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Decentralized finance (DeFi) is a disruptive technology that is transforming the way we interact with the financial industry.
DeFi has opened up new opportunities like instant lending, decentralized trading, and peer-to-peer lending. Born in 2018, the industry is growing rapidly and has now entered its next phase dubbed DeFi 2.0.
In this article we talk about the industry, the concept of DeFi 2.0, its main characteristics and the new opportunities it offers.
What is DeFi?
Decentralized finance is an emerging financial industry powered by public blockchains such as Ethereum, Solana, and Tron. DeFi aims to create a new financial industry that is fair, free and open to anyone with internet access.
DeFi differs from the traditional financial industry as its users do not rely on or need to interact with intermediary financial institutions.
Users trade cryptocurrencies, buy derivatives, borrow and lend money, and earn interest with decentralized applications (dApps). These functions in these applications are automated and controlled by smart contracts.
The key features of early DeFi 1.0 were:
- Stablecoins: Fiat-pegged cryptocurrencies like USDT and DAI offered crypto users dollar exposure and stable prices.
- Crypto Lending and Borrowing: Decentralized applications like Aave and MakerDAO pioneered the 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 cryptocurrencies and receive interest in return.
What is DeFi 2.0?
DeFi 2.0 is the evolution of the early decentralized finance industry. It tries to solve the limitations and problems of the initial phase of the DeFi movement.
Key features of DeFi 2.0 include:
- Improved scalability
- Cross-chain interoperability
- Optimized yield farming opportunities
- Improved on-chain governance
- Competitive Oracle Market
- Better user experience
We have the leaderboard for current DeFi 2.0 coins for you. This is constantly renewed.
Opportunities in the DeFi 2.0 space
The dream of the entire crypto industry is to achieve mass production. The limited size of underlying blockchains like Ethereum has hampered the growth of the DeFi industry.
In 2022, Ethereum completed its long-awaited transition to a Proof-of-Stake (PoS) consensus mechanism, paving the way for Ethereum to enable 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 compatibility of L2 rollups is a major win for the DeFi ecosystem. EVM compatibility allows developers to easily duplicate their existing Ethereum-based applications onto L2 rollups without having to rewrite the code.
The growth of DeFi on L2 chains has huge potential. Leading DeFi platforms like Uniswap and Aave have already expanded their presence to L2 chains like Optimism and Arbitirum. Expect more projects to follow, while newer applications may even choose to boot directly onto L2 chains.
When the DeFi movement started in 2018, cryptocurrencies existed in isolated environments. Cryptocurrencies based on a specific blockchain could not interact with other blockchains.
However, the advent of cross-chain bridges has enabled the transfer of cryptocurrencies from one blockchain to another. This cross-chain movement of cryptocurrencies has allowed the DeFi movement to thrive beyond larger chains like Ethereum.
Capital is now flowing into new projects, enabling innovation in the DeFi sector. This is a key feature of DeFi 2.0.
Where are the opportunities? Cross-chain bridges are an emerging technology. Bridges are not perfect and have security gaps. Blockchain networks like Polkadot and Cosmos, which have built-in interoperability features, have fledgling DeFi ecosystems that could see accelerated growth in the future.
EVM-compatible Layer 1 blockchains like Avalanche and BNB Chain also have a chance to challenge Ethereum for DeFi market share.
A higher level of adaptability for developers and end users will be a key feature of the DeFi ecosystem.
Cosmos allows developers to create application chains. In 2022, a trend emerged with DeFi applications moving away from L1 blockchains and launching their own native chains.
Crypto derivative DEX dYdX made headlines when it announced it would move to Cosmos and exist on its own blockchain. The main motive behind this movement is to enable greater levels of customization and greater scalability.
In June 2023, the leading DEX Uniswap announced their vision for a highly customizable Uniswap v4. The DEX will introduce smart contracts called “hooks” that will allow developers to create bespoke pools of liquidity.
The new features include on-chain limit orders, customized on-chain oracles, dynamic fees based on volatility, and much more.
There are numerous opportunities for yield farming in DeFi 2.0. Liquid staking token (LST) yield farming gained traction after Ethereum made its move to PoS consensus.
The emergence of crypto staking platforms like Lido and Rocketpool issuing staking tokens to users has spawned a new yield farming strategy called leveraged staking.
Here is an example of leveraged bets: Max owns 100 ETH tokens and decides to stake all his ETH on Lido for returns. Lido issues him 100 stETH tokens that he can use to redeem his locked (wagered) ETH.
In search of more returns, Max deposits 100 stETH as collateral on crypto lending platform Aave to borrow new ETH tokens. He then uses the borrowed ETH and receives new stETH in return. Depending on his risk tolerance, Max can repeat the process. This is called leveraged ETH betting.
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 for governance for all users with the introduction of a voting and financial system. Meanwhile, Polkadot announced an open governance platform that will allow DOT owners to vote on budget allocation, software updates, and more.
Off-chain tools like Snapshot are also used by projects to simplify voting processes and allow for gas-free voting.
The road to better blockchain governance is a difficult endeavour. The world has already seen several instances where on-chain governance has failed. If the crypto industry gets a grip on this, the impact will be significant.
Competitive Oracle Market
DeFi applications rely heavily on data oracles for off-chain information on which smart contracts execute commands. The heavy reliance on Oracle is one of DeFi’s biggest weaknesses.
At the moment, the Blockchain Oracle sector is dominated by Chainlink. Most decentralized applications use Chainlink Oracle for price feeds, automation and random number generation.
Alternative oracle services are now emerging, which could lead to a healthy and competitive blockchain oracle market. In October 2022, Binance launched its oracle service, which is expected to be used by 1,400 applications on the BNB chain.
Alternative first-party oracle services like API3 promise accuracy and trusted data straight from the source.
The usability of DeFi applications has improved significantly since the early days. The improvements in crypto wallets have been and will continue to be the key to a better user experience.
Simple solutions like Wallet Connect, which allows users to log into dApps without having to install browser applications, have helped. More complex solutions, such as the launch of smart contract wallets, are expected to simplify user onboarding, the cross-chain experience, and the payment of gas fees.
The bottom line
DeFi 2.0 is by no means the definitive form of blockchain finance. The growth of the DeFi sector depends entirely on innovation in the underlying public blockchain space. Ethereum is considered the hotbed of DeFi, and Ethereum’s scalability roadmap signals that there is still a long and difficult road ahead.
The full potential of DeFi is yet to be seen. However, current developments promise a fairer and more open financial system for all.