Decentralized finance (DeFi) is a disruptive technology that is changing the way we interact with the finance industry.
DeFi has opened up new possibilities like instant loans, decentralized trading, and peer-to-peer lending. The industry that emerged in 2018 is fast-growing and has now entered its next phase, called DeFi 2.0.
In this article, we talk about the industry, the concept of DeFi 2.0, its key features, and the new opportunities it presents.
What Is DeFi?
Decentralized finance is an emerging financial industry that is powered by public blockchains like Ethereum, Solana, and Tron. DeFi aims to create a new financial industry that is fair, free, and open to anyone with internet access.
DeFi differentiates itself from the traditional finance industry as its users do not have to depend on or interact with intermediary financial institutions.
Users trade crypto assets, buy derivatives, lend and borrow funds and earn interest using decentralized applications (dApps). These functions on these applications are automated and powered by smart contracts.
The main features of the early DeFi 1.0 were:
- Stablecoins: Fiat-pegged cryptos like USDT and DAI provided crypto users with dollar exposure and stable prices.
- Crypto lending and borrowing: Decentralized applications like Aave and MakerDAO pioneered crypto lending markets.
- Decentralized exchanges (DEX): Smart contract technology allowed users to trade on DEXs.
- Yield farming: The need for liquidity in DEXs and lending platforms created liquidity pool markets for users to contribute their cryptos and earn interest on them.
What Is DeFi 2.0?
DeFi 2.0 is the evolution of the early decentralized finance industry. It looks to address limitations and solve problems of the initial stage of the DeFi movement.
The key features of DeFi 2.0 include:
- Improved scalability
- Cross-chain interoperability
- Optimized yield farming opportunities
- Enhanced on-chain on governance
- Competitive oracle market
- Better user experience
Opportunities in the DeFi 2.0 Space
Achieving mass scale is the dream of the entire crypto industry. The limited scale of underlying blockchains like Ethereum has hindered the growth of the DeFi industry.
In 2022, Ethereum completed its long-awaited transition to a proof-of-stake (PoS) consensus mechanism, which paved the way for Ethereum to facilitate faster and cheaper transactions using layer two (L2) rollups. As the underlying infrastructure improves, the DeFi applications built on top of it are expected to become more scalable and efficient.
The EVM-compatible nature of L2 rollups is a big boost for the DeFi ecosystem. EVM compatibility allows developers to easily duplicate their existing Ethereum-based applications to L2 rollups without having to rewrite the code.
The growth of DeFi on L2 chains has enormous potential. Leading DeFi platforms like Uniswap and Aave have already extended their presence to L2 chains like Optimism and Arbitirum. Other projects are expected to follow, while newer applications may even choose to directly launch on L2 chains.
When the DeFi movement started in 2018, cryptocurrencies existed in isolated environments. Cryptos native to a particular blockchain could not interact with other blockchains.
However, the emergence of cross-chain bridges has enabled the transfer of cryptos from one blockchain to another. This cross-chain movement of crypto has allowed the DeFi movement to flourish beyond bigger chains like Ethereum.
Capital is now flowing into upcoming projects, thereby enabling innovation in the DeFi sector. This is a key characteristic of DeFi 2.0.
Where does the opportunity lie? Cross-chain bridges are an emerging technology. Bridges are not perfect and come with security vulnerabilities. Blockchain networks like Polkadot and Cosmos that have built-in interoperability features have fledging DeFi ecosystems that could see accelerated growth in the future.
EVM-compatible layer one blockchain like Avalanche and BNB Chain also have the chance to eat into Ethereum’s DeFi market share.
Higher levels of customizability for developers and end users will be a key feature in the DeFi ecosystem.
Cosmos – which was featured in Techopedia’s 8 best DeFi 2.0 projects list – allows developers to create application chains. 2022 saw an emerging trend where DeFi applications chose to move away from L1 blockchains and start their own native chains.
Crypto derivative DEX dYdX made headlines when it announced that it will move to Cosmos and will exist on its custom blockchain. The main motive behind this movement is to allow higher levels of customizability and greater scalability.
In June 2023, leading DEX Uniswap announced its vision for a highly-customizable Uniswap v4. The DEX will introduce smart contracts called “hooks” that will allow developers to create customized liquidity pools.
The new features will include on-chain limit orders, customized on-chain oracles, dynamic fees based on volatility, and more.
There are numerous ways to yield farm in DeFi 2.0. Liquid staking token (LST) yield farming gained prominence after Ethereum completed its move to PoS consensus.
The emergence of crypto staking platforms like Lido and Rocketpool that issue staking tokens to users has given birth to a new yield farming strategy called leveraged staking.
Here is an example of leveraged staking. Max owns 100 ETH tokens and chooses to stake all of his ETH for yield on Lido. Lido issues him 100 stETH tokens which he can use to redeem his locked (staked) ETH.
In search for more yield, Max deposits 100 stETH as collateral on the crypto lending platform Aave to borrow new ETH tokens. He then stakes the borrowed ETH and receives new stETH in return for it. Max can choose to repeat the process depending on his risk appetite. This is called leveraged ETH staking.
Note that these strategies are risky and can result in devastating losses.
Developing effective ways to implement on-chain governance is one of the biggest challenges in the crypto sector.
Blockchains like Polkadot and Cardano are pushing for upgrades to improve their on-chain governance system. Cardano aims to governance to all users with the introduction of a voting and treasury system. Meanwhile, Polkadot announced an open governance platform that will empower DOT holders to vote on budget allocation, software updates, and more.
Offchain tools like Snapshot are also being used by projects to simplify voting processes and to facilitate gas-less voting.
The road to better blockchain governance is a tricky one. The world has seen several instances of on-chain governance failures. If the crypto industry gets this right, the impact will be noteworthy.
Competitive Oracle Market
DeFi applications are highly dependent on data oracles for off-chain information based on which smart contracts execute commands. The heavy reliance on oracles is one of DeFi’s biggest vulnerabilities.
At the moment, the blockchain oracle sector is dominated by Chainlink. Most decentralized applications use Chainlink oracles for price feeds, automation, and random number generation.
Now, alternative oracle services are appearing, which could result in a healthy and competitive blockchain oracle market. In October 2022, Binance launched its oracle service, which is expected to be used across 1,400 applications on the BNB Chain.
Alternative first-party oracles services like API3 promise accuracy and trustworthy data directly from the source.
User experience on DeFi applications has significantly improved since the early days. The improvements in crypto wallets have been and will remain key to better user experience.
Simple solutions like Wallet Connect, which allows users to log in to dApps without the need to install browser applications, have helped. More complex solutions, like the introduction of smart contract wallets, are expected to simplify user onboarding, cross-chain experience, and gas fee payments.
DeFi 2.0 is by no means the final form of blockchain finance. The growth of the DeFi sector is completely dependent on innovation in the underlying public blockchain space. Ethereum is considered the hotbed of DeFi, and Ethereum’s scalability roadmap signals a long and tricky road ahead.
We are yet to see the full potential of DeFi. And as things stand, the current developments promise a fairer and open financial system for all.