• DeFi 1.0 has a number of issues that DeFi 2.0 attempts to solve
  • Scalability, lack of insurance and impermanent loss are primary concerns
  • Self-repaying loans, impermanent loss insurance, and more yield from staking beneifts of DeFi 2.0

When Bitcoin (BTC), the world's first and largest cryptocurrency by market cap, was invented in 2009, it was considered a joke. However, by 2020, we witnessed the growth of Decentralized Finance or popularly known as the DeFi industry: an industry that improves the technology on which Bitcoin is based.

Decentralized Finance is a blockchain-based financial industry that combines technical and financial aspects to enable payments and investments. The industry has several promising projects lined up. Some common DeFi platforms include Ethereum, DyDx and Cardano.

While growing, the adoption of DeFi has been limited mainly due to issues such as lack of insurance and loans. DeFi 2.0 is the improved version of DeFi that solves all the problems that existed with version 1.0 and aims at higher adoption.

Problems with DeFi 1.0

DeFi 1.0 had several issues that slowed down its adoption. Some of them are listed below.

  • DeFi 1.0 lacks decentralization as the concept of DAOs, or decentralized autonomous organizations, is missing. The current version of DeFi is leaning toward centralization.
  • Most DeFi 1.0 protocols suffer from high gas fees and congestion, which need to be eliminated. A simple task can take hours to complete.
  • When updates are implemented on a platform, previous security audits become menigless, making it more vulnerable.
  • In almost all protocols, tokens staked cannot be used elsewhere, reducing flexibility and leading to lack of capital. Furthermore, the liquidity pools are spread across different platforms, splitting liquidity.

What is DeFi 2.0?

DeFi 2.0 includes a lot of blockchain-based platforms that try to bridge the gaps existing in the DeFi system. The first wave of DeFi platforms like ZCash, Litecoin and Ethereum tried to improve on issues faced by Bitcoin.

These networks were very successful; currently Ethereum is the biggest name in the DeFi sector. However, there are drawbacks to these platforms as well. For example, Ethereum suffers from high gas fees and congestion.

DeFi 2.0 platforms will still need to adhere to regulations that the government and other regulatory authorities will implement sooner or later. However, they are more decentralized in nature and ensure that the initial principles of the Bitcoin creator are incoporated.

"DeFi 2.0 matters because it can democratize finance without compromising on risk," said a Binance blog.

There are several projects on major blockchain networks like Ethereum, Solana and other platforms compatible with smart contracts, which are the basis of DeFi 2.0.

More earning from staked funds

A major issue with staking is that millions of dollars are locked in the vaults providing liquidity. While staking a token pair, you get a liquidity token in return, which are called LP tokens or Liquidity Protocol tokens.

These tokens can further be staked to generate APY, but in DeFi 1.0, these are locked for liquidity provisions. DeFi 2.0 protocols use these LP tokens, which are staked as collateral to avail a loan from crypto lenders or even to mint tokens, as in the case of MakerDAO (MKR).

Taking the example of MakerDAO (MKR), which is based on Ethereum (ETH) from DeFi 1.0, the protocol takes the LP tokens to mint a stablecoin, DAI.

"The price of DAI is soft-pegged to the U.S. dollar and is collateralized by a mix of other cryptocurrencies that are deposited into smart-contract vaults every time new DAI is minted," says the description by CoinMarketCap.

Insurance of smart contracts

There is a risk associated with investiing in a smart contract-based project — of not having certainity on the security aspect. Unless one is an experienced developer, it difficult to figure out if a platform is worth investing in. However, the DeFi 2.0 has come up with the concept of insurance for the funds.

If the smart contract one invested in is compromised, one can get it refunded by your insurance for a fee. The fee varies.

Impermanent loss insurance

If one invested in a liquidity pool and, due to price fluctuations, lost a portion of the investment, that the loss is called an impermanent loss and is common in the volatile crypto space.

DeFi 2.0 has a solution for this. Taking an example of Mr. X, who understands the risks associated with the crypto space, invests in a single-sided Liquidity Protocol where he doesn't need to add another pair. In such a scenario, the protocol will add their governance token to the other side of the pair. For each swap made in the respective pair, the investor and the protocol both will receive fees.

This fee is used by the protocol to build up an insurance fund that can cover up impermanent funds. If the fund is not enough to cover losses, the protocol will mint new tokens and burn or store the excess.

Self-repaying loans

Another major feature of DeFi 2.0 is self-repaying loans. To understand this, let's bring Mr. X and his business partner, Mr. Y, into the picture.

Mr. X is in need of money and asks Mr. Y for $10. Mr. Y agrees, but wants $5 as collateral. Once Mr. X deposits this, Mr. Y lends the $10.

In DeFi 2.0, this entire process is controlled by smart contracts and is automatic.

The next step in the process is Mr. Y using the crypto deposit of Mr. X to earn yields from the same. If the token depreciates, the process of yielding will continue until the $10 plus premium has been recovered. Once complete, Mr. X will get his deposit back.