If you are interested in Decentralised Finance (DeFi) and yield farming, you would have probably heard the chatter about projects such as Olympus DAO and Wonderland.
You might have also come across their seemingly insane APYs and hundred forks, and dismissed them as scams, but are they really?
These projects are part of DeFi 2.0, a rising trend catching the attention of many farmers and DeFi enthusiasts today.
But what’s the hype over Defi 2.0 all about? Is this just another passing fad? Or is this here to stay?
We’ll explore this topic today, in a simple and easy-to-understand manner. Let’s get acquainted with Defi 2.0.
Starting from DeFi 1.0
To understand Defi 2.0, we need to first begin with its predecessor, Defi 1.0. During the previous DeFi Summer, new DeFi protocols sprung up all over the place.
When new protocols launch, they need a sizable pool of liquidity to ensure the protocols run efficiently for their users.
Amidst strong competition and a limited pool of capital, how do they stand out and attract new users to use their protocol?
Their answer: Incentives
These protocols set up lucrative yield farms with sky-high rewards to incentivize new users. Naturally, most users were happy to switch over to earn high incentives on these highly rewarding farms. The protocol gets more users, while users earn attractive rewards — All’s good, right?
However, there were a few problems at hand.
First, the liquidity pools offering rewards with high APYs can only be sustained for a limited period of time. Once there was an increasing number of users providing liquidity, the APY rewards fell.
Next, users joining the yield farms were earning rewards in the form of the protocol’s native token. Put these two together, and you have a potential recipe for disaster.
When the rewards declined, users looked to remove their liquidity provided and jump to the next shiny new farm. They would also typically sell their rewards they earned, causing a huge selling pressure on the protocol’s native token.
Selling pressure from ‘whales’ with huge capital would also have a huge negative impact on price.
This is also why Defi 1.0 is being described as “renting liquidity”. Users only “rent” liquidity to the protocols for a short time, due to the promise of high rewards.
This attracts short-term mercenaries who provided liquidity just to earn a profit. Once they are done making profits, they pull out their liquidity from the protocols.
Worse still, this punishes holders of the native token that truly believe in the project long term.
This is a pretty bleak picture of DeFi 1.0. But are there any other way for new protocols to distribute tokens and raise liquidity at launch?
Here’s where DeFi 2.0 comes into play:
The promise of DeFi 2.0
The main problem with DeFi 1.0 is the unfortunate situation of protocols “renting” out their liquidity, at the risk of users abandoning the protocol once rewards turn less attractive.
To tackle this problem, DeFi 2.0 aims to attract long-lasting liquidity, in a sustainable way. This is done so by having protocols “own” their liquidity.
How does this work?
In essence, DeFi 2.0 protocols “buy” users’ assets, in exchange for the protocol’s native tokens. In this way, the protocols get to have control over their own liquidity.
To incentivize users to sell their assets to the protocol instead of trading on the market, protocols often also sell their native tokens at a discount.
This means that the users gets to “buy” the native token at a discount, depending on the discounted rates of different assets.
To prevent arbitrage, users typically can only vest their discounted tokens over a period of 5 days.
Why is this important?
The key difference between DeFi 1.0 and DeFi 2.0 protocols is that DeFi 2.0 protocols have their own liquidity stored in its treasury. This is also known as Protocol Owned Liquidity.
Instead of having to depend on users to provide liquidity through liquidity pools, the protocol owns their liquidity now.
This pool of treasury balance is made up of different tokens that they bought from users.
This gives it three key advantages:
First, by owning its liquidity, the protocol can grow its treasury value over time. It can make use of the liquidity it now owns to invest in other projects, to grow the treasury balance further.
Second, with this treasury balance, it gives the native token tangible value. The native token is now backed by a basket of assets, and has a “floor price”. This can be calculated by the total treasury balance, divided by the supply of circulating tokens.
Finally, incentives are now aligned between the protocol and the various users.
The protocols can then focus on growing their owned treasury balance. This increases the token’s backing and potential staking rewards, which should improve the attractiveness of the protocol over time.
Users are also incentivised to stake or bond for a long period of time to earn the high staking rewards typically provided by Defi 2.0 protocols. Prospects of pump and dumps are also slimmer with the large pool of protocol-owned treasury balance.
Where to begin
Olympus DAO and Wonderland are two of the earlier and more established DeFi 2.0 protocols that have huge amounts of treasury balances and Total Value Locked.
As with all good things, there are also often copycats.
Forks of Olympus DAO in various blockchains today are a dime in the dozen. But given their unproven nature, I would suggest staying away before you have a good grasp of these new protocols.
Is DeFi 2.0 here to stay?
Given the early nature of DeFi 2.0, the major protocols are still not quite battle-tested in bear markets, but early results are promising.
Major DeFi 2.0 protocols have locked up a huge amount of treasury, with a fanatic community.
This gives them optionality — with these funds at hand, they can choose to build other projects that further offer their token utility, while rewarding and engaging the community.
Wonderland founder Daniele Sesta recently mentioned in an interview that he is considering evolving Wonderland into the base currency of multiple gaming projects they are building too.
While DeFi 2.0 is early, and the future is uncertain, I am hopeful.
Happy farming in Defi 2.0!
Featured Image Credit: The Capital via Medium