The Investor's Guide to DeFi 2.0

What is DeFi 2.0, and how can you invest in it?

Want more like the Guide to DeFi 2.0? Scroll to the bottom for further reading and a list of other Blockworks Investor’s Guides.

A quick primer on DeFi

Decentralized finance (DeFi) is a category of blockchain-based solutions that aims to solve the problems of traditional finance, namely, centralization and the lack of personal autonomy and ownership over one’s finances.

For clarity in this guide, we’ll call it DeFi 1.0. It comprises a broad range of financial services, including decentralized exchanges (DEXes), yield farming or liquidity provision, decentralized autonomous organizations (DAO) governance, lending platforms, payment gateways and much more.

For deeper reading on DeFi in general, check out the Investor’s Guide to DeFi.

What is DeFi 2.0?

DeFi 2.0 is the second generation of DeFi protocols, which aims to correct the problems of the first iteration of DeFi.

Below, we’ll explore some of those problems and detail strategies to invest in DeFi 2.0. This guide will also give an overview of some of the most popular DeFi 2.0 projects you can invest in.

The case for DeFi 2.0

Most technology tends to grow along a similar adoption curve and evolves through similar stages of development.

If you’ve spent time in crypto or emerging tech markets, the main obstacles to DeFi adoption may look familiar.

DeFi 1.0 is risky

The first problem is the risk of adopting new technology. In DeFi 1.0, a lot can go wrong:

The volatility of individual cryptocurrencies has aftershocks in DeFi, as price changes can result in an impermanent loss for liquidity providers (LP).

Decentralized platforms leave no one individual accountable for security breaches, so there is little to be done if your funds are stolen or smart contracts have a flaw. Today, many users lock their funds into smart contracts without realizing the risk of a smart contract failure.

Because cryptocurrencies live on different blockchains, low or inconsistent liquidity plagues less popular platforms and their respective currencies are not always able to be easily exchanged. A user might need to use multiple platforms to trade assets with low liquidity, or accept losses due to slippage.

DeFi 2.0 combats risk

Impermanent loss can be offset by impermanent loss insurance. Likewise, smart contracts can be protected by smart contract insurance. Open-source communities or insurance providers executing security audits help ensure that smart contracts don’t have critical flaws or exploitable back doors, while insurance serves to reimburse users who’ve lost funds.

Low liquidity can be offset by cross-chain bridges which connect blockchains using layers of smart contracts and liquidity pools, giving users access to assets not native to the blockchain they’re using. This way, if there isn’t enough liquidity for an asset on one chain, they can trade between sufficient pools across chains.

DeFi 2.0 can combat the financial risks of both DeFi 1.0 and traditional finance, making it a financial paradigm unlike anything markets have ever seen.

For example, lending in DeFi 1.0 mimics traditional lending practices, except on a peer-to-peer basis. Users borrow funds from other users with interest, usually after supplying a hefty amount of collateral.

In DeFi 2.0, however, loans can repay themselves. Self-repaying loans use collateral for yield farming (liquidity provision which reinvests yield) to pay off the loan balance. Once the full balance has been repaid by what is essentially a passive income stream, the borrower’s original collateral is returned and they have paid effectively nothing out of pocket.

DeFi 1.0 is inaccessible

The second major problem any new technology tends to encounter is accessibility.

While today, everyone has the internet in their pocket, at first, very few people owned the computers needed to access it. Cryptocurrency adoption and DeFi 1.0 encountered the same problem.

For a decade, the cryptocurrency sector was an insular industry overrun by people throwing around jargon to sound smart. Buzz-phrases like “distributed ledger technology,” “fungible” and “Byzantine Generals Problem” would tell other crypto enthusiasts you knew what you were talking about — and make you completely uninteresting to the average person.

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DeFi 1.0 has suffered from the same self-inflicted malady.

Niche platforms that require a highly tech-savvy user are common. Inconsistent and risky yields (in some cases as high as 1300% APY like FTM/TOMB) rightly cause users unease and uncertainty. Excessively specific terminology leaves little room for casual engagement.

To top it off, most people are unaware of what DeFi platforms exist and how to use them because DeFi marketing hasn’t yet learned how to cater to a beginner audience.

DeFi 2.0 educates and integrates

Crypto figured out how to make itself accessible to the average person over time by correcting its narrative, and it’s now a household topic. DeFi 2.0 is following that model and making DeFi accessible to all in two major ways: education and integration with traditional financial platforms.

The best DeFi 2.0 projects are ones that have simplified their features on the front-end and have created materials that educate their new users about their platform.

Integration with centralized traditional financial platforms is a controversial subject when it comes to DeFi, which is inherently decentralized.

However, as DeFi 2.0 becomes increasingly simple and approachable, traditional financial services can integrate DeFi 2.0 protocols into their platforms via APIs and oracles, which connect blockchains to external systems. Ultimately, the integration will allow users to use decentralized financial protocols from within centralized TradFi apps and web interfaces.

Making DeFi usable

Similar to accessibility, usability suffers in the early stages of any new technology. Cluttered and confusing interfaces were the standard for all of DeFi’s history.

However, DeFi 2.0 is introducing layer-2 and even layer-3 platforms that make decentralized financial services like lending, yield farming and asset management, easy to use, even for beginners.

Apple continues to win for many reasons. But one key trend underlying all of their innovations is usability. New users are guided swiftly and simply through setup processes, something DeFi 1.0 couldn’t do, that DeFi 2.0 is fixing.

How to invest in DeFi 2.0

There are multiple ways to invest in DeFi 2.0, but it’s helpful to conceive of them in two categories: buying tokens and using DeFi 2.0 platforms.

Buying tokens

One of the easiest ways to invest in DeFi 2.0 is to use a DeFi platform to trade or HODL the native token of a DeFi protocol. As the project grows, so should the value of your investment (as long as it’s not a stablecoin, which is designed to have a stable price).

Not much needs to be said about buying tokens. Simply find the right project, and acquire its native token. At the end of this Guide is a list of a few projects to help you get started.

Using DeFi 2.0 platforms

DeFi 2.0 adds a layer of complexity to the use cases for DeFi, but (ideally) simplifies the process on the front-end. This means you can do more than ever with your money, easier than ever.

If you want to generate returns, consider using DeFi protocols you trust that offer the features you’re looking for. Platforms are typically called decentralized applications (dApps).

Features

Yield farming – Yield farming has become a blanket term for all activities in DeFi which generate a return (yield) on a type of digital asset collateral, usually calculated in APY. In each yield farming activity, reinvesting returns is widely considered a critical part of “farming,” though not required. Each investor should weigh their goals and risk tolerance.

Lending – One opportunity to yield farm in which users can provide loans in return for interest payments. Self-repaying loans offer more peace of mind for both the borrower and lender.

Liquidity mining or liquidity provision (LP) – Another opportunity to yield farm in which users provide cryptocurrencies to liquidity pools for other users to trade against, in return for fees. Impermanent loss insurance can mitigate losses if markets turn.

Staking – Another opportunity to yield farm in which users can become validators for a proof-of-stake blockchain and earn block rewards by locking that chain’s validator token/currency.

DAO participation – Users can buy (and sell) tokens that distribute governance authority for DAOs among token holders. The benefits of DAO participation vary depending on the purpose of the organization.

Trading (DEX) – Decentralized exchanges offer users a way to trade crypto without a centralized third party controlling each transaction. They typically have fewer fees than centralized exchanges, and offer features such as margin trading. Regulations vary by country and state.

Gaming – While decentralized gaming is its own industry, it overlaps with DeFi 2.0 wherever money becomes involved. This space is very new and rapidly developing, so keep an eye on opportunities for play-to-earn and ownership models based on DeFi 2.0 as the space matures.

Projects

Below is a list of some of the most popular DeFi projects today:

OlympusDAO ($OHM) – Decentralized reserve currency model with bonds, LP, staking, and more. Check out the Investor’s Guide to OlympusDAO for links to further reading.
Curve Finance (CRV) & Convex (CVX) – Top 3 (currently) TVL of DeFi protocols. Curve is the DAO, exchange, LP, stablecoin and more, on which the yield farming platform Convex is built.
Synapse ($SYN) – Trustless cross-chain bridge and automated market-maker (AMM).
Wonderland ($TIME) – Avalanche-based reserve currency protocol with responsive APY (above 72,000% APY at some points).
Avalanche ($AVAX) – Fast, low-cost programmable smart contract platform upon which DeFi 2.0 dApps can be built. Layer-1.
Solana ($SOL) – Also a layer-1 smart contract platform, Solana is a primary competitor to Avalanche and Ethereum.
Yearn Finance ($YFI) – Yield and lending aggregator and insurance provider on the Ethereum blockchain. Unavailable to US citizens.
Rarible ($RARI) – DAO governance and yield generation based on NFT sales.
Abracadabra ($MIM) – Protocol generating the Magic Internet Money (MIM) stablecoin as yield for various lending practices.
Alchemix ($ALCX) – Low-maintenance protocol attempting to push the boundaries of DeFi with self-repaying loans, future yield, and DAO governance.
MakerDAO ($MKR, $DAI) – $MKR token holders govern the DAO that regulates $DAI, the native stablecoin pegged 1:1 with the US dollar.
Algorand ($ALGO) – Layer-1 and layer-2 smart contract protocols focused on scale and blockchain interoperability.

Final considerations

This is far from a complete list. The projects and features listed above include projects that will help you become familiar with DeFi 2.0, after which you’ll be equipped to evaluate new projects you discover.

As with all investments, be careful to consider your risk tolerance, as well as the ethos behind your investment practices.