What is DeFi 2.0?

08.06.2022

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#DeFi

Key points

DeFi 2.0 is the second generation of decentralised finance, whose projects aim to fix the flaws of the first wave. That includes more efficient use of capital, mechanisms to stabilise liquidity and longer-term user incentives.
There is no strict definition of what qualifies as DeFi 2.0. The label covers at least several dozen projects, including Olympus DAO, Abracadabra Money, Alchemix, Tokemak and others.
DeFi 2.0 protocols often build on existing DeFi infrastructure, including decentralised exchanges that use automated market makers (AMM-DEX) and collateralised lending protocols.

What problems does DeFi 2.0 address?

Decentralised finance remains one of the crypto industry’s main pillars. As it has evolved, however, structural shortcomings have become clear—limited scalability and high fees, unstable liquidity and returns, security issues in smart contracts and centralisation. DeFi 2.0 projects seek to deploy new principles and approaches to tackle these problems.

Long-term liquidity

Most DeFi protocols attract investors by offering rewards in the project’s native token. Liquidity mining works well in the short term, but accelerated token issuance to pay liquidity providers creates sell pressure. Sooner or later yields are cut, raising the risk of capital fleeing to other protocols.

DeFi 2.0 tries to address this by building a protocol reserve, or treasury, which is deployed to earn yield across popular DeFi applications. Treasuries also enable DeFi 2.0 projects to provide “liquidity as a service” (Liquidity as a Service, LaaS) to other DeFi services. The end goal is a stream of recurring revenue that allows protocols to dispense with outsized emissions of governance tokens.

Impermanent loss

Investors providing liquidity to DeFi pools in pairs of cryptoassets constantly face the risk of impermanent loss (IL). It arises when the relative prices of the two assets in the pool move, eroding expected returns and making such allocations less attractive.

Some popular AMM-DEX offer ways to mitigate IL (Balancer, for instance, allows arbitrary weightings), but only DeFi 2.0 services have tried to attack the issue head-on with single-sided pools.

Centralisation

Many DeFi services were launched by anonymous teams that made all development decisions. That creates scope for fraud and raises the odds of intentional or accidental governance mistakes that harm a project’s health and the safety of users’ funds.

The response has been the spread of DAOs—decentralised autonomous organisations—whose participants decide most tactical and strategic questions via on-chain votes.

For DeFi 1.0, the shift to DAOs was slow and optional; for DeFi 2.0 it is an industry standard from the outset. Handing control to the community usually signals maturity: the core functionality is built and the project has attracted users and liquidity.

Origins and notable DeFi 2.0 projects

Most second-generation DeFi projects began operating in 2021, when the term DeFi 2.0 also entered common use. Here are several of the most prominent examples.

Olympus DAO (OHM)

Launched in spring 2021 on Ethereum. It aims to create a decentralised reserve currency backed by its own reserve fund (treasury).

The main way Olympus DAO fills its treasury is by selling the OHM governance token via a bonding mechanism. Users can buy short-term bonds with a range of cryptoassets (DAI, ETH, etc.) and receive OHM at a small discount over five days.

Sell pressure was reduced via staking OHM. At launch, staking yields topped 200,000% APY (with automatic restaking every eight hours).

To improve stability, the team gradually lowered OHM staking yields. It also launched the LaaS—product Olympus Pro, which lets other DeFi protocols use bonding to acquire their own liquidity. In this way, using treasury funds, the protocol created a revenue source that does not depend on a constant influx of new investors.

At its peak in November 2021, Olympus DAO’s total value locked (TVL) exceeded $860m, and OHM’s market capitalisation hit $4.3bn. The success spawned a wave of imitators that reused Olympus DAO’s code to launch copies.

As of June 2022, the OHMfork and DeFi Llama services list more than 130 Olympus DAO forks across major blockchains. Most differ from OlympusDAO only by name and staking yields on the native token, while being run by anonymous developers—raising the risk of loss. Dozens of such projects have already ended in exit scams.

Abracadabra Money (SPELL)

Launched in May 2021, initially only on Ethereum, it now runs across popular EVM-compatible networks including Arbitrum, Fantom, Avalanche and BNB Smart Chain. The protocol lets users convert cryptoassets (including yEarn Finance, Curve and SushiSwap treasury tokens) into the algorithmic stablecoin Magic Internet Money (MIM). MIM trades on many decentralised and centralised exchanges, so investors can easily swap it for other stablecoins. As an incentive for liquidity providers, the project issues the SPELL governance token, gradually reducing rewards. To stabilise liquidity, Abracadabra uses Olympus Pro, buying discounted bonds to build treasury reserves. SPELL is used in DAO votes. In addition, staked SPELL holders receive a share of Abracadabra’s fees.

Alchemix (ALCX)

A decentralised lending platform, launched in February 2021 on Ethereum. It lets users take “self-repaying” loans against crypto collateral by issuing highly liquid synthetic tokens. Debt positions are automatically repaid using yield generated via integrations with the yEarn Finance aggregator and the Aave and Compound lending protocols.

The first version of Alchemix allowed users to mint the synthetic stablecoin alUSD by depositing DAI. Later USDT, USDC, ETH and other assets were added as collateral. For all assets, the Loan-to-Value (LTV—loan to value) parameter is 50%. That is you can borrow up to half of the posted collateral.

Control of the platform is being transferred to Alchemix DAO, which receives 10% of protocol revenues. Holders of the ALCX governance token can vote to fund projects that expand alUSD’s use.

Tokemak (TOKE)

Launched in August 2021 on Ethereum, this project focuses on long-term liquidity and impermanent loss. It accepts deposits like a lending protocol but allocates each cryptoasset to a separate pool called a “reactor”.

Holders of the TOKE governance token vote on how to deploy liquidity from each reactor. Participation in votes is incentivised with TOKE. Third-party DeFi services can borrow liquidity accumulated in the protocol, paying fees as they use it. These fees flow to the treasury (Tokemak Treasury).

Over time, fee income is expected to reach a level at which the protocol no longer needs to attract outside liquidity.

Risks and drawbacks of DeFi 2.0

Although DeFi 2.0 has its advantages, it still shares many of DeFi’s risks, including the human factor, bugs and vulnerabilities in smart contracts, and the possibility of price manipulation due to faulty price oracles.

Unaudited smart contracts have already caused serious financial losses in DeFi 2.0. For example, in June 2021, shortly after launching support for alETH, a synthetic asset pegged to ETH, an incident occurred in the Alchemix protocol. Owing to a logic error in a smart contract, several users improperly received a total of 4,300 ETH ($6.5m at the time).

Projects that support algorithmic stablecoins (such as MIM and alUSD) also carry the risk of losing their fiat pegs due to manipulation or market conditions.

A more specific DeFi 2.0 risk is that most projects start out with classic liquidity mining, hoping to migrate to a steadier, treasury-based model. Yet growth in treasury revenues depends heavily on overall market conditions in DeFi. During downturns, self-sustaining liquidity may prove out of reach for DeFi 2.0 protocols.

Outlook for DeFi 2.0

In 2021, as crypto’s market capitalisation and user base grew, DeFi 2.0 projects showed they could attract users and capital with a series of innovations. But the bear trend in equities and crypto that began in 2022 amid global economic and political events crushed TVL and the market caps of all projects in the segment.

The ensuing crypto winter will test the resilience of the entire DeFi industry. It is hard to say which DeFi 2.0 projects will survive and which will disappear. In any case, the more interesting approaches to attracting liquidity and users that have already proved themselves will continue to be used regardless of market conditions.