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What Is DeFi 2.0, How It Improves on DeFi 1.0 — and How to Invest in It

Intermediate

May 5, 2022

11 min read

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The first wave of decentralized finance, collectively known as DeFi 1.0, gave people a way to invest and exchange cryptocurrency outside of traditional, centralized markets. Now, a new generation of decentralized initiatives is taking shape, and it’s already been dubbed DeFi 2.0. This in-depth guide will answer the question, “What is DeFi 2.0?” It will also explain DeFi 2.0 vs. DeFi 1.0 and describe how to invest in DeFi 2.0, giving you the knowledge you need to capitalize on the latest innovations in decentralized finance (DeFi).

What Is DeFi 2.0?

DeFi 2.0 is a collection of decentralized finance projects that aim to improve on the previous efforts of DeFi 1.0. The movement focuses on making improvements in the areas of liquidity, scalability, governance and security.

Once we’ve answered our initial question and discovered what DeFi 2.0 is, we need to understand why the movement exists. DeFi 2.0 traces its origins to OlympusDAO, a decentralized autonomous organization (DAO) based on the OHM token. This organization manages the control of its signature token through a system of policies, and the protocol is backed by assets held by the associated Olympus Treasury. Launched in May 2021, Olympus demonstrated a new range of possibilities for DeFi. In the months since its release, a slate of similar DAOs and projects have developed, marking the beginning of DeFi 2.0.

DeFi 2.0 vs. DeFi 1.0

Any investigation of this topic needs to start with the question, “What is DeFi 2.0?” From there, the natural follow-up is, “How is DeFi 2.0 different from. DeFi 1.0?”

While the idea of DeFi 2.0 vs. DeFi 1.0”suggests two separate ideas, it’s worth remembering that they spring from the same general theory. Both DeFi 1.0 and DeFi 2.0 are iterations of a single notion: The idea that blockchains allow for a decentralized finance ecosystem which bypasses traditional centers of financial power.

“DeFi” in general refers to a collection of decentralized applications that use smart contracts and secure oracle networks to conduct finance without intermediaries. DeFi 2.0 remains true to this central premise, but makes adjustments to overcome some of DeFi 1.0’s principal shortcomings.

As crypto enthusiasts flocked to DeFi applications, they couldn’t help but notice considerable limitations. For one thing, liquidity was hard to come by. The fact that providing liquidity required users to lock up their funds led to an undesirable amount of financial rigidity and capital inefficiency. DeFi protocols also had notoriously complicated user interfaces, meaning few beyond experienced crypto traders could navigate the applications. The protocols’ reliance on Ethereum caused further complications, as the blockchain’s increasing popularity produced slower transaction times and higher fees.

When considering DeFi 2.0 vs. DeFi 1.0, you need to remember that DeFi 2.0 represents a concerted effort to overcome some of these central difficulties. While the DeFi ecosystem is still far from perfect, a few key improvements are already apparent. Once you understand them, you’ll be ready to learn how to invest in DeFi 2.0.

DeFi 2.0 Creates Stronger Connections Between Users

If you’re thinking about what DeFi 2.0 protocols are — and how they’re different from more traditional financial applications — DeFi 2.0 protocols are essentially decentralized financial applications that endeavor to connect users who contribute liquidity. These applications promote the types of horizontal connections that foster lasting relationships. This, in turn, will produce a DeFi ecosystem that’s decentralized but still interconnected.

DeFi 2.0 Uses Optimized Governance Patterns

Governance is a key issue in any decentralized endeavor, and DeFi 2.0 is based on better administrative solutions. In DeFi 2.0 protocols, community members cooperate to make decisions and create policies. This democratic process allows frameworks to develop without relying on a powerful arbiter.

DeFi 2.0 Includes User-Friendly Incentive Schemes

Decentralized finance can only survive with liquidity, and DeFi 2.0 projects are employing creative incentive programs to acquire and maintain sufficient capital. Not only do incentives help solve the liquidity problems that plagued DeFi 1.0, but they also foster connections between users, thus helping to produce more cooperative communities.

DeFi 2.0 Promises a More Sustainable Ecosystem

If there’s one thing you should understand after asking what DeFi 2.0 is, it’s that the new decentralized protocols are being designed with an eye toward sustainability. This is also the key factor in the “DeFi 2.0 vs. DeFi 1.0” discussion. The combination of liquidity, interconnectedness and sound governance should create a decentralized ecosystem that can last. This sustainability will allow DeFi 2.0 projects to gather further momentum, attract more users, and redefine finance on a larger scale.

DeFi 2.0 Strengths and Use Cases

You can answer the question, “What is DeFi 2.0?” without knowing how the associated protocols operate. A quick overview of DeFi 2.0 vs. DeFi 1.0 is enough to explain the basic idea behind the latest iteration of decentralized finance, but a more in-depth discussion demonstrates exactly how investors can benefit from DeFi 2.0.

There are several features unique to DeFi 2.0 that make the movement a more appealing target for crypto investors. From smart contract insurance to self-repaying loans, these novel ideas lay the groundwork for a sustainable DeFi ecosystem.

Insurance for Smart Contracts

In the DeFi 2.0 vs. DeFi 1.0 discussion, one of the biggest issues is user-friendliness. DeFi 2.0 protocols often allow investors to take out insurance on their smart contracts. This is a significant source of protection, especially for novice investors.

Many people would love to stake LP tokens in a smart contract but worry that the contract could become compromised. They know that a compromised contract is impossible to rectify on the blockchain, and they lack the technical nous to protect their investments on their own. An insurance policy allows them to stake tokens without any concerns. Not only does this help individual investors, but it also encourages the influx of more capital into the protocol.

Impermanent Loss Insurance

With DeFi 1.0, users who have locked two tokens into a protocol in order to start liquidity mining could lose out if the price ratio between the two tokens fluctuates. This phenomenon is called impermanent loss, and it’s among the most distressing features of decentralized finance.

DeFi 2.0 projects are introducing new measures to mitigate this inherent risk. Some protocols use the proceeds from fees to insure users against impermanent loss. They can also mint new coins to make up for losses. All of these policies make DeFi a safer option for crypto investors.

Self-Repaying Loans

The DeFi 2.0 ecosystem allows for a remarkable financial maneuver in which loans pay for themselves. A lender can provide a user with a loan in exchange for collateral in the form of a small deposit. This deposit is then invested by the lender, who goes on to earn interest. Once the lender has earned the full price of the initial loan, they return the deposit, and the loan recipient ends up not having to repay the loan.

DeFi 2.0 Risks

Most people who ask, “What is DeFi 2.0?” are also curious about any risks that might be associated with investing in the movement. While this second iteration of DeFi is generally safer than its predecessor, there’s still no guarantee that every investment will prove successful. Even the best DeFi 2.0 projects have inherent drawbacks, and investors should be aware of any potential pitfalls before staking tokens. Once you’ve learned about the main risks, you’ll understand more about how to invest in DeFi 2.0.

The Continued Threat of Hackers

Crypto investors can’t be completely sure that the smart contracts they’re interacting with won’t be hacked. Before staking tokens, always investigate the project thoroughly. Even after you’ve done your due diligence, a surprising hack could occur. Luckily, insuring your smart contracts can help limit the damage in case of illegal activity.

Future Government Regulations

As decentralized finance attracts users and more people learn how to invest in DeFi 2.0, governments around the world will become increasingly eager to get involved. Many governments will try to impose regulations on DeFi 2.0 protocols. As an investor, it’s important to recognize that your future activities might be affected by rules and limitations that don’t yet exist. While this concern shouldn’t scare you off from participating altogether, it’s certainly something to keep in mind as you discover how to invest in DeFi 2.0.

The Volatility of Cryptocurrencies

Decentralized finance can only occur with cryptocurrencies, many of which are remarkably volatile. When prices fluctuate wildly, investors are left dealing with the consequences. Some protocols mitigate this risk by offering users stablecoins to use for transactions. All the same, the inherent volatility of crypto markets will always be a factor in decentralized finance.

How To Invest in DeFi 2.0

We’ve answered our initial question, “What is DeFi 2.0?” We’ve also learned about DeFi 2.0 vs. DeFi 1.0. Now, it’s time to learn how to invest in DeFi 2.0. Decentralized finance involves several types of maneuvers that may be unfamiliar to crypto newcomers. Once you’ve learned a bit about common investment strategies, you’ll have a better understanding of the general DeFi 2.0 ecosystem.

Yield Farming

If you were at all familiar with decentralized finance before learning what DeFi 2.0 is, you might have questioned how the new movement deals with yield farming. This mechanism, a key innovation of DeFi 1.0, has become even more useful for investors in the latest installment of decentralized finance.

As with older projects, DeFi 2.0 protocols use yield farming to get liquidity from users. However, they go even farther by letting investors use tokens as collateral for loans. This twist on yield farming makes the protocols a more enticing option for investors.

Staking

Staking is a form of passive income generation as it allows users to become validators for blockchains that operate on a proof-of-stake basis. If you take this route, you can essentially lock your currency on the blockchain and earn block rewards in the process.

Lending

Self-repaying loans represent wonderful opportunities for lenders and loanees alike. Offering loans in exchange for interest payments is a great way to engage in yield farming within a DeFi 2.0 protocol.

Liquidity Provision or Liquidity Mining

Liquidity provision gives crypto holders an easy way to profit from their holdings. With this maneuver, holders pass some of their cryptocurrency to a liquidity pool so that users can trade against it. In exchange, the holder who provides the currency receives a fee. These types of simple, win-win transactions allow DeFi 2.0 protocols to attract liquidity while users earn a profit.

Trading on Decentralized Exchanges

Decentralized exchanges (DEXs) allow users to pursue crypto transactions outside the realm of third-party organizations, such as banks. While some states and countries impose regulations on this type of trading, the decentralized nature of the practice offers considerable freedom. Not only do DEXs often have lower fees, but they also enable margin trading and other appealing types of transactions.

Participating in DAOs

Anyone asking about DeFi 2.0 is likely to be equally curious about DAOs, the autonomous organizations that provide the basis for most decentralized finance. Investors can join a DAO by purchasing the organization’s token. Once you’ve bought yourself into the community, you should have a say in governance. This direct participation represents a motivation for learning about how to invest in DeFi 2.0.

Best DeFi 2.0 Projects

If you want to know how to invest in DeFi 2.0, you need to have a basic understanding of the existing projects. While there are too many protocols to list them all, this guide will introduce you to some of the most important undertakings.

Olympus DAO

If there was a single project you’d heard of when you first wondered about DeFi 2.0, it was probably Olympus DAO. This decentralized reserve currency protocol set new standards in DeFi and became the starting point for DeFi 2.0. Investors can use the project for all sorts of yield farming, from staking to purchasing bonds. The organization is especially famous for its unique, user-friendly bonding model.

Synapse

Synapse is an automated market maker (AMM) with considerable influence in the DeFi 2.0 ecosystem. Its status as a trustless cross-chain bridge makes it an appealing option for a wide range of crypto investors trading in a variety of currencies.

Curve Finance

Curve Finance is a DAO with its own exchange, liquidity pool and stablecoin. It also provides the basis for the associated yield-farming complex Convex, which has been constructed on its platform. As a massively popular DEX, Curve Finance is often regarded as the “Uniswap for stablecoins” because of its unique pricing formula.

Rarible

Rarible is a DeFi 2.0 project built around the concept of non-fungible tokens (NFTs). It consists of a DAO with its own governance model, allowing for considerable yield generation. Unlike the highly popular NFT marketplace OpenSea, Rarible lets users who are bullish for the platform invest in RARI tokens. RARI tokens give individuals the opportunity to decide the future of Rarible, voting on issues like fee changes and how Rarible’s treasury is spent.

Alchemix

Alchemix is a DeFi 2.0 protocol on the cutting edge of the DeFi 2.0 movement. While its simplicity makes it especially user-friendly, its variety of novel features is attracting enthusiastic investors. The protocol offers opportunities like self-repaying loans, DAOs and future yield, all of which make it worthy of consideration for crypto holders.

MakerDAO

MakerDAO was one of the first giants of decentralized finance, prompting countless people to ask about DeFi 2.0. It’s managed by the holders of its native stablecoin, DAI, a token that’s been pegged to the dollar. This combination of stability and innovation makes MakerDAO intriguing for investors.

The Bottom Line

For DeFi beginners trying to understand DeFi 2.0, it’s simply a movement that seeks to improve on DeFi 1.0 by freeing up additional liquidity, fostering more connections between users and creating a sustainable financial ecosystem. In considering DeFi 2.0 vs. DeFi 1.0, remember that the latest iteration of decentralized finance represents a major improvement, but it hasn’t been perfected yet. From here, you can employ your newfound understanding of how to invest in DeFi 2.0.