The concept of DeFi has become extremely popular in the last few months. Many phases have succeeded the great DeFi summer of 2020. In this blog, we shall discuss the next step in decentralized finance and probably the one which needs your immediate attention — DeFi 2.0.
As we already know, decentralized finance or DeFi uses blockchain technology to provide all the services that are being given by the traditional trade finance system. From yield farming to NFTs, we all have been a part of the journey.
The collective TVL of all DeFi projects was over $250 B by the end of December 2021 and the graph only seems to be going up. Though these numbers are nowhere near the volume of money in the traditional finance system, the future looks promising.
DeFi 1.0 has been able to provide us with a variety of financial services, from lending and borrowing to dexes in a very decentralized manner.
Though DeFi 1.0 is a huge success and a massive stride forward in creating a truly decentralized financial system, it still has a variety of problems that need to be addressed.
Problems of DeFi 1.0
One of the major problems faced by DeFi 1.0 is that of sustainable liquidity. To understand this problem let us first take a quick recap on how liquidity mining works.
Most DeFi protocols get their liquidity through incentivizing third-party liquidity providers. Liquidity miners stake their tokens in the desired protocol and enable the users of that protocol to enjoy services like collateralized borrowing and token trading on that particular platform. In return, liquidity providers are incentivized by the protocol with fees as well as their native tokens.
With the advancement of DeFi, new protocols started promising more and more APY values to liquidity providers to gain more liquidity. This is where the problem of unsustainability arises.
The only thing that keeps the liquidity providers from withdrawing their assets from the pool of a protocol is the incentives provided by the protocol for staking their assets. Over time, the protocols run out of funds to incentivize their liquidity providers or the value of their LP tokens decreases in value because of inflation. This is when the liquidity providers cash out their funds and dry out the pool. This causes the protocol’s native token to crash and we all move to the next shiny protocol with higher APY. This is the problem of the unsustainability of liquidity in DeFi 1.0 protocols.
DeFi 2.0 — The Beginning
The protocols in DeFi 2.0 plan to tackle this problem by using a concept called Protocol-Controlled Liquidity or PCL which allows the protocols to own the majority of their liquidity. Hence, their tokens can provide high liquidity per unit of their TVL. Let us discuss one such protocol called Olympus DAO in this blog.
Most stable coins in popular protocols are pegged to some centralized physical currency like the US Dollar. Though it seems that the users of these stablecoins are free from the risk of cryptocurrency volatility as they are pegged to the USD, this is not the case. The depreciation of USD automatically depreciates the value of these stable coins.
Olympus DAO aims to solve this problem by introducing a free-floating reserve currency, OHM which is backed (not pegged to) by a basket of assets containing DAI, wETH, and Frax. As a result, the value of 1 OHM is always equal to or greater than 1 DAI. The market value of Olympus DAO’s treasury assets is $703,821,885.
By using a protocol-managed treasury, Olympus DAO is able to own a maximum part of its liquidity. The bond mechanism and rewards for staking allow the Olympus DAO protocol to increase the supply of OHM without affecting the price of OHM thus making it sustainable. We will discuss these topics in detail in our future blogs.
From a game theory perspective, the best possible outcome for the users of the Olympus DAO protocol is if everyone stakes their OHM for the long term. Selling their OHM would be detrimental for the users because of the protocol’s algorithm. As a result of this, users are encouraged to stake their tokens which in turn is very beneficial for the sustainability of the protocol.
The Olympus DAO uses an efficient algorithm to ensure that the price of OHM does not go below the floor price. Though it is somewhat susceptible to bank runs, the Olympus DAO earns in the form of gas fees as it owns almost all its liquidity which results in the increase of value locked in its treasury.
We shall discuss the working mechanism of Olympus DAO and other such protocols in our upcoming blogs. So make sure you stay connected to us.
DeFi 2.0 protocols are still very new in the world of decentralized finance. With the passage of time, we will be able to understand more and how these protocols will shape our future. As of now, all we can do is research and support the protocols which are the most promising.