base layer for more innovation to be built upon it, as technology advances and creativity on managing capital improves.
The Shortcomings of DeFi 1.0
DeFi 1.0 however comes with many risks, with the two biggest being smart contract risk and the risk of a bank run on liquidity pools. Although smart contract risk is borne with any protocol, the high TVL in DeFi (over $200 billion currently) makes it especially prone to hacks and attacks.
Additionally, DeFi protocols currently revolve around a model that temporarily incentivises liquidity providers through high yields, but this attracts ‘mercenary capital’ — i.e. a lot of the liquidity providers do not care about the protocol itself but simply look for the best reward. Thus, the risk of a bank run is borne through a snowball effect.
Big Data Protocol is one of many examples of this taking place, where after not even a week of release in March 2021 they had over $6B in TVL, even ahead of blue chip DeFi protocols Uniswap and Compound. However, shortly after there was a very steep collapse, with TVL decreasing over 99%, to only a couple million.
DeFi 2.0
The emergence of DeFi 2.0 stemmed from the need to solve some of the problems surrounding the traditional DeFi model, especially the risk of attracting mercenary capital. These new DeFi protocols create sustainable liquidity through unique designs to their protocols which will be further explored below.
Furthermore, the overall culture of DeFi 2.0 is more collaborative and takes advantage of a dynamic governance structure. Through DAOs, DeFi 2.0 protocols largely democratise their decisions and processes — e.g. you can vote for any type of asset that you wish to use as collateral. The frameworks of DeFi 1.0 are more rigid and does not have as much freedom.
The Potential Shortcomings of DeFi 2.0
With the collaborative nature of DeFi 2.0 protocols adding on top of existing mechanisms through DAOs, they are not only vulnerable to oligarchy, but they suffer from an amplification of smart contract risk. The protocol will require sound tokenomics to reduce the risk of whales wielding the majority of the voting power. Furthermore, although the risk of attracting mercenary capital is mitigated, competitive risk still exists in the space which will result in less liquidity, but the process will be more stable compared to a DeFi 1.0 protocol.
The biggest DeFi 2.0 projects now:
- OlympusDAO
OlympusDAO is a protocol that owns their liquidity through a process called bonding, which in turn minimises mercenary capital. Although their native token $OHM is used as more of an asset now, the long-term goal is to become a reserve currency that is used as an alternative to fiat.
- Tokemak
Tokemak’s unique design involves a decentralised market making system which democratises liquidity provision and thereby incentivises sustainable liquidity. With the core activity being directors of liquidity, the goal is to become the “primary vessel through which liquidity can flow freely and efficiently across networks.”
- Wonderland
Wonderland is a fork of OlympusDAO on the Avalanche Blockchain with very similar mechanics. However the long-term goal of Wonderland is different to that of OlympusDAO in that it seeks to become a VC DAO and be the base currency for games.
Final word
Similar to how the first wave of DeFi seeks to solve the issues of traditional finance, DeFi 2.0 was an answer to many of the bottlenecks that DeFi 1.0 suffered from — the two main ones being unsustainable liquidity provision and capital inefficiency. Thus, DeFi 2.0 was a necessary evolution to ensure further innovation in the DeFi space. In no way are these 2.0 protocols perfect, but they provide the framework for further creativity and innovation as the crypto industry evolves.
