DeFi 2.0 Primer: Decentralized Finance is Poised to Expand its Reach But Challenges Loom

Despite offering a wide range of financial tools for anyone to use, DeFi is relatively nascent and has a myriad of flaws. Issues like impermanent loss and problems with liquidity mining mean users have to take on unnecessary risks.

Enter DeFi 2.0.

What Is It:

DeFi 2.0 is a movement focused on improving the shortcomings of its forebears. The key differences between DeFi 1.0 and DeFi 2.0 centers on liquidity, scalability, security, and centralization.

Why Does It Matter:

One common aspect of any successful business (or service) is that it offers a path of least resistance for end-users.

Amazon saves customers time by automating product delivery. Uber and Airbnb simplify and reduce the cost and effort of transportation and accommodation.

The purpose of DeFi is similar in its intent to lower the barrier of entry to competitive financial solutions. People who ordinarily struggle with accessing loans can find non-prejudicial alternatives with MakerDAO or Compound.

However, the current ways to benefit from core DeFi activities like lending, staking, and yield farming are still fairly convoluted. By simplifying the user experience, offering scalable, consistent incentives, and following industry regulations, DeFi 2.0 can help make finance more safe and accessible for everyone.

The Shortcomings of DeFi 1.0:

To better understand the value of DeFi 2.0, we can explore some of the problems it’s trying to solve.

Liquidity: Providing liquidity to a pool requires locking up funds and total value. Because liquidity is spread across disparate blockchains and markets, this can lead to inefficient use of capital.

Liquidity Mining: Many DeFi protocols suffer from a lack of practical incentives for liquidity providers outside of distributing LP tokens. At the time of writing, a common issue with liquidity providers is that they routinely withdraw both their allocated resources and rewards once eligible or when a more competitive protocol with a higher APY comes around. This periodic or capitulated sale of a protocol’s native tokens on the market often dilutes the supply.

Scalability: DeFi platforms that undergo periods of high network activity can suffer from data congestion. These bottlenecks slow transaction speeds and make network fees, like gas (in the case of ETH), more costly.

Security: Even though smart contracts are regularly audited, routine software updates can make audit reports redundant, even if they’re authored by reputable security companies like Certik. Given the technical nature of these systems, many DeFi users still don’t understand how to safely manage risk or validate the security of a network as they stake (lock up) large volumes of capital.

Centralization: Many DeFi protocols sacrifice some decentralization to achieve better scalability and security, as highlighted by the blockchain trilemma.

Oracles: Financial services relying on off-chain information need better third-party data sources (oracles) than what is currently available in Web3.

DeFi 2.0 Projects

The total value locked (TVL) in DeFi grew from $667 million in December 2019 to over $100 billion in December 2021.

This rapid growth was driven by platforms like UniSwap (2018), MakerDAO, and Compound. Other notable projects that emerged during this period include:

• Curve
• Aave
• SushiSwap
• Yearn Finance

Despite the various technological improvements these projects made to the sector, incentives around activities like liquidity mining still weren’t sustainable. In response to these industry challenges, Olympus DAO emerged as one of the first DeFi 2.0 solutions, offering a unique bonding mechanism as an alternative approach.

What is OlympusDAO

Launched in May 2021, Olympus is a decentralized reserve currency protocol using the OHM token, backed by a basket of assets in the Olympus Treasury.

The project’s goal is to create a policy-controlled currency system using OlympusDAO to manage the performance of the OHM token.

The Olympus Treasury holds various assets, including DAI, FRAX, LUSD, ETH, and LP tokens like OHM/DAI from SushiSwap.

OlympusDAO Bondings – An Example of DeFi 2.0

A key feature of Olympus is its unique approach to bonding. Unlike traditional finance, where bonds are used to manage loans, Olympus uses bonding to manage the performance of the OHM token.

In traditional markets, a bond is a type of loan. When a corporation or entity needs more capital, it may issue a bond to finance a loan for a fixed period.

During the bond period, the company or bond issuer pays the investor a fixed amount of interest, called the coupon, on selected dates (often quarterly). There are various types of bonds, including government, corporate, municipal, and mortgage bonds.

Bonds carry inherent risks for investors, such as credit risk and interest rate risk. If the issuer fails to repay their debt, the bond can default. Consequently, the higher the risk surrounding the bond issuer, the higher the required interest rate.

Bonding with Olympus differs by mirroring the structure of a discounted token sale. Instead of receiving interest, investors sell assets to the Olympus treasury to receive OHM at a discount. This process typically involves a vesting period of about five days. Investors won’t see returns on their discounted OHM unless they stake it or benefit from price appreciation in the market.

As bond sales generate profit for the treasury, Olympus can accumulate more of its liquidity in the OHM SushiSwap pools, known as “Protocol-owned-Liquidity.” Users in the Olympus ecosystem can choose from a range of bond types based on ROI percentage, including DAI bond, wETH bond, FRAX bond, OHM-FRAX LP bond, and OHM-DAI LP bond.

According to data from the Olympus website and analytics firm Messari, the protocol owns and manages over 99% of the liquidity of the OHM-DAI bond. This internally controlled and managed structure mitigates OHM’s capital inefficiency and instability.

How Does Olympus DAO Help Its Users?

While there’s an ongoing debate about the need for a reserve currency in crypto markets, users can still benefit and earn revenue through Olympus DAO by staking their OHM tokens.

Similar to staking mechanisms in other DeFi protocols, users are rewarded based on the amount of OHM tokens they stake. Olympus offers a high annual percentage yield (APY) to encourage users to buy more OHM or participate in bonding. These actions help maintain a high OHM price and reduce the need for the protocol to redeem liquidity from the pool.

When staking, users receive sOHM, which can be sold or used on other DeFi platforms. To convert sOHM back to OHM, users need to burn their sOHM tokens.

Risks of OlympusDAO

Olympus claims that its Protocol-owned Liquidity and Bonds-as-a-Service protocol services will help mitigate the problems with liquidity mining today. However, this doesn’t come without risks. As the protocol owns more of its token liquidity, it gains more centralized control and can manipulate the price of OHM.

OlympusDAO Price Declines & Losses

Since OlympusDAO is still in its infancy, market volatility can quickly impact investor sentiment and support, especially regarding the price and stability of OHM. This was evident in January 2022, when the crypto markets declined following the Federal Reserve’s announcement of interest rate hikes. As a result, the Olympus protocol fell over 50%.

The price decline of OHM affected similar projects. For example, Wonderland (TIME) dropped over 30%, and the Olympus-DAO-backed fork Redacted Cartel has struggled since its launch in mid-December.

Despite the appeal and sophistication of a protocol like OlympusDAO, extreme price volatility is expected during any growth phase for crypto-assets.

DeFi 2.0 Advantages and Benefits:

More flexibility for staked assets:

In many DeFi protocols, users receive an LP token when they stake a token pair in a liquidity pool. DeFi 1.0 allowed users to compound their returns by staking these LP tokens in a yield farm. However, options were limited beyond these core functions, resulting in millions of dollars locked in various vaults to provide liquidity for protocols.

DeFi 2.0 adds further layers of utility and incentives by using yield farm LP tokens as collateral for loans or to mint additional tokens like MakerDAO’s DAI. While the process varies by platform, in DeFi 2.0, LP tokens can unlock new opportunities while still generating APY.

Insurance-covered smart contracts:While DeFi protocols are mostly open-source, conducting due diligence and risk analysis can be challenging for those with limited technical expertise. DeFi 2.0 addresses this issue by offering users insurance on smart contracts. Previously, staking LP tokens in a yield farm came with the risk of losing all funds if the smart contract became compromised.

With DeFi 2.0, you can get insurance for your deposits in yield farms for a fee, reducing risk and providing peace of mind. This added layer of security encourages more participation and trust in the DeFi ecosystem. However, these insurance plans aren’t perfect and depend on the specific smart contract. For instance, if the liquidity pool contract is compromised but the yield farm contract is safe, the insurance won’t cover your loss.

Insurance for impermanent loss: Usually, when users invest in liquidity pools and engage in liquidity mining, any change in the price ratio of the two locked tokens can lead to financial loss. DeFi 2.0 is actively working on ways to reduce these risks.

With DeFi 2.0, users collaborate with the protocol to create token pairs. A user can add one token to a single-sided LP, while the protocol adds its native token as the other half of the pair. Both the protocol and the user earn fees from swaps made with that pair.

Over time, the protocol uses the fees generated to build an insurance fund to protect against potential impermanent loss. If the loss exceeds the fees in the insurance fund, the protocol can mint new tokens to cover the difference. It can also burn excess tokens to reduce supply or save them for later use.

Self-repaying loans: Typically, users who take out loans face liquidation risks and high interest rates. DeFi 2.0 addresses these issues with self-repaying loans. In a self-repaying loan, the interest earned on the deposited collateral is used to repay the loan over time. Once the lender has earned the total amount of the loan plus a premium, the collateral returns to the borrower. There’s no risk of liquidation with self-repaying loans. If the collateral token loses value, there will be additional time to repay the loan.

DeFi 2.0 risks

DeFi 2.0 still shares many risks of DeFi 1.0. Some of the more common of these are:

Compromised smart contracts: An audit will never guarantee the safety of a smart contract. That’s why it’s important for users to do their own thorough research and due diligence on a protocol before investing.

Fluctuating regulations: As governments and regulators show more interest in DeFi, projects and platforms may need to adjust their rules and services to meet new mandates and industry standards. While this can provide more stability and security, it also changes the degree of decentralization involved.

Impermanent Loss: Even though DeFi 2.0 offers improved safety nets like insurance structures, the market’s volatility still poses a significant risk for anyone participating in liquidity mining.

Clunky user experience: If a DeFi project’s website goes down, users won’t be able to withdraw their staked assets unless they have the technical skills to deal directly with the smart contract. To avoid this issue, users should find and save the smart contract address on a blockchain explorer for future reference.

Conclusion

With the rapid advancement of DeFi 2.0, users can access these solutions and find immediate use cases. Projects like Ethereum, Binance Smart Chain, Solana, and other emerging blockchains are beginning to offer these services across their networks.

Mason Marcobello is a writer, entrepreneur, and aspiring creative technologist.