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DeFi 2.0 Benefits and Risks

A popular discussion panel in the recently concluded Blockchain Hub Davos 2022 was “DeFi — “Programmable Money is Here — and It’s Changing the World as We Know It.” Hosted by CoinTelegraph’s Kristina Lucrezia Cornèr, its panelists are visionaries and leaders from SwissBorg, Kraken Europe, Coral Capital, and CasperLabs platforms.

Lucian Aguilar of Kraken stated that the spirit of DeFi and its narrative shifted from shilling new and existing projects to “building, adapting and innovating.” Patrick Horsman of Coral Capital added that projects operating similarly to the Terra network created an unsustainable DeFi ecosystem.

Such projects undermined DeFi’s ambition of creating a financial inclusion solution that empowers marginalized communities. Decentralized finance can lower the existing prejudicial disparity in the traditional finance system, but it must first be self-sustaining.

SwissBorg’s Alexander Fazel said that “there’s no better way to earn wealth than in DeFi .” Speaking of the rising Web3 and metaverse projects and trends such as Axie Infinity and STEPN, Fazel said that DeFi has proven that it can help its users “generate wealth without necessarily having wealth in the beginning.”

The “building, adapting, and innovating” trend in DeFi is heating up as Ethereum approaches the Merge. The Merge is a sunny spot in the ongoing crypto winter, signaling the decentralized finance network’s shift to the proof-of-stake consensus algorithm.

This technical upgrade development will place ether holders at the heart of the smart contract network’s sustainability and future. Slated for August 2022, the Merge will, for instance, eliminate the millions in gas fee charges that Ethereum users pay to miners daily.

Additionally, it will lower Ethereum’s network carbon footprint and congestion. The Merge will also speed up the DeFi ecosystem major upgrade, DeFi 2.0. DeFi 2.0 protocols will unchain the ecosystem from unsustainable trends that have given rise to flaws such as capital insufficiency.

DeFi 2.0 benefits

DeFi 1.0 comprises innovative financial services such as decentralized exchanges and their liquidity pools, lending and borrowing platforms, payment gateways, and DAO governance. These blockchain innovations have had a profound impact on the financial landscape.

They have, for instance, demonstrated that technology and decentralization could solve some of the world’s most challenging financial service provision difficulties.

That said, the first iteration of the DeFi ecosystem has risks such as impermanent loss, rampant insecurity, and low decentralization. DeFi platform users also suffer slippage due to inconsistent or insufficient liquidity. In contrast, DeFi 2.0 will usher in benefits such as:

Protocol owned liquidity

DeFi 2.0 creates a safer, scalable, and sustainable DeFi ecosystem by first eliminating platform reliance on subsidized liquidity. DeFi protocols such as Olympus DAO, for instance, create protocol-controlled liquidity for sustainable platform growth.

Consequently, DeFi 2.0 protocols will no longer have to water down their token governance supply to incentivize fleeting deposits. Instead, protocol-controlled liquidity has long-term sustainability and creates a revenue stream for DeFi 2.0 platforms.

Due to this feature, DeFi platforms will earn trading fees after purchasing liquidity from users.

Capital efficiency

Another DeFi 2.0 trend is the enhancement of capital efficiency in locked-up funds. For instance, the Mimo Protocol now integrates Uniswap V3’s DeFi 2.0 liquidity pools.

Uniswap V3 has a concentrated liquidity protocol that offers higher rewards to liquidity providers with higher exposure to preferred assets. Moreso, on Uniswap V3, the Mimo Protocol’s liquidity providers can set custom price ranges for their liquidity and enjoy lower slippage rates on their trades, just as they would on centralized exchanges.

Scalability and smart contract automation

DeFi 2.0 protocols not only tackle the poor capital usage but enhance DeFi platform scalability too. Most DeFi platforms, especially those that run on the Ethereum network, such as the Mimo Protocol, have to endure its legendary data congestion that slows down transaction speeds and increases network fees.

For this reason, the Mimo Protocol now operates on the faster and scalable Fantom and Polygon networks. But unfortunately, DeFi 1.0 also exposes its users to the blockchain trilemma risk of centralization. This is because many DeFi 1.0 platforms sacrifice decentralization metrics on the altar of security and scalability.

Mimo now leverages the DeFi 2.0 Gelato Network protocols to address the twin challenges of scalability and centralization. In addition, Gelato automates DeFi smart contracts. In late 2021, it raised $11 million in seed funding from its Series A funding round led by Dragonfly Capital.

Gelato’s network is now enjoying explosive growth as it automates blockchain smart contracts, a feature that could dominate the growing Web3 ecosystem. Hilmar Orth, the Gelato co-founder, says that smart contract automation is such a massive market that it will eclipse Google Cloud or blockchain oracle services in the future.

“What Gelato offers, rather than you building every bot from scratch for every single specific use case out there in Web 3, and there are millions, we just built a general-purpose protocol and network that you can plug into, and you can automate any function you want without having to build this infrastructure,” says Hilmar Orth.

Contrary to popular belief, DeFi 1.0 smart contracts rely heavily on entities that execute their commands. As per the Gelato whitepaper, the Ethereum Virtual Machine’s smart contracts are designed to run a few milliseconds at a time.

Consequently, the EVM’s smart contracts only store logic and state. “Without an outside impulse, they are functionally inactive. To execute their logic and change their state, they require an external party to send a transaction to them in the first place”, the Gelato whitepaper states.

To this end, some smart contract projects build bots that execute their smart contracts, centralizing their operations. Other projects rely on a decentralized ‘keepers’ or ‘executors’ bot network for smart contract execution.

Like oracles, these bots form the middleware infrastructure that keeps the blockchain stack functional. They are, therefore, the pillars that support a hitch-free DeFi ecosystem. As an illustration, the MakerDAO network relies on an external “Maker Keepers” network for its liquidations protocol.

Any independent node can join the Maker keeper network and participate in its liquidation process. The process heavily incentivizes liquidation auctions, encouraging the keeper network to bid for the right to liquidate under collateralized DAI debt positions.

The keeper that earns the right to liquidate an under-collateralized debt position earns cheap assets in the auctions. The decentralized Maker keeper network allows the project’s developer and team to step away from the liquidation auctions process that underpins Maker’s billion-dollar TVL.

Consequently, the keeper network creates a trustless liquidation process free of central point of failure risks. Unfortunately, as efficient as the Keeper bot network is, it is also highly susceptible to systemic failure due to counterparty risks.

Gelato’s DeFi 2.0 smart contract automation protocols create economically sustainable bot incentives by doing away with the DeFi 1.0 capital-intensive and inefficient winner-take-all system.

Its smart contract automation processes match decentralized application developers and teams with a decentralized bot operator network. For instance, Gelato’s bot network can work in coordinated cohorts, performing vault liquidation in turns.

This process abolishes bot races creating an efficient automation process that is economically feasible for operators of all sizes. As a result, Gelato has created a profoundly decentralized and robust automated smart contract platform that supports liquidity provision management on Uniswap V3.

To this end, Mimo Protocol holders on Uniswap V3 can enjoy automatic management of their positions. As a result, they can optimize their debt payments and avoid getting ‘rekt’ should their collateral-to-debt ratio plunge to certain levels.

Gelato’s automation processes can re-organize your portfolio and sell your highest value collateral, covering any debt owed to collateral debt positions.

Smart contract insurance

DeFi 1.0 users lost over $10.5 billion to risks such as smart contract exploits in 2021. For instance, the Axie Infinity community lost $552 million worth of crypto to a Ronin sidechain hacker. DeFi 2.0 can lower user risk by instituting smart contract insurance protocols at a fee.

Impermanent loss insurance

DeFi 2.0 can provide liquidity provision management and impermanent loss insurance from user-generated fees.

DeFi 2.0 risks

DeFi 2.0, like Ethereum’s Merge event, is a gamechanger. But, all these dynamic changes in DeFi operations can create vulnerabilities that could cripple some platforms. These risks include;

Regulatory risks

Governments worldwide are taking a keen interest in the blockchain sector. However, DeFi 2.0’s heightened focus on decentralization is a feature that most regulators may strive to eliminate.

User experience challenges

DeFi cannot enhance financial inclusion due to its rigid user experience metrics. In addition, DeFi 2.0 could increase DeFi platform complexity for its users, adversely affecting mass adoption.

Impermanent loss

While the DeFi 2.0 platform can offer impermanent loss insurance, it does not offer a one-off solution for impermanent loss caused by market volatility.

Conclusion

At the heart of the DeFi 2.0 movement are robust relationships between users and decentralized applications. This ecosystem will offer its users sustainable incentive schemes, community-based governance structures, and unlimited financial and technological innovation scope.

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