Decentralized finance, commonly known as DeFi, has been one of the most impactful and successful waves of blockchain-based innovation since its inception 2 years ago. However, over the past few months, a rising movement of liquidity-focused DeFi projects has brought forth a new wave of DeFi innovation, commonly referred to as DeFi 2.0.
DeFi 2.0 refers to a subset of DeFi protocols that are building on top of previous DeFi advancements, such as yield farming, lending, and more. A primary focus of notable DeFi 2.0 protocols is to overcome the liquidity limitations faced by many on-chain protocols that have native tokens.
This article considers the past innovations that set the stage for the DeFi 2.0 movement and introduces the liquidity problem that DeFi 2.0 protocols are attempting to solve before diving into the utility and new financial paradigms introduced by the DeFi 2.0 ecosystem. Without further ado, let’s dive into what is DeFi 2.0 and why does it matter?
DeFi 1.0
Early DeFi pioneers such as Uniswap, Bancor, Aave, Compound, MakerDAO, and more have built a solid bedrock for the developing DeFi economy, introducing many crucial and composable “money LEGOs” into the ecosystem.
Uniswap and Bancor were the original decentralized automated market makers (AMMs), the first to offer users the ability to seamlessly swap tokens without giving up custody. Aave and Compound introduced decentralized lending and borrowing, providing on-chain yield for deposits and access to working capital in a permissionless manner. MakerDAO enabled ecosystem users to hold and transact in a decentralized stablecoin, providing a hedge against the volatility of cryptocurrencies.
Through these protocols, users received access to reliable exchanges, frictionless lending/borrowing, and stable pegged currencies – three core financial primitives widely available in traditional financial markets. The various technological implementations behind each of these decentralized services serve as the bedrock for DeFi innovations.
Liquidity Provision
A core example of a blockchain-specific DeFi innovation is Liquidity Provider (LP) tokens in Automated Market Maker (AMM) Decentralized Exchange (DEX) protocols. While DEXs effectively act as an alternative for centralized order-book exchanges, the most popular DEXs employ an AMM model known as a Constant Product Automated Market Maker (CPAMM).
Decentralized liquidity pools in AMMs are used to facilitate token exchanges, in which individual liquidity providers commonly provide equal amounts of each cryptocurrency to contribute to an exchange pair’s liquidity pool. In return, they receive an LP token that represents both their share of the liquidity pool and the fees earned from facilitating swaps.
LP tokens triggered a cascading flow of DeFi innovation, as they were quickly adopted by other DeFi protocols in a multitude of ways. For example, lending protocols such as Aave and Compound iterated on the idea of giving users receipt tokens that represented an underlying deposit, now known as aTokens and cTokens.
The permissionless nature of AMMs and LP tokens also empowered DeFi startups, whereby with sufficient liquidity, newly launched tokens could be immediately traded on a DEX. However, without sufficient liquidity, the token exchange function of a DEX becomes limited in utility, with users required to pay astronomical prices for large swaps due to slippage. This led to one of the most prominent problems that currently exists in DeFi: the liquidity problem.
The Liquidity Problem
Liquidity has been a source of frustration for many emerging DeFi projects since the earliest days of the DeFi economy. The entire ecosystem is bootstrapped by tokens, which act as a way for teams to align the incentives of participants, collect rewards from user fees, and become composable with the larger DeFi ecosystem. However, in order to provide users with a robust source of liquidity to trade their tokens on AMM protocols, DeFi teams needed access to a large pool of funds.
A partial answer to this problem was found in third-party liquidity providers on AMM protocols, through which any independent person with sufficient funds could provide liquidity for a token pair. Teams could hypothetically source sufficient liquidity from others, rather than provisioning liquidity by themselves.
However, there were few incentives for end-users to bootstrap liquidity for a new token, as this would mean exposing themselves to the risk of impermanent loss in exchange for minimal fee revenue from swaps. They needed a sufficient economic reason to take on that risk.
This led to a chicken and egg problem. Without a sufficient level of liquidity, the slippage induced by swaps discourages users from participating in a DeFi protocol’s ecosystem. Without users participating through token transactions, there isn’t enough fee volume generated to incentivize third-party actors to pool their tokens and provide liquidity.
As a result, another crucial DeFi innovation was born. Rewards based on LP tokens became the primary way of bootstrapping liquidity for new DeFi protocols, a process known as yield farming.
Yield Farming
The advent of yield farming (also known as liquidity mining) caused a surge in DeFi activity in the summer of 2020, known as “DeFi Summer” by blockchain enthusiasts. The idea behind yield farming is simple. Users provide liquidity for an exchange pair on an AMM protocol, receive an LP token for their trouble, and then stake the LP token for returns that are compensated in a project’s native token.
This implementation solved the chicken and egg problem by giving third-party liquidity providers a compelling economic reason to provide liquidity for a token: more yield. In addition to generating greater cumulative fees on AMM swaps, incentivized by deeper liquidity, they could earn further yield by staking and receiving more of the project’s native token.
With the introduction of yield farming, new DeFi projects were able to bootstrap sufficient amounts of liquidity to begin and sustain operations, as well as lower slippage for users entering their ecosystem. This led to an exponential rise in the number of DeFi protocols across the board, a testament to the degree that yield farming lowered the barrier to entry for both users and DeFi project founders.
Limitations of Yield Farming
Though highly effective, yield farming does not fully solve the liquidity problem by itself due to the particular limitations of long-term yield farming initiatives. Yield farming excels at bootstrapping initial liquidity, but it must be done with a long-term plan in mind to secure long-lasting, sustainable liquidity.
This is because of supply dilution, an inherent feature of yield farming. Founding teams distribute native tokens to liquidity providers and provide additional sources of yield, incentivizing liquidity providers to keep their liquidity locked in AMM pools.
However, as more tokens are allocated to third-party liquidity providers, an increasing percentage of the total token supply is given to rented liquidity, with liquidity providers able to remove their liquidity at any time and sell their earned LP staking rewards. DeFi teams cannot be certain that liquidity providers will stay if staking rewards dissipate, while keeping staking rewards at high levels for a long period of time increasingly dilutes the native token’s supply.
As projects increasingly look to expand to different cross-chain AMMs and even AMM protocols on the same chain, a variety of yield farming initiatives across different exchanges are required to establish a deep liquidity pool for each. This exacerbates the aforementioned limitation, as emerging DeFi projects must finely balance supply expansion to numerous AMM protocols – often without the manpower, means, or information to do so effectively.
Yield farming has served as an impactful way of bootstrapping liquidity for DeFi projects, but it does not come without its longer-term risks. It is both necessary and healthy for most DeFi projects to run yield farming initiatives and bootstrap liquidity, but project teams must be mindful of their token supply and long-term yield farming strategies in order to avoid negative, long-lasting impacts.
What is DeFi 2.0 and Why Does it Matter?
In the context of liquidity, DeFi 2.0 refers to a few emerging DeFi projects that hope to revolutionize the common problems associated with liquidity provisioning and incentivization.
They provide alternatives and supplements to the yield farming model, giving projects a way to source liquidity that can be sustained for the longer term. But how exactly do blockchain-based projects with native tokens maintain a healthy amount of liquidity that’s allocated in an ideal fashion?
OlympusDAO and Protocol-Owned Liquidity
One solution that has risen to the forefront of the DeFi community in 2021 is OlympusDAO’s bonding model, which focuses on Protocol-Owned Liquidity (POL). Through its bonding model, OlympusDAO flips the script for yield farming on its head. Instead of renting liquidity through yield farming initiatives that expand supply, OlympusDAO uses bonds to exchange LP tokens from third parties for the protocol’s native token at a discount.
This provides an advantage to the protocol, and to any project that uses the protocol (e.g. bonding-as-a-service). Through bonds, protocols can buy their own liquidity, removing the potential for liquidity exits and building up a long-lasting pool that can also generate revenue for the protocol.
On the other hand, users are incentivized to exchange their LP tokens through bonds because the protocol offers a discount on the token. For example, if the price of token X is $500 with a discount of 10%, the user can bond $450 worth of LP tokens to receive $500 in token X. The result is a net profit of $50, dependent on a short vesting schedule (normally around 5 days to a week) to help prevent arbitrageurs from extracting value.
Another crucial aspect of liquidity-focused bonds is that the bond prices change dynamically and can have a hard cap. This serves an important purpose for the protocol, allowing it to control two levers: the rate at which tokens are exchanged for liquidity and the total amount of liquidity exchanged.
If too many users are purchasing bonds, the discount rate declines and can even become negative, acting as a way to control the rate at which the protocol’s token supply is expanding. The protocol can also determine its desired liquidity amount through a hard cap, in which bonds are no longer available, further controlling supply expansion based on precisely determined parameters.
Realigned Incentives
This multifaceted model helps to realign incentives between third-party liquidity providers and on-chain protocols. Protocols are better positioned to be exposed to impermanent loss than an independent third-party liquidity provider.
While third-party liquidity providers are faced with opportunity costs representing every other liquidity pool and yield farming protocol on the market, protocols have an additional incentive to keep the liquidity as it helps secure low-slippage swaps for users transacting with their native token, lowering the cost of entering their respective ecosystem.
Ultimately, OlympusDAO’s bonding model allows protocols to better mitigate the risk of low liquidity in a long-term, sustainable manner. Combined with yield farming, DeFi protocols now have more tools at their disposal to meticulously plan their growth phases, from initial liquidity bootstrapping to sustainable long-term growth.
Other DeFi 2.0 Advancements
Another subset of DeFi 2.0 protocols is building on top of previous yield generating mechanisms and assets to build novel financial instruments.
A prime example of this is Alchemix, a self-repaying lending platform that has a “no liquidation” design. The protocol lends out representative tokens pegged 1:1 to the collateralized asset. For example, by posting the DAI stablecoin as collateral, users are able to borrow 50% of the amount as alDAI. The underlying collateral is then deposited into yield-generating protocols so that it incrementally increases.
Through the combination of representative tokens and yield-generating collateral, Alchemix can offer a liquidation-free lending platform that enables users to spend and save at the same time – with decreasing loan principal amounts as the collateral continues to garner yield.
Abracadabra, another DeFi 2.0 protocol, employs a similar mechanism, but with a system that’s relatable to MakerDAO. Users can post yield-bearing collateral and receive the MIM stablecoin in exchange, maintaining exposure to the collateral while simultaneously garnering yield and unlocking liquidity for users.
Without the early innovations that first brought the decentralized economy to life – AMM protocols, decentralized stablecoins, and price oracles – there could be no liquidity bonding, liquidity flow mechanisms, or yield-generating collateral. From the early stages of AMM LP tokens and decentralized stablecoins to the DeFi 2.0 protocols of today, every project is a valuable iteration towards building the decentralized economy.
Closing Thoughts
So what is DeFi 2.0 and why does it matter? Because protocols now have an alternative solution to address the issues presented by liquidity mining today. If any of these approaches prove to be successful, some of the more established DeFi protocols may adopt these concepts and allow for a more sustainable DeFi ecosystem in the future. That said, it will be worth monitoring the adoption of the DeFi 2.0 movement.
