Decentralized finance (DeFi) is a disruptive technology that is changing the way we interact with the financial industry.
DeFi has opened up new possibilities such as instant lending, decentralized trading, and peer-to-peer lending. The industry that emerged in 2018 is growing rapidly and has now entered its next phase, called DeFi 2.0.
In this article we talk about the sector, the concept of DeFi 2.0, its main features and the new opportunities it presents.
What is DeFi?
Decentralized finance is an emerging financial sector powered by the public sector. blockchains as Ethereum, Solana and Tron. DeFi aims to create a new financial sector that is fair, free and open to anyone with access to the internet.
DeFi differentiates itself from the traditional financial sector because its users do not need to depend on or interact with intermediary financial institutions.
Users trade crypto assets, purchase derivatives, lend and borrow funds, and earn interest using decentralized applications (dApps). These functions on these applications are automated and powered by smart contracts.
The main features of the first DeFi 1.0 were:
- Stablecoins: Fiat-linked cryptocurrencies like USDT and DAI have provided cryptocurrency users with exposure to the dollar and stable prices.
- Cryptocurrency lending and borrowing: Decentralized applications like Aave and MakerDAO pioneered crypto lending markets.
- Decentralized exchanges (DEX): Smart contract technology has enabled users to trade on DEXs.
- Yield farming: The need for liquidity in DEXs and lending platforms has created liquidity pool markets for users to tender their cryptos and earn interest on them.
What is DeFi 2.0?
DeFi 2.0 is the evolution of the first decentralized financial sectors. It seeks to address the limitations and resolve issues of the initial phase of the DeFi movement.
The main features of DeFi 2.0 include:
- Improved scalability
- Interoperability between chains
- Yield-optimized agricultural opportunities
- Improved on-chain governance
- Competitive oracle market
- Better user experience
Opportunities in the DeFi 2.0 space
Reaching mass scale is the dream of the entire crypto industry. The limited scale of underlying blockchains like Ethereum has hindered the growth of the DeFi industry.
In 2022, Ethereum completed its long-awaited transition to a proof of participation (PoS) consensus mechanismwhich paved the way for Ethereum to facilitate faster and cheaper transactions using layer two (L2) accumulations. As the underlying infrastructure improves, DeFi applications built on top of it should become more scalable and efficient.
The EVM-compatible nature of L2 rollups is a big boost for the DeFi ecosystem. EVM The compatibility allows developers to easily duplicate their existing Ethereum-based applications to L2 rollups without having to rewrite code.
The growth of DeFi on L2 chains has huge potential. Major DeFi platforms like Uniswap and Aave have already expanded their presence to L2 chains like Optimism and Arbitirum. Other projects are expected to follow, while newer applications could even choose to launch directly on L2 channels.
Interoperability between chains
When the DeFi movement began in 2018, cryptocurrencies existed in isolated environments. Cryptocurrencies native to a particular blockchain cannot interact with other blockchains.
However, the emergence of cross-chain bridges has enabled the transfer of cryptos from one blockchain to another. This cross-chain movement of crypto has allowed the DeFi movement to flourish beyond larger chains like Ethereum.
Capital is now flowing into upcoming projects, enabling innovation in the DeFi sector. This is a key feature of DeFi 2.0.
Where is the opportunity? Cross-chain bridges are an emerging technology. Bridges are not perfect and have security vulnerabilities. Blockchain networks like Peas and Cosmos that have built-in interoperability features have nascent DeFi ecosystems that could see accelerated growth in the future.
EVM-enabled layer 1 blockchain like Avalanche and BNB Channel also have the chance to eat into Ethereum’s DeFi market share.
Higher levels of customization for developers and end users will be a key feature of the DeFi ecosystem.
Cosmos – which was featured in Techopedia’s Top 8 DeFi 2.0 Projects list – allows developers to create application chains. 2022 saw an emerging trend where DeFi applications chose to move away L1 blockchains and start their own native chains.
DEX crypto derivative dYdX made headlines when it announced it would move to Cosmos and exist on its custom blockchain. The main motivation for this move is to enable higher levels of customization and greater scalability.
In June 2023, DEX leader Uniswap announced its vision for a highly customizable Uniswap v4. The DEX will introduce smart contracts called “hooks” that will allow developers to create custom liquidity pools.
New features will include on-chain limit orders, custom on-chain oracles, dynamic fees based on volatility, and much more.
There are many ways to generate agricultural yield in DeFi 2.0. Liquid staking token (LST) yield farming rose to prominence after Ethereum completed its move to PoS consensus.
The emergence of crypto staking platforms like Lido and Rocketpool that issue staking tokens to users has given rise to a new yield farming strategy called leveraged staking.
Here is an example of leveraged staking. Max owns 100 ETH tokens and chooses to stake all his ETH for a return on Lido. Lido issues him 100 stETH tokens which he can use to recover his (staked) ETH.
Looking for more yield, Max deposits 100 stETH as collateral on crypto lending platform Aave to borrow new ETH tokens. He then stakes the borrowed ETH and receives new stETH in exchange. Max may choose to repeat the process depending on his risk appetite. This is called leveraged ETH staking.
Note that these strategies are risky and can lead to devastating losses.
Developing effective ways to implement on-chain governance is one of the biggest challenges in the crypto industry.
Blockchains like Polkadot and Cardano are pushing for upgrades to improve their on-chain governance system. Cardano aims for governance of all users with the introduction of a voting and treasury system. Meanwhile, Polkadot announced an open governance platform that will allow DOT holders to vote on budget allocation, software updates, and more.
Off-chain tools like Snapshot are also used by projects to simplify voting processes and facilitate gas-free voting.
The path to better blockchain governance is difficult. The world has seen several cases of on-chain governance failures. If the crypto industry succeeds, the impact will be remarkable.
Competitive Oracle Market
DeFi applications rely heavily on data oracles for off-chain information based on which smart contracts execute orders. The heavy reliance on oracles is one of the biggest vulnerabilities in DeFi.
Currently, the blockchain oracle industry is dominated by Chainlink. Most decentralized applications use Chainlink oracles for price feeds, automation, and random number generation.
Today, alternative Oracle services are emerging, which could result in a healthy and competitive Oracle blockchain market. In October 2022, Binance launched its Oracle service, which is expected to be used in 1,400 applications on the BNB chain.
Alternative first-party Oracle services like API3 promise accurate and reliable data straight from the source.
The user experience on DeFi applications has improved significantly since the early days. The improvements in crypto wallets have been and will remain the key to a better user experience.
Simple solutions like Wallet Connect, which allows users to connect to dApps without needing to install browser apps, have been helpful. More complex solutions, like the introduction of smart contract wallets, are expected to simplify user onboarding, cross-chain experience and gas fees Payments.
DeFi 2.0 is by no means the final form of blockchain finance. The growth of the DeFi sector is entirely dependent on innovation in the underlying public blockchain space. Ethereum is considered the home of DeFi, and Ethereum’s scalability roadmap signals a long and tricky road ahead.
WWe have not yet seen the full potential of DeFi. And oneAs things stand, current developments promise a fairer and more open financial system for all.