DeFi (decentralized finance) is a blockchain-based ecosystem that is open and accessible to everyone. In its operation, it assumes the absence (or maximum limitation) of any intermediaries' participation in transactions and the lack of controlling bodies. It allows users to take advantage of various services like loans, cryptocurrency exchanges, investment portfolio management, and much more. DeFi gives users autonomy and freedom. It makes them independent of traditional financial institutions overcoming geographical, political, or economic barriers. The launch of the first DeFi projects took place in 2016.
Limitations of DeFi 1.0
Decentralized finance 1.0 is struggling with several significant problems arising from the technical aspects of the ecosystem and its reliance on a blockchain. Among the main issues are:
Centralization: some projects available in the DeFi space provide only apparent decentralization. That means that there are central entities that perform a control function on, e.g., exchanges. The solution may be to base dapps on DAO principles.
Oracles: the quality of data provided to applications that require external sources is often insufficient for proper program operation.
Scalability: heavy blockchain traffic can result in slower application performance and high gas fees.
Liquidity: DeFi protocols often struggle with capital inefficiencies resulting from the fact that liquidity pools are spread across different platforms and blockchains. Tokens staked in LPs cannot be used elsewhere.
Security: DeFi users are vulnerable to smart contract security problems, DDoS attacks (an attack that aims to block access to a server or service by flooding it with many bogus requests), or other attacks on blockchain infrastructure.
UX/UI: dapps’ user experience is low. It is challenging to operate on them due to complex interfaces.
Explore DeFi 2.0
The second generation of decentralized finance is a streamlined version of DeFi, which aims to solve its predecessor's problems in terms of interoperability, scalability, and security. DeFi 2.0 applications will use new technology and infrastructure to create a more efficient financial system. One of the key innovations is the emergence of Layer 2 solutions that enable faster and cheaper transactions, allowing more users to be served without sacrificing speed and security.
Another goal of DeFi 2.0 is the integration of individual blockchain networks. Currently, most applications are built on a single blockchain, which limits the ability to move assets and data between networks.
The user experience will also be improved. That area is currently an area that is criticized by a significant portion of users. Operating decentralized applications in DeFi 1.0 often requires technical knowledge and experience. Assuming that decentralized finance is an ecosystem made for everyone, improving UX/UI will reduce the barrier to entry into the DeFi world.
In terms of solving the centralization problem, DeFi 2.0 will offer the solution of relying on the principles of DAO (Decentralized Autonomous Organization). This form of organizational cell brings together people with common goals, who work out solutions, indicate directions for application development, and resolve disputes. The tool for this is management tokens, which provide voting rights in DAO structures. It represents a step toward full decentralization and a reference to the original rules of democracy.
DeFi 2.0 use cases
At this point, it is possible to point out interesting use cases of the second generation of decentralized finance. Among the blockchains on which DeFi 2.0 projects are based, one can point to Ethereum, Solana, Binance Smart Chain, or other networks supporting smart contracts. Among the innovative solutions, one can point out the following: Insurance of smart contracts
If you are not an experienced developer, a smart contract due diligence audit may not be feasible for you. Because of this, you can't fully know all the risks the contract may have. That creates a considerable risk of losing funds. With DeFi 2.0, obtaining insurance on selected smart contracts will be possible. Insurance projects can offer you (for a fee) that if you lose your deposits due to, for example, a smart contract breach, they will be paid out to you.
Insurance against permanent loss
When you invest in a liquidity pool, any change of two locked tokens can lead to losses. DeFi 2.0 protocols create insurance funds from swap fees or the issuance of new tokens to cover them to mitigate the risk. If the loss exceeds the value of the tokens in the insurance fund, the protocol can mint new tokens to pay it off or burn tokens to reduce supply. This protects the depository from the effects of losses and provides stability for users.
Unlocking the value of staked funds
In DeFi 1.0, you could stack LP tokens in yield farms to increase your profits. In the second generation of decentralized finance, they have additional value because they can be used as collateral for loans or minting new tokens. That means they no longer need to be locked up in treasuries but have the potential to generate more value. The mechanism for using LP tokens may depend on the project, but the idea remains the same - unlocking value and using it in other processes while still generating APY.
This innovative way of borrowing funds provides repayment of the loan and protection against the risk of liquidation without the lender's intervention. They secure the loans with deposits that are used to earn interest to repay them. Borrowers do not have to worry about the liquidation of their positions in the event of a decline in the value of cryptocurrencies.
Summary - tips for DeFi 2.0 users
Despite the vast potential and great innovation behind the second generation of decentralized finance, it is worth exercising caution before committing your funds to a project of your choice. To this end, doing as much of your research as possible on the project's smart contract is always a good idea. Its audit is not always a guarantee that there is no security gap.
If you apply funds through a website, remember to locate the smart contract address in the explorer. In case of expiration or failure of the site, you will know where the source code of the contract in which I invested my funds is located.
Watch for changing blockchain regulations. Governments are taking an increasing interest in DeFi. The services you use may, at some stage, be forced to change their operating rules as a result of legal developments.
However, DeFi 2.0 will, as time goes by, spread its wings more and more, streamlining the operation of its ecosystem. Looking at the immense popularity of the first generation, one can speculate that its next version will be in great demand, so it is worth staying tuned and keeping an eye on this area of finance.
We power your Web3 future
We are a team of experienced blockchain enthusiasts who are more than willing to help you on your way to Web3. We provide end-to-end blockchain solutions for enterprises and ambitious startups. Let's create your future Web3 success together.