Troubleshooting DeFi 2.0
We just learned about DeFi and is there DeFi 2.0? As it is known especially in the world of technology things are evolving very quickly for this “DeFi 2.0” targets the problems of first-generation DeFi protocols. But what exactly are these problems and how does DeFi 2.0 deal with them?
DeFi 1.0: Stopping the tradfi status quo
The foundation of decentralized finance was originally established to address the ills of traditional financial systems. Barriers to entry, centralized power structures, and lack of ownership of funds were the main problems they required in an improved financial system.
As a result, we saw the creation of DeFi a financial system based on the top of blockchains. DeFi aims to create a financial ecosystem that is globalized, open to all, and operates without banks or any other central entity to control people’s operations and money. And although its evolution into an efficiently operating system took years, it does what it promised to do. What does this actually look like?
Trading
Consider a decentralized exchange like the 1inch aggregator. You don’t need any login details or provide data on a centralized platform to use the service. Instead, to get started, users just need to log in using their own wallet.
There is no centralized entity, no control process, no data sharing enabling you to log in and start your transactions.
By taking a loan or giving
The same evolution can be seen in lending and lending, with protocols like Aave removing banks and central entities from the equation to provide loans and borrow for users, using smart contracts.
So, now, you can simply go to Aave, connect your crypto wallet, deposit the required security, and take out a loan. There are no bank commissions, no data requirements, and no minimum barriers to entry.
Problems with DeFi 1.0
Does that all sound very good right? Well, it is, but DeFi 1.0 also came up with its own problems.
Protocol Fluidity: The Eternal Carousel
Without talking about large, centralized entities, one of the defining features of decentralized finance is that it draws liquidity from the users themselves.
Let’s say you go to Uniswap to exchange your ETH for USDT. you simply select the tokens, enter the price, and receive USDT in exchange for your ETH. But have you ever wondered where USDT came from or where your ETH went?
If not, the answer is a pool: a stock of coins managed by a protocol that is readily available to allow users to trade tokens easily.
Liquidity comes from other users, called liquidity providers or LPs. These users are motivated by rewards or yields (similar to farming) paid to them by the exchange to leave their tokens as part of the liquidity pool.
But that creates a problem. Rewards are higher on exchanges where liquidity is lower in order to attract providers (LPs) but decrease again when liquidity is restored to protocol. Reliability is not something here after all: if we are given the opportunity to either earn 5% APY or 15% APY in our liquidity, surely, we would all like the latter. This means that liquidity is constantly flowing on any platforms They offer the highest rewards, a dynamic known as mercenary capital.
This dynamic creates an unstable DeFi ecosystem, where platforms are locked into a constant struggle to maintain enough liquidity to attract users, while LPs are always looking for better rewards in exchange for their liquidity. It also leads to poor symbolic fluidity of the protocols after the inherent token reward has dried up.
Stablecoins: The Volatility in DeFi
DeFi has also encountered another small problem that you may not be aware of. Stablecoins are key to DeFi because they provide price certainty to a market known for its volatile fluctuations. However, they are necessary for two reasons:
As a settlement currency. Stablecoins are needed as a settlement currency, allowing investors to set up an exchange and know that the final price will not change due to price fluctuations in their payment token.
Store value, stablecoins are also a means of storing value when traders are idle. Their price stability means that traders can maintain their accrued performance in crypto without worrying that a price fluctuation will skyrocket its value.
Centered: The sensitivity of Stablecoins
Stablecoins are usually backed by an asset, such as dollars for example. So, for every stablecoin in circulation, there is, in theory, one dollar in reserve and you could redeem that dollar at any time, which is why their value is fixed.
The key phrase here is “in reserve” who keeps the stock? Stablecoin stocks must be held by a fund in other words, they are concentrated around a key entity. And this brings with it many of the problems of the traditional banking system, such as whether this entity will be loyal to the system and whether the reserve may be subject to some regulation or seizure by governments.
You only need to scan some recent titles to find out that this has already caused controversy and big lawsuits for some well-known stablecoins. So, we know that this is a basic and very real compromise in the current approach to creating fixed-value coins.
And what about their value?
As we know, cryptocurrencies were designed to avoid basic problems of the traditional system such as inflation. But since the stock for stablecoins is often held ina Fiat, the value of this reserve will constantly erode, taking with it the value of the linked cryptocurrency. Thus, over time, stablecoins do not retain their value better than Fiat currencies.
In short, the elements required to make stablecoins stable reintroduce many of the risks designed to solve the decentralized monetary system.
Stablecoins Part 2: Goodbye Central Reserve
And what about stablecoins? How does the new DeFi wave deal with the problems we mentioned above?
Growth in this area is another positive element of the DeFi 2.0 movement. There are a variety of different projects that address this problem, but for now, let’s look at two of the main approaches.
Algorithmic Stablecoins
Algorithmic stablecoins give up a central reserve, and the problems associated with it achieve stability through an algorithm that controls the supply of tokens. So, how does this work? Let’s understand the idea by taking a look at an example, Ampleforth.
Ampleforth’s central commitment is to “translate price volatility into supply volatility.” The token has an “elastic supply” this allows it to maintain a fixed price by adjusting the circulating supply of its tokens according to price changes. These adjustments are known as rebasing.
Let’s take a closer look at it. Let’s say you keep a token that aims to achieve a stable value equal to 1 EUR. The available stock of this token is 1000 and you have 10 of them in your wallet. Overnight, the price of the token doubles – as a reaction to this, the algorithm that controls the coin’s supply will be repositioned, doubling the total amount of tokens available so that their value remains the same. So now, you’ll have 20 tokens in your wallet – and each one will still be worth 1 euro just like it was yesterday.
The current iteration of algorithmic stablecoins is not perfect. In fact, they often find it difficult to achieve the stability they intend to achieve. Despite this, they represent an important development for the DeFi ecosystem, bringing to the fore a fixed-value cryptocurrency that not only enables transactions and settlements, but also avoids the inherent risks of a central reserve.
Decentralized reserve currency
Another interesting approach to price volatility can be seen in OHM, the native token of the Olympus DAO. The OHM token uses a type of reserve to stabilize its value simply not concentrated. On the contrary, the stock has the form of a protocol (somewhat like the reserves in an automated dealer) that guarantees a minimum price for each OHM, without “associating” it with this value.
How does this work? OHM uses an “asset basket,” all based on cryptocurrency, to support its value, but at an absolute minimum, there will always be 1 DAI to support each OHM token. So, no matter how much the value of OHM falls, it can never fall below the price of 1 DAI, but it can rise as high as the market takes it.
This is technically not a constant currency, as there is no upper limit to the price of OHM. However, it serves to provide a fixed “floor price” for tokens, and without the risks of using a central entity. Although the success of this system can really only be known over time, its approach can change people’s expectations about the value of their tokens in the future.