DeFi 1.0 vs. DeFi 2.0
DeFi 1.0 had its break-out party in the summer of 2021 and revolutionized the way users interact with decentralized exchanges (DEXs). Innovation and vision are at the forefront of what DeFi has to offer, and these factors make DeFi superior to traditional finance.
DeFi 2.0 has emerged as the new way for investors to interact with Ethereum and its Layer 2 solutions. HODLers can continue to benefit from DeFi 2.0’s entry to the scene by buying ethereum.
This week’s Netcoins Progressive Investor post will take a deep dive into DeFi 2.0, what it is, how it works, and how investors can win.
What Is DeFi 1.0?
Interacting with Ethereum in the summer of 2020 was a dream scenario for investors. Why?
The Ethereum blockchain saw the launch of an enormous amount of DeFi 1.0 projects when smart contract fees were still relatively low. Understanding DeFi 1.0 and how it evolved might give you some insight into how 2.0 came to be.
Very briefly, DeFi stands for decentralized finance, meaning users can interact with financial products without the need to use a centralized bank or intermediary simply by using sophisticated smart contracts.
DeFi in its current form primarily lives and breathes on the Ethereum network. The revolutionary capabilities of smart contracts has led to the birth of functions such as liquidity pools and staking. We’ll cover more on these functions in the sections below.
What you need to know for now is that DeFi 1.0 demonstrates that banks are in trouble, and that users can use their crypto to earn annual returns that a savings account never will.
DEXs and DeFi
DeFi frees investors to store their funds outside the control of centralized banks and allows them to transact freely with one another. This new reality is the dream envisioned by Satoshi Nakamoto when he unleashed Bitcoin to the world back in 2008.
How DEXs Work
Decentralized Exchanges (or DEXs) use an algorithm known as constant product automated market maker. Deposited token pairs create a liquidity pool so trading can take place. A liquidity pool makes the prices of tokens less volatile by making it less likely for whales to create sell pressure when they choose to flood the market with a given asset.
DEXs incentivize holders to stake liquidity by issuing rewards, usually in a liquidity pool (or LP) token, which can be left in the ecosystem or claimed. This incentivization paves the way for functions such as swaps to be relatively cheap and easy (at least it was before).
As the popularity of DeFi and Non-fungible tokens (or NFTs) grows, the usability and scalability of Ethereum becomes a bigger challenge. More traffic on the network raises gas fees, thereby increasing the cost of transactions. Thankfully, savvy developers anticipated the need for scalability on Ethereum and have been developing solutions in the form of Layer 2.
Layer 2 solutions (L2) use the infrastructure and security provided by layer 1 blockchains to process transactions cheaply and efficiently. These L2s led us to the DeFi 2.0 experiment we’re now living through.
DeFi 2.0 Is DeFi 1.0 On Steroids
Promises of incredibly high returns are almost too good to be true. However, further exploration of these protocols reveals their ingenuity and a commitment to creating a financial ecosystem where everyone’s a winner and can be an active participant in the direction of the protocol.
The decentralized nature of liquidity pools positions holders in a place in which their participation mitigates sudden price swings. After all, HODLers play an essential role in the availability and scarcity of a given asset. This new way forward for crypto has been taken to a whole new level in DeFi 2.0 through the use of decentralized autonomous organizations known as DAOs.
Decentralization keeps the power in the hands of many, which is the complete opposite of the traditional financial world.
DAOs tackle this challenge by offering high rewards for staking that are otherworldly. Some of the new DAO protocols’ annual percentage yield (or APYs) range from 37,000% to upwards of 2,000,000%! DAOs promises and then delivery of these APYs is a financial experiment rooted in economics and human psychology.
While the advertised yields are astronomical and enticing, they are typically paid out in tokens that are connected to the protocols. They can dip in value significantly, so there is a definite risk of significant gain or loss. Invest in these protocols at your own risk.
Crypto and Game Theory Join Forces
DAOs, much like NFTs, are only as successful as the community backing them. DeFi 2.0 uses DAOs to protect retail investors from crypto’s volatility. That’s because DAOs encourage holders to stake their tokens to create a robust treasury that shares revenue among holders. DAOs can also use Game Theory to ensure engagement in their project and maintain some stability in the price action of their tokens.
In its simplest form, Game Theory features two participants, each with three options. DAO participants can choose to either stake, bond, or sell their tokens. The worst-case scenario for both parties is the selling off of assets, which damages the DAO and pushes the price of its token down. Bonding is attractive as it builds in scarcity; it also pays out some rewards.
The best-case scenario is that participants engage in staking, as this has the effect of pushing the token price up. You may come across projects using the term (3,3) when talking about how they use Game Theory. A project that benefits (3,3) outcomes to reward participants is simply rewarding a scenario in which everyone makes a decision that collectively benefits the protocol’s mission.
This utopic scenario is only possible if all participants stay the course, making these jaw-dropping APYs a reality.
Some of these well-meaning protocols include Wonderland, Hector DAO and KlimaDAO. Maybe you have heard of them? Either way, each of these projects is a fork of Olympus DAO, the first DeFi 2.0 DAO to gain traction among investors on a large scale.
Olympus DAO: The DeFi 2.0 Trailblazer
Olympus DAO is to DeFi 2.0 what Bitcoin is to cryptocurrency. At the time of writing, Olympus DAO has a market cap of $4 billion, of which $1 billion is locked by holders. These impressive valuations put Olympus DAO in the same realm as other big capitalization projects like Litecoin, Stellar, and XRP.
Let’s dive a little deeper to understand better the protocol and the forks it has birthed.
The first thing to know about Olympus DAO is OHM, the native token at the centre of the functioning and prosperity of the protocol. The stable price of OHM plays a significant role in the APY rate and scarcity of OHM.
What makes OHM different from other stable reserves is that it is not backed by one asset. Instead, OHM is currently backed by a basket of assets that algorithmically maintain its value. This stability of OHM is what makes high APYs possible.
Staking DAO Tokens To Earn High APYs
Olympus DAO incentivizes holders to stake OHM in liquidity pools or directly purchase bonds. Purchasing bonds allow investors to buy OHM at a discounted price providing more upside when staking.
The high APYs offered by Olympus and other forks are a means to incentivize holders to stake their tokens for the long term. The protocols are pretty straightforward in that these APYs are not meant to stay in the 5-6 digit figures forever and are expected to taper off over time.
Part of the mechanism behind the high APYs is compounding interest. The more OHM staked means there is less OHM on the market available for trading, keeping its value high. Thus more returns are provided to stakers.
The rewards stakers earn from liquidity pools, known as liquidity pool tokens (LP), can also be staked directly in the protocol. By staking the LPs, Olympus DAO now owns more of its token and earns fees by minting their LPs! The treasury uses its liquidity to create a price floor for OHM, keeping its price relatively constant.
The more bonds purchased and the higher the total locked value, the more profitable the treasury becomes. In traditional finance, a high treasury splits profits amongst shareholders. In the case of Olympus DAO, the more prosperous the treasury, the more stable the protocol and the higher the rewards for stakers.
The only caveat is rewards are locked for up to five days before they can be claimed. This keeps funds locked in the project so rebasing can occur.
What Is Rebasing?
Rebasing refers to the active rebalancing of the protocol to maintain a stable floor price for the token, in which rewards are then evenly distributed to stakers. Rebasing changes the supply, the cost and the amount of tokens each holder has to create a stable ecosystem. With OHM and most other similar projects, rebasing occurs about three times every 24 hours, and rewards are paid out at the same intervals.
Let’s use OHM as an example. As the price of the token increases, the treasury will buy back more OHM to bring the price floor down and keep the APY high. Conversely, if too many OHM are staked, the APY decreases and pushes the OHM price higher. The DAO works to maintain a balance that protects your investment.
Supply and price changes are used to maintain the dollar value of the holder’s investment. After all, most investors in crypto still view the value of their holdings in fiat terms. The DAO appreciates this view and understands that to keep value locked, investors want to see the investment protected in terms of dollar value.
DAOs are certainly an interesting tool in crypto. The ideas underpinning this industry certainly can change finance to prevent whales from influencing the direction of markets, making it a more rewarding and equitable space for all.
DeFi 2.0 and DAOs Are Here to Stay
DeFi 2.0 offers investors another means of earning income and rewards without worrying about price volatility. The old saying it takes a village to raise a child applies to protocols like OlympusDAO, Wonderland, KlimaDAO and HectorDAO, which are supported by solid communities.
The vision of these protocols is to create a robust community that protects investors from nefarious whales crashing a market by dumping large amounts of supply at any given time.
Enter The DeFi 2.0 World with Netcoins
You can fund your journey into the world of high APY DAOs by signing up for your free account to make crypto purchases via online bill payments, e-transfers or depositing your existing crypto directly to Netcoins.
Although these protocols are difficult to understand, investors should consider reading each protocol’s whitepaper learning more about DeFi 2.0. The best place to initiate your learning and engagement with crypto projects starts by regularly checking in to Netcoins Progressive Investor posts.
Stay tuned for the Netcoins blog post!
Writer, content marketing at Netcoins.