Blockchain technology has transformed the financial sector, and one of the key developments based on its protocol is decentralized finance (DeFi).
Decentralized Finance (DeFi) is a type of blockchain-based finance that does not rely on central financial intermediaries to provide services. Instead, it uses blockchain-based smart contracts to conduct transactions. A smart contract is a piece of automated code that runs on the blockchain and cannot be changed or removed. As a result, smart contract transactions are handled by the blockchain without the intervention of a third party or any central authority.
DeFi had its drawback with the issue of security, scalability, impermanent loss, and liquidity. However, liquidity poses the biggest challenge to the DeFi protocols because it requires third-party providers (liquidity providers) to ensure transactions. Liquidity providers gain tokens as rewards for lending out assets through liquidity mining protocols. This guarantees the protocol's stability and provides a quick and effective way to add liquidity. However, the model is no longer sustainable because the procedure is predicated on rewards. This limitation led to the rise of DeFi 2.0, the second wave of decentralized projects to address DeFi's shortcomings.
What is DeFi 2.0?
DeFi 2.0 is a ground-breaking innovation created to improve and address the issues with the original DeFi protocol. DeFi 2.0 is a generation of initiatives designed to overcome the shortcomings of the first generation of decentralized finance (DeFi 1.0), including scalability, security, liquidity, user interface, and information accessibility. DeFi 2.0 leverages the established user base protocol and the adoption of the first generation DeFi to create the next wave of DeFi applications. In essence, DeFi 2.0 protocols are decentralized apps that work to link users who provide liquidity. These programs encourage horizontal interactions that lead to enduring bonds.
In addition, DeFi 2.0 provides insurance to protect liquidity providers, who use their crypto assets to fund a liquidity pool from potential losses caused by the cryptocurrency market's volatility. By requiring security audits of the contracts from open-source communities or insurance companies, DeFi 2.0 ensures that smart contracts are free of significant defects.
To comprehend the shift and the issue that DeFi 2.0 seeks to address, it is necessary to first investigate the key issues of DeFi 1.0.
Challenges of DeFi 1.0
Scalability is one of the crucial challenges faced by DeFi 1.0 projects. For example, DeFi protocols on blockchains with heavy traffic and gas prices are frequently slow. As a result, transactions take a long time to be confirmed. Similarly, increased network congestion brought on by high traffic and sluggish services raises transaction prices. Similarly, heavy traffic and slow services cause additional network congestion, increasing transaction fees. Finally, due to the exorbitant transaction fees, average traders could not participate.
Despite periodic audits of the smart contract programs, cyber hacking remains a problem in the ecosystem, with millions of dollars siphoned off through porous smart contracts. Given the highly technical nature of these systems, most DeFi users still don't grasp how to manage risk securely or objectively assess a network's security. Exploits can still exist if suitable mechanisms for accounting for updates are not in place.
Liquidity is one of the major challenges that plagued DeFi 1.0. Unfortunately, providing liquidity also locks up funds and their total value, resulting in capital inefficiency because locked-up tokens cannot be accessible outside the protocol.
Unfriendly User interface/experience
The DeFi platform's usability is a big barrier because it is challenging to use. As a result of their complex user interfaces and unpleasant user experiences, decentralized products are challenging to utilize. This is why experienced crypto enthusiasts make up most of DeFi's active users.
Advantages of DeFi 2.0
Liquidity pools let liquidity providers gain incentives for staking pairs of tokens. However, DeFi 1.0's liquidity concerns can be mitigated by cross-chain bridges, which connect blockchains via layers of smart contracts and liquidity pools, granting users access to assets that are not native to the blockchain protocol on which they are created. If an asset does not have adequate liquidity on one chain, it can trade across good pools across chains. In addition, DeFi 2.0 includes a mechanism for insurance against this risk for a modest fee.
Loans can now pay for themselves thanks to the unique strategic approach made possible by the DeFi 2.0 ecosystem. For example, a lender may grant a loan to a borrower in return for a minor collateral deposit. Then, the lender invests this money after the interest is received.
Consider a situation where a lender is prepared to offer $2000 in bitcoin in exchange for a $1000 deposit as security. The lender starts earning interest after receiving the deposit and putting it to use. The lender gives the borrower their $1,000 deposit back once the interest has accrued up to $2,000 plus a fee. There is no possibility of liquidation with this. And if the submitted collateral loses value, the repayment period will be extended.
Impermanent Loss Insurance
When the ratio of two assets kept in a liquidity pool becomes unequal because of the sudden price fluctuation in one of the assets, Liquidity providers may suffer impermanent loss. As a result, the threat of temporary loss has been the nightmare of liquidity providers. DeFi 2.0 protocols are developing new strategies to lessen the risk. The protocol uses its fees to gradually create an insurance fund that will protect your deposit from the effects of impermanent loss. In addition, the protocol can issue new tokens to offset losses if there are not enough fees to cover them.
Smart Contract Insurance
The risk of losing crypto assets due to a compromised smart contract is a key concern with DeFi 1.0. Investors understand that a breached contract is impossible to repair on the blockchain, thereby exposing their investment and resulting in a loss of funds. However, DeFi 2.0's insurance policy would improve smart contract due diligence and project evaluation to protect investors' assets.
How to Invest in DeFi 2.0
DeFi 2.0 makes it easier to use your funds to do more things.
DeFi 2.0 is an improvement to the existing DeFi use case that will expand the technology's adoption by more users and organizations. The second generation of DeFi will offer consumers fascinating new ways to progress on their journey to financial freedom. However, as with any investment, you must have a risk tolerance and conduct proper research before committing your assets.
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