Even for HODLers and experienced crypto users, DeFi can be daunting and challenging to understand. However, it aims to lower barriers to entry and create new earning opportunities for crypto holders. Users who might not get a loan with a traditional bank might do with DeFi.
DeFi 2.0 matters because it can democratize finance without compromising on risk. DeFi 2.0 also attempts to solve the problems noted in the previous section, improving the user's experience. If we can do this and provide better incentives, then everyone can win.
We don't have to wait for DeFi 2.0 use cases. There are already projects providing new DeFi services across many networks, including Ethereum, Binance Smart Chain, Solana, and other smart contract capable blockchains. Here we’ll look at some of the most common:
If you've ever staked a token pair in a liquidity pool, you will have received LP tokens in return. With DeFi 1.0, you can stake the LP tokens with a yield farm to compound your profits. Before DeFi 2.0, this was as far as the chain goes for extracting value. Millions of dollars are locked in vaults providing liquidity, but there is potential to further improve capital efficiency.
DeFi 2.0 takes this a step further and uses these yield farm LP tokens as collateral. This could be for a crypto loan from a lending protocol or to mint tokens in a process similar to MakerDAO (DAI). The exact mechanism changes by project, but the idea is that your LP tokens should have their value unlocked for new opportunities while still generating APY.
Doing enhanced due diligence on smart contracts is difficult unless you're an experienced developer. Without this knowledge, you can only partially evaluate a project. This creates a large amount of risk when investing in DeFi projects. With DeFi 2.0, it's possible to get DeFi insurance on specific smart contracts.
Imagine you're using a yield optimizer and have staked LP tokens in its smart contract. If the smart contract is compromised, you could lose all your deposits. An insurance project can offer you a guarantee on your deposit with the yield farm for a fee. Note that this will only be for a specific smart contract. Typically you won't get a payout if the liquidity pool contract is compromised. However, if the yield farm contract is compromised but covered by the insurance, you will likely get a payout.
If you invest in a liquidity pool and start liquidity mining, any change in the price ratio of the two tokens you locked may lead to financial losses. This process is known as impermanent loss, but new DeFi 2.0 protocols are exploring new methods to mitigate this risk.
For example, imagine adding one token to a single-sided LP where you don’t need to add a pair. The protocol then adds their native token as the other side of the pair. You will then receive fees paid from swaps in the respective pair, and so will the protocol.
Over time, the protocol uses their fees to build up an insurance fund to secure your deposit against the effects of impermanent loss. If there are not enough fees to pay off the losses, the protocol can mint new tokens to cover them. If there is an excess of tokens, they can be stored for later or burned to reduce supply.
Typically, taking out a loan involves liquidation risk and interest payments. But with DeFi 2.0, this doesn't need to be the case. For example, imagine you take a loan worth $100 from a crypto lender. The lender gives you $100 of crypto but requires $50 as collateral. Once you provide your deposit, the lender uses this to earn interest to pay off your loan. After the lender has earned $100 with your crypto plus extra as a premium, your deposit is returned. There’s no risk of liquidation here either. If the collateral token depreciates in value, it just takes longer for the loan to be paid off.