One of the primary goals of blockchain technology development is to eliminate the need for third-party or intermediary financial institutions such as banks in the process of financial transactions over the internet.
With the creation of bitcoin, users could simply make financial transactions over the internet using bitcoin, a crypto wallet, and an active internet connection, ensuring that users could make transactions without the control of third-party institutions, high fees, and lengthy processes. This is where Defi enters the picture.
What is Defi?
The term “decentralized finance” is abbreviated as “Defi.” Decentralized finance is a system or protocol that aims to provide users with financial services similar to those provided by traditional financial institutions but with greater transactional benefits and control.
With the launch of bitcoin, the invention and adoption of blockchain technology enabled users to send and receive payments over the internet without the need for a third party, resulting in a trustless environment because the blockchain is secure.
These financial services, however, were taken to the next level with the introduction of Ethereum and smart contracts. Defi protocols can use smart contracts to provide financial services other than just sending and receiving payments over the internet, such as lending and borrowing cryptocurrencies for an agreed percent of interest, providing lenders with an additional source of income.
How Does Defi Work
Defi protocols make use of Ethereum, the world’s second-largest cryptocurrency after bitcoin. Unlike the Bitcoin network, Ethereum is designed to support the creation of new projects in addition to sending and receiving payments. This is accomplished with the help of smart contracts.
Smart contracts are pre-programmed rules that are only carried out when certain conditions are met. Defi protocols can program projects that offer complex financial services such as lending, borrowing, staking, and more, all with the goal of providing a means of benefit for users while also giving them control over their funds, thanks to smart contracts.
Ethereum’s programming language, Solidity, is specifically designed for programming smart contracts and is used to program and design smart contracts.
Benefits of Defi
- There is no obligation to apply for anything or to “open” an account. Creating a wallet is all it takes to gain access.
- You are not required to provide your name, email address, or any other personally identifiable information.
- You can move your assets to any location, at any time, without obtaining permission, waiting for lengthy transfers, or paying exorbitant fees.
- Interest rates and rewards are updated frequently (every 15 seconds or less) and can be significantly higher than those found on traditional Wall Street.
- Transparent: All parties involved have access to the entire set of transactions (private corporations rarely provide this level of transparency).
Use cases of defi
DeFi has grown into a complete ecosystem of useful apps and protocols that benefit millions of people. DeFi ecosystems now hold more than $30 billion in assets, making it one of the most rapidly growing segments of the public blockchain space.
Defi is used in a variety of ways, including:
- Decentralized exchanges
Decentralized exchanges are cryptocurrency exchanges that allow peer-to-peer transactions, eliminating the need for a third-party intermediary such as a bank. This type of transaction is entirely self-contained and is powered by algorithms and smart contracts.
The majority of DEXs are also Automated Market Makers (AMMs), which means they price cryptocurrency assets using a mathematical formula rather than an order book.
Another important type of decentralized finance in use is stablecoins. It is common knowledge that cryptocurrency prices are more volatile than fiat currencies, which is inconvenient for people who want to know how much their money is worth in a week’s time.
Stablecoins are cryptocurrencies that are pegged to non-cryptocurrencies, fiat currencies like the US dollar, or commodities like gold in order to maintain price stability. As the name implies, stablecoins aim to provide price stability, similar to fiat currencies. Tether (USDT) and USD Coin (USDC), as well as Dai (DAI) and Binance USD (BUSD), are well-known examples of stablecoins.
- Cryptocurrency Lending protocol
Lending protocols are quickly becoming one of the most popular forms of decentralized finance. The lending protocol connects cryptocurrency users who want to borrow some cryptocurrency (borrowers) with cryptocurrency users who want to lend out their cryptocurrency for a fee or agreed interest rate, all of which is governed and controlled by the lending protocol’s rules programmed into the smart contract.
Lending protocols such as Compound provide a platform for users to borrow cryptocurrencies or offer their own loans. Users can earn money by lending out their money and earning interest on the transaction when using lending protocols like these. Compound uses an algorithm to determine interest rates, so if a cryptocurrency is in high demand, interest rates will rise.
The majority of these DeFi loans are collateral-based, which means that in order to obtain a loan or borrow cryptocurrency on the platform, a user must provide collateral, which is frequently ether, the Ethereum token. This means that, unlike traditional, non-DeFi loans, users are not required to reveal their identity or credit score in order to obtain a loan.
- Prediction markets
Prediction markets were one of the first DeFi applications on Ethereum. In prediction markets, users can wager on the outcome of a specific event, such as “Will Liverpool FC win the 2022 Champions League Cup?”
The primary goal of most participants is to make money, though prediction markets can sometimes outperform traditional methods such as polling in predicting outcomes. Intrade and PredictIt are two centralized prediction markets with a good track record in this area. DeFi has the potential to increase interest in prediction markets, which are traditionally frowned upon by governments and frequently shut down when run in a centralized manner.
- Liquidity mining
Liquidity mining is a decentralized finance mechanism in which participants contribute a portion of their crypto assets to various liquidity pools in exchange for tokens and fees.
Liquidity mining has grown in popularity among investors due to the fact that it generates passive income, i.e., you can profit from crypto liquidity mining without having to make active investment decisions. How much of a liquidity pool you own determines your total rewards.
- Yield farming
Yield farming is a system in which users deposit cryptocurrency into a pool with other cryptocurrency users with the goal of pursuing investment gains, most commonly through interest earned by lending the pooled cryptocurrency to other cryptocurrency users.
It’s important to remember, however, that yield farming is a high-risk strategy with a high reward potential, so proper risk management strategies should be used when conducting such transactions.
Challenges of Defi
The user-friendliness of DeFi platforms is one of the first major challenges associated with Defi 1.0 protocols. Most newcomers struggle to use Defi 1.0 platforms, and as a result, are unable to use decentralized products. The vast majority of active users of these seasoned crypto enthusiasts are seasoned crypto enthusiasts.
Because of the high volume of transactions on these Defi platforms, as well as the overall increase in network activity, transaction fees frequently rise, and some transactions take longer to complete.
For transactions to run smoothly on a decentralized exchange, a high level of liquidity is usually required, and some of these defi projects only provide liquidity temporarily, which can be removed at any time, leaving investors stranded on the dex.
What is Defi 2.0
The DeFi 2.0 protocols emphasize how the first wave of DeFi product offerings effectively bootstrapped the industry by establishing a user base and developing critical DeFi primitives that future manufacturers can now use to create the next wave of DeFi apps. The purpose of this new generation of DeFi protocols is to ensure the sector’s long-term viability.
Defi 2.0 aims to address some of the major issues that have plagued traditional defi protocols. One such issue is the withdrawal of liquidity by liquidity providers or holders, which leads to pump and dump schemes. The development of OlympusDAO is an example of Defi 2.0 in action in this context.
In a report, OlympusDAO provides a solution to own its own liquidity. This is also referred to as Protocol-Owned Liquidity (POL). Because the liquidity is now owned by the DAO, the problem of liquidity providers leaving is eliminated.
OlympusDAO accomplishes this through a process known as ‘bonding.’ Bonding is the practice of selling Olympus’ own token (OHM) at a discount in exchange for LP tokens such as OHM-DAI and OHM-WETH. Following this, OlympusDAO becomes the owner of the LP tokens, as well as the underlying liquidity.
OlympusDAO owns 99.5 percent of its own liquidity across all markets and exchanges as of November 5, 2021.
Another way DeFi 2.0 is expected to assist Defi projects like decentralized automated organizations is through the development of protocol-controlled value mechanisms. The next generation of DeFi products will create valuable tools that will allow DAOs to compete with corporations, reinforcing the movement’s B2B focus.
Defi 2.0 Use cases
Unlocking the value of staked funds
The idea behind this is that users can have their staked cryptocurrency value unlocked while still generating APY. this helps as a means to provide capital efficiency. Although the mechanism differs per project, however the main idea is to unlock staked funds value while generating APY.
Smart contract insurance
Assuming you’re using a yield optimizer and have LP tokens staked in its smart contract. You could lose all of your deposits if the smart contract is compromised. However, for a fee, in Defi 2.0 an insurance project can provide you with a guarantee on your deposit with the yield farm. It should be noted that this will only apply to a single smart contract.
If the liquidity pool contract is breached, you will typically not be paid. However, if the yield farm contract is compromised but insured, you will most likely receive a payout.
Impermanent loss insurance
In Defi 2.0 the protocol uses its accumulated fees to build up an insurance fund to protect your deposit from the effects of impermanent loss over time. In the case where the fees aren’t enough to cover the losses, the protocol can create new tokens to compensate. Tokens that are in excess can then be saved for later use or burned to reduce supply.
Taking out a loan usually entails the risk of liquidation as well as interest payments. This doesn’t have to be the case with DeFi 2.0.
Take, for example, a $100 loan from a cryptocurrency lender. The lender lends you $100 in cryptocurrency in exchange for $50 in collateral. When you make a deposit, the lender invests it to pay off your loan with interest. Your deposit is returned once the lender has made $100 with your cryptocurrency plus a premium.
There’s also no danger of liquidation here. If the collateral token depreciates in value, the loan will take longer to repay.
Differences between Defi 1.0 and Defi 2.0
It works primarily on the Ethereum network.
Users have to transact using ETH, dealing with high gas fees and slower transaction speeds.
Liquidity is rented, giving room for pump and dump.
It works primarily on the Ethereum network.
Since blockchain is bridged, it can take on more transactions faster and without the need for high gas fees.
Platforms are more user-friendly.
Liquidity is owned and held by the protocol, therefore, mitigating room for pump and dump schemes.
DeFi 2.0 is a collection of projects that address the shortcomings of DeFi 1.0. DeFi aims to bring finance to the masses, but it has faced challenges in terms of scalability, security, centralization, liquidity, and information accessibility.
DeFi 2.0 aims to address these issues and improve the user experience. If DeFi 2.0 is successful, it will help to reduce the risk and complications that prevent crypto users from using it.