DeFi 2.0 Primer: Decentralized Finance is Poised to Expand its Reach But Challenges Loom
In this DeFi 2.0 primer, Mason Marcabello explores the next iteration of the DeFi story.
By: Mason MarcobelloDeFi 101
Compared to the walled gardens of traditional finance the benefits of DeFi offer a more ubiquitous range of financial tools for consumers. But with that said, the very nascency of its ecosystem has led to a plethora of flaws, like impermanent loss and shortcomings with liquidity mining that require many users to compromise on risk.
This is where DeFi 2.0 comes in.
What Is It:
In essence, and as with any iteration of technology (not just blockchain), DeFi 2.0 is a movement focused on improving on the shortcomings of its forebears. While a more detailed insight will be covered in the following DeFi 101 article, key differences between DeFi 1.0 and DeFi 2.0 have centered on liquidity, scalability, security, and centralization.
Why Does It Matter:
At the risk of generalising, one shared aspect of any successful business or service (regardless of industry) is that it helps create (or reinforce) a path of least resistance for end-users.
For example, Amazon helps its customers save time by automating the delivery of its products. Uber and Airbnb help streamline and save time on the cost and effort of transportation, accommodation, etc.
One could argue from both a macro and micro perspective that the purpose of DeFi is similar in its intent to lower the barrier of entry to competitive financial solutions. For example, people who would ordinarily struggle with accessing loans can find non-prejudicial alternatives with MakerDAO or Compound.
However, the current methods needed to benefit from core DeFi-centric activities like lending, staking, or yield farming are still relatively daunting for the average user. But through simplifying the user experience, providing stronger incentives, aligning with updated regulations, and mitigating against the levels of uncertainty in web3 markets, DeFi 2.0 can help move its rich tapestry of platforms and resources further along the more expansive journey to democratise finance safely and securely.
The Shortcomings of DeFi 1.0:
To better understand the relevance of DeFi 2.0, we can explore some of the more common problems it’s trying to solve.
Liquidity: Providing liquidity to a pool requires a lock-up of funds and their total value. While separated across disparate blockchains and markets, this financial rigidity often results in capital inefficiency.
Liquidity Mining: Many DeFi protocols suffer from a lack of long-term, practical incentives for liquidity providers outside of distributing LP tokens. As it stands, one common problem 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 and capitulated sale of a protocol’s native tokens on the market often causes a diluted supply.
Scalability: DeFi platforms that experience high periods of network activity can often suffer from data congestion. These bottlenecks slow the speed of transactions and make network fees, like gas (in the case of Ethereum), increasingly expensive.
Security: While there are periodic audits of smart contracts, routine upgrades and changes to software can often lead to outdated and redundant information even from credible DeFi security companies like certik. Given the highly technical nature of these systems, most DeFi users still don’t understand how to safely manage risk or objectively validate the security of a network as they stake (lock-up) large volumes of funds.
Centralization: Consistent with the issues outlined by the blockchain trilemma, many DeFi platforms sacrifice decentralization to allow for higher levels of scalability and security.
Oracles: Financial services that depend on external or off-chain information need a higher quality of third-party data sources (oracles) than what is currently available in web3.
DeFi 2.0 Projects:
The total value locked (TVL) in DeFi has dramatically increased to more than $100 billion in December 2021 from $667 million in December 2019.
While the overall movement was largely accelerated due to the rise of services like UniSwap (2018), MakerDAO and Compound, several of the more significant projects that emerged throughout this period also include:
Although each of these respective platforms helped contribute a diverse range of technological improvements, incentives surrounding activities like liquidity mining still weren’t proving sustainable. In response to the continued industry shortcomings, Olympus DAO was one of the first DeFi 2.0 solutions to offer a different route through its unique bonding mechanism.
What is OlympusDAO:
Launched in May 2021, Olympus is a decentralized reserve currency protocol based on the OHM token, backed by a basket of assets in the Olympus Treasury. The project’s goal is to build a policy-controlled currency system that uses its associated OlympusDAO to help manage the performance of the OHM token. The Olympus Treasury holds a range of assets, including DAI, FRAX, LUSD, ETH, and LP tokens like OHM/DAI from SushiSwap.
OlympusDAO Bondings – An Example of DeFi 2.0
As mentioned, a central and competitive focal point for Olympus is its unique take on bondings. While also used as a method to manage the performance of the OHM token, the bonding structure of Olympus does not follow the same methods as traditional finance.
In traditional markets, a bond is a type of loan. When a corporation or entity requires more capital, they may issue a bond to finance a loan for a fixed period. During that time, the company or bond issuer pays the investor a set amount of interest, called the coupon, and on selected dates (often quarterly).
There is a range of bond types, including government, corporate, municipal, and mortgage bonds. As bonds are debts, there is still an inherent level of risk for the investors – typically credit risk and interest rate risk. If the issuer fails to pay back their debt, the bond can default. Therefore the more risk surrounding the bond issuer (borrower), the higher the interest rate required.
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.
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 also involves a typical vesting period of approximately five days. Investors also won’t receive any returns through their discounted OHM unless staked or through greater price appreciation on the market.
As bond sales generate profit for the treasury, over time, Olympus can accumulate more of its liquidity in the OHM SushiSwap pools – coined as “Protocol-owned-Liquidity”. Users in the Olympus ecosystem can select from a strategic range of bond types based on ROI percentage. These include DAI bond, wETH bond, FRAX bond, OHM-FRAX LP bond, and OHM-DAI LP bond.
According to statistics on the Olympus website and data analytics firm Messari, the protocol owns and manages more than 99% of the liquidity of the OHM-DAI bond. As this structure is controlled and managed internally at a high level through the DAO, they mitigate against capital inefficiency and instability of OHM.
How does Olympus DAO benefit its users?
While there is continued speculation around whether crypto markets would need a reserve currency, end users can still benefit and earn revenue through Olympus DAO by staking their OHM tokens.
Consistent with the staking mechanisms that underpin alternative DeFi protocols, users are rewarded based on the amount of OHM tokens they stake. By promising a high rate of return (APY), Olympus encourages its supporters and investors to buy more OHM from the market or act on more bondings from the protocol. A confluence of these factors help keep the price of OHM high and mitigate against the protocol needing to redeem any liquidity from the pool. When staking, users receive sOHM, which can then be sold or leveraged on other DeFi protocols. To swap or receive OHM from sOHM, users need to burn their sOHM tokens.
Risks of OlympusDAO:
Olympus claims that their Protocol Owned Liquidity and Bonds-as-a-Service protocol services will help mitigate (or even solve) the problems with liquidity mining today. However, this doesn’t come without risk. For example, as the protocol continues to own more of its token liquidity, they gain more centralized control and can manipulate the price of OHM accordingly.
OlympusDAO Price Declines & Losses
As the OlympusDAO protocol is still very much in its infancy, broader market volatility can quickly impact investor sentiments and support, especially in regards to the price and stability of OHM. This has been evident by the recent decline of the crypto markets throughout January 2022 following an announcement from the Federal Reserve that it would increase interest rates. As such, the market sell-off has caused the Olympus protocol to fall over 50% since January 10th.
That said, the recent price decline of OHM has also been shared across projects that use similar tokenomics. For example, Wonderland (TIME) has dropped over 30% throughout recent weeks. And on Ethereum, the Olympus-DAO-backed fork Redacted Cartel is also suffering since its launch in mid-December.
All in all, despite how attractive or sophisticated a protocol and service like OlympusDAO may sound, it’s imperative to understand that during any growth phase, extreme price volatility is standard.
DeFi 2.0 Advantages and Benefits:
Offering a wider level of flexibility for staked assets: A standard feature for many DeFi protocols is that when users stake a token pair in a liquidity pool, they will receive an LP token in return. The DeFi 1.0 ecosystem allowed users to further compound their returns by staking LP tokens in a yield farm. However, there wasn’t much else outside of these core value propositions, which resulted in millions of dollars locked in various vaults to help provide liquidity for their protocols.
DeFi 2.0 helps add further layers of utility and incentives by using yield farm LP tokens as collateral for a loan, or to mint additional tokens like MakerDao (DAI). While the process varies according to the platform, in DeFi 2.0, LP tokens can have their value unlocked for new opportunities while still generating APY.
Insurance covered smart contracts: While DeFi operates on transparent and open-source infrastructures, conducting due diligence and risk analysis of protocols can be difficult for people with limited technical experience. DeFi 2.0 mitigates against the obfuscated nature of the market by offering insurance on smart contracts for users. In the past, someone staking their LP tokens in a yield farm would previously assume risk as they could lose all their funds if said smart contracts were compromised.
With DeFi 2.0, an insurance project can offer guarantees on a deposit with the yield farm for a fee. While an improvement on the risk exposure, the overall details of these insurance platforms aren’t perfect and depend heavily on the specific smart contract. For example, if the liquidity pool contract is compromised but not the yield farm contract, then the insurance firm won’t cover the loss.
With the rapid advancement of DeFi 2.0, users don’t need to wait for access to these solutions or to find practical use-cases.
Insurance for impermanent loss: Ordinarily, for users who invest in liquidity pools and engage with liquidity mining, any change in the price ratio of the two tokens locked may result in a financial loss. DeFi 2.0 is actively creating methods to mitigate these risks.
With DeFi 2.0, a user works with the protocol to create token pairs. In this situation, someone can add one token to a single-sided LP, with the protocol also adding their native token as the other side of the pair. Both the protocol and the user will then receive fees from swaps made in that respective pair.
Over time, the protocol then uses fees generated to build up an insurance fund to safeguard deposits against the potential of impermanent loss. If the loss out values the number of fees built up in the insurance fund, the protocol can mint new tokens to cover the balance. The protocol can also burn excess to reduce supply or store them for later use.
Self-repaying loans: Typically users that take out a loan are exposed to liquidation risks and high-interest rates on repayments. DeFi 2.0 helps overcome these pitfalls by offering self-repaying loans. In a self-repaying loan structure, a lender can use the interest earned on the deposited collateral to pay off the loan over time. After the lender has earned the total amount of the loan plus extra as premium, the deposited collateral is returned to the borrower. There’s also no risk of liquidation with self-repaying loans. If the collateral token depreciates, then the time it takes to pay the loan will be extended accordingly.
Outstanding risks of DeFi 2.0 and how to prevent them:
Although a step forward, DeFi 2.0 still shares many of the same risks as DeFi 1.0. Some of the more common risks are:
Compromised smart contracts: An audit never guarantees the security and safety of a smart contract. Therefore it’s important that users do as much layered due diligence and research of a protocol before investing in it.
Changing regulations: As governments and regulators have a growing interest in DeFi, projects and platforms may need to adjust rules and services to accommodate updated mandates and industry standards. While it can help offer greater stability and security, it also changes the level of support and compromises the amount of decentralisation involved.
Impermanent Loss: Even though DeFi 2.0 offers improved safety nets like the aforementioned insurance structures, there is still a significant risk for anyone who opts into liquidity mining due to market volatility.
Rigid user experience: If the website of a DeFi project goes down (for whatever reason), users will not be able to withdraw their staked assets unless they have the technical expertise to interact directly with the smart contract. To prevent this, it’s suggested that users also locate the smart contract on a blockchain explorer as well for their reference.
With the rapid advancement of DeFi 2.0, users don’t need to wait for access to these solutions or to find practical use-cases. Projects like Ethereum, Binance Smart Chain, Solana, and other competitive emerging blockchains are all starting to offer the services mentioned earlier across their networks. With that said, it’s recommended to do as much research as possible as investing in web3 always involves risk.
Mason Marcobello is a writer, entrepreneur, and aspiring creative technologist.