DeFi 2.0: Addressing the Problems of DeFi

By Mohammad Musharraf

You just got to grips with DeFi, and now you’re reading about DeFi 2.0?! What is this trickery?! We get it – things are changing fast. But we’re here to explain in plain English.

Decentralized finance, a.k.a. DeFi, is an ocean. The deeper you dive, the more fascinating it gets. Its rapid innovations constantly seek to make the system more efficient. 

And we’re currently in the midst of a changing of the guards, as “DeFi 2.0 “ as it’s known, takes aim at the problems of first generation DeFi protocols. But what exactly are those problems, and how does DeFi 2.0 tackle them? Let’s take a deep dive into this transition.

DeFi 1.0: Disrupting the TradFi Status Quo

The foundation of decentralized finance was established in the first place to tackle the woes of traditional financial systems. Barriers to entry, centralized power structures, and lack of ownership of funds were the key problems that called for an improved financial system. 

As a result, we saw the creation of DeFi — a financial system based on top of blockchains. DeFi aims to create a financial ecosystem that is globalized, open to all. It works without banks or any other central entity controlling people’s actions and money. Although its evolution into an efficiently functioning system took years, it is doing what it promised to do. So how does that look in reality? 

Trading

Think of a decentralized exchange such as 1inch aggregator. You don’t need login details, or to provide any data at all to a central platform in order to use the service. Instead, to get started, users simply need to connect using their own, non-custodial wallet. You can even do this by simply connecting your Ledger Nano.

There is no central entity, no screening procedure, no data sharing, and no geographic restrictions – simply plug in, and start trading.

Lending and Borrowing

The same evolution can be seen in lending and borrowing. Protocols like Aave removing banks and central entities from the equation to provide peer-driven lending and borrowing for users, using smart contracts.

So, now, you can just go to Aave, connect your crypto wallet, deposit the required collateral, and take out a loan. There are no bank fees, no data requirements and minimal barriers to entry.

Problems with DeFi 1.0

All of this sounds pretty good right? Well it is, but DeFi 1.0 also came with its own problems.

Protocol Liquidity: The Eternal Carrousel

With no big, central entities to speak of. One of the defining features of decentralized finance is that it sources liquidity from users themselves. 

Suppose you go to Uniswap to exchange your ETH to USDT. You simply select the tokens, enter the value, and you get USDT in return for your ETH. But did you ever ask where the USDT came from or where did your ETH go to?

If not, the answer is a liquidity pool: a reserve of coins managed by a protocol that is readily available to allow users to swap easily.

Liquidity comes from other users, called liquidity providers or LPs. These users are incentivized by rewards – or yield – paid to them by the exchange for leaving their tokens as part of the liquidity pool. 

But this creates a problem. Rewards are highest in exchanges where liquidity is lowest in order to attract LPs, but fall again when liquidity is restored to the protocol. Loyalty isn’t a thing here. After all, if given the chance to either earn 5% APY or 15% APY on our liquidity, we’d all certainly want the latter. This means liquidity is constantly flowing to whichever platforms offer the highest rewards, a dynamic known as mercenary capital. 

This dynamic makes for a volatile DeFi ecosystem. Where platforms are locked in a constant struggle to maintain enough liquidity to attract users. While LPs are always seeking better rewards in exchange for their liquidity. It also leads to poor token liquidity of protocols after the native token reward has dried out.

Stablecoins: DeFi’s Not So Stable Lifeblood

DeFi has also been facing another little issue you might not be aware of. 

Stablecoins are key to the DeFi system because they provide price certainty in a market otherwise known for its volatile fluctuations. They are, therefore, essential for a couple of reasons.

• As a settlement currency. Stablecoins are needed as a settlement currency. Allowing traders to set up an exchange and know the final price won’t be subject to change due to a price fluctuation in their payment token.
• Storing value without off-ramping. Stablecoins are also a means of storing value when traders are dormant. Their price stability means traders can keep their accrued yield in crypto without worrying that a price fluctuation will knock out its value. This also means they don’t need to off-ramp into Fiat, which is both inconvenient and impractical.

This all sounds straightforward enough – so what’s the problem?

Centralization: The Vulnerability of Stablecoins

Stablecoins are normally backed by an asset, such as dollars for example. So for every stablecoin in circulation, there is, theoretically, a dollar in reserve. You could redeem that dollar at any time – this is why their value is stable. 

The key phrase here is “in reserve” – who maintains the reserve? Stablecoin reserves need to be maintained by a treasury – in other words; they are centralized around one key entity. This brings with it many of the problems of the traditional banking system. Such as whether that entity will act in good faith, and whether the reserve might be subject to regulation or seizure by governments.

You only need to scan some recent headlines to know that this has already caused controversy – and major lawsuits – for some well-known stablecoins. So we know that this is a key, and very real, compromise in the current approach to creating coins of stable value.

And What About Value? Great Question.

As we know, cryptocurrency was designed to evade key problems of the traditional system such as inflation. But since the reserve for stablecoins is often kept in Fiat, the value of that reserve will be constantly eroding, taking the value of the attached crypto with it. So over time stablecoins don’t maintain value any better than Fiat.

In short, the elements required to make stablecoins stable re-introduce many of the risks the decentralized monetary system was designed to solve.

As you can see, although DeFi has brought users unprecedented levels of financial freedom. It’s also faced limitations – chiefly, sourcing stable liquidity and balancing stability with decentralization. These are the central themes of DeFi 2.0 innovation.

DeFi 2.0 — Addressing the Limits of DeFi 1.0

The term “DeFi 2.0” was coined in the wake of a batch of new protocols taking innovative approaches to the challenges discussed above.

Let’s take a look at some examples of how these solutions are being implemented.

Olympus DAO: Answering the Call for Stable Liquidity

Olympus DAO is one protocol that’s currently sending waves through DeFi. Changing the norms of what we expect from the space. The main strength of Olympus protocol’s lies in the fact that it is able to own its liquidity and therefore achieve a level of stability DeFi 1.0 could not. How does it do this?

Owned Liquidity Doesn’t Move

To understand, let’s go back to the liquidity mining example we shared above. You’ve added liquidity and now you have the LP tokens. In the previous setup, you are free to unstake your LPs at any time and withdraw your liquidity if a better offer comes up – the dynamic behind mercenary liquidity. 

But with Olympus, the transaction is not necessarily done when you receive your LP tokens. Instead, Olympus allows you to then sell your LP tokens of its token pairs — OHM-USDT, OHM-wETH, etc. — back to Olympus, in exchange for discounted OHM. So you, the user, are incentivized by the offer of discounted tokens. Olympus gets the benefit of being able to control its liquidity.

How exactly does that work? Say you add OHM-USDT liquidity on Uniswap – you can then go to Olympus and use your LP tokens to buy OHM at a discounted price. Which means in turn that you’re passing on your control over the LP tokens back to the Olympus protocol itself. This is known as “bonding”.

Now that Olympus owns the LP tokens that represent the OHM-USDT liquidity you added on Uniswap, it in fact owns and controls that liquidity. This method has proven extremely effective and has allowed Olympus to own over 99% of its liquidity across exchanges.

More importantly, the developers of Olympus DAO have enabled this same mechanism to be deployed across the DeFi ecosystem, via Olympus Pro. This offers its solution as a service to all DeFi protocols so they can also own their liquidity. So not only is Olympus pushing the boundaries of DeFi for its own tokens. It’s also providing a stepping stone for the entire ecosystem. So we’re likely to see a host of new protocols change the face of DeFi going forward.

Stablecoins Part 2: Goodbye Central Reserve!

And what about stablecoins? How is the new wave of DeFi tackling the problems we mentioned above?

Development in this area is another zeitgeist of the DeFi 2.0 movement. There are a variety of different projects tackling this problem, but for now, let’s look at two of the main approaches.

Algorithmic Stablecoins

Algorithmic stablecoins forgo a central reserve – the problems associated with that – and instead achieve stability via an algorithm that controls token supply. So how does that work? Let’s unpack the concept by taking a look at one example, Ampleforth. 

Ampleforth’s central commitment is to “translate price volatility into supply volatility”. The token has an “elastic supply”. This allows it to maintain a constant price by adjusting the circulating supply of its tokens in line with price changes. These adjustments are known as rebasing.

Let’s look at that more closely. Say you’re holding a token that is aiming to achieve a stable value of 1 EURO. The circulating supply of that token is 1000 and you have 10 of those in your wallet. Overnight, the price of the token doubles – in response to this, the algorithm controlling the supply of the currency will rebase, doubling the total amount of tokens in circulation so that their value stays the same. So now, you’ll have 20 tokens in your wallet. Each one will still be worth 1 euro, just like yesterday.

The current iteration of algorithmic stablecoins is not perfect. In fact, they often struggle with achieving the stability they set out to achieve. Nonetheless, they’re an important development for the DeFi ecosystem. Bringing into view a cryptocurrency of stable value that not only enables trading and settlements, but also avoids the inherent risks of a central reserve.

Decentralized Reserve Currency – an Honourary Mention

Another interesting approach to price volatility can be seen in OHM, the native token of Olympus DAO. The OHM token does use a type of reserve to stabilize its value – it’s just not centralized.  Instead, the reserve is in the form of a protocol (sort of like the reserves in an automated market maker) which guarantees a minimum value for each OHM, without “pegging” it to that value. 

How does this work? OHM uses a “basket of assets”, all of them crypto-based, to back its value, but at an absolute minimum, there will always be 1 DAI to support every OHM token. So no matter how much the value of OHM falls, it can never fall below the value of 1 DAI. It can rise as high as the market drives it.

This is technically not a stablecoin, since there is no upper limit to the value of OHM. However it does serve to provide a stable “floor price” for tokens, and without the risks of using a central entity. While the success of that system can only really be known over time, its approach may come to change peoples’ expectations about the value of their tokens going forward.

DeFi 2.0: Passing Buzzword or New Wave of DeFi?

So there you have it – an overview of the innovations defining the next generation of DeFi. 

With the industry built on an open-source model that developers can build on easily, DeFi lends itself to fast innovation. It can be more nimble than traditional finance since progress doesn’t wait for quarterly reports and cumbersome business processes. 

DeFi 2.0 is a perfect reflection of this. Nobody knows whether the term itself will stick. Or if eventually DeFi 2.0 will just be plain old DeFi – sequels are never good anyway. The one thing that we can be sure of is that the use cases brought by DeFi 2.0 protocols like Olympus and Ampleforth have carved out new avenues in crypto, which are sure to define where we’re headed and up the ante for future protocols.

Knowledge is Power.

Trust yourself and keep on learning. If you want to know more about decentralized entities, check out this School of Block episode all about DAO’s – redefining human organisation.