Explained: DeFi 2.0 and the improvements it will bring to the world of decentralised finance

The second generation of DeFi protocols aims to improve on the shortcomings that projects and users currently face in this budding space.

Tag along as we explain what DeFi 2.0 is and what improvements it could bring to the world of decentralised finance.

Before diving into DeFi 2.0, it is essential to understand the first generation of decentralised finance and what it brings to the table. In a nutshell, DeFi is an umbrella term for several peer-to-peer financial services that are hosted on public blockchains, most commonly Ethereum.

The central premise is to allow anyone with internet access to lend, borrow, trade assets, buy derivates, and more without going through any middlemen. Instead of depending on intermediaries such as banks and other third parties, DeFi protocols automate everything through smart contracts.

DeFi 2.0 is not a revolutionary update to its predecessor. Both concepts stem from the same general idea and philosophy: to create a peer-to-peer, pseudonymous, and open to all banking system, free of any middlemen and third parties.

DeFi 2.0 merely aims to solve the problems currently hindering the decentralised finance industry. Therefore, to understand what the next generation of DeFi protocols stands for, we must look at the issues it is trying to solve.

The DeFi space is filled with instances of hacks, attacks and smart contract bugs that result in enormous losses for users. There is also the risk of impermanent losses. This occurs when the price of a token falls while a user's funds are locked in a DeFi protocol. Therefore, when the funds are withdrawn, they could be worth much less than what they were worth when deposited.

DeFi 2.0 platforms allow users to take out insurance against such losses. This can be very helpful for novice investors and help safeguard users against the volatile nature of cryptocurrencies.

Despite being a revolutionary concept, DeFi protocols were not scalable. Transactions often took very long, and in some instances, gas fees made the regular banks look saintly. This is because most DeFi protocols were built on the Ethereum network, which is sluggish and expensive.

Now, with DeFi 2.0, other popular blockchains such as Solana, Cardano and Polkadot have also entered the decentralised finance space, helping DeFi enter the mainstream. It also ensures that transactions are quicker and more affordable.

The UI and UX of current DeFi platforms are not user-friendly, especially for newbies. It's one of the reasons why seasoned crypto enthusiasts populate the DeFi space. Therefore, if DeFi 2.0 platforms aim for mass adoption, they must be user-friendly and easy to use.

While the goal of DeFi was to offer banking services without intermediaries, DeFi projects still suffered from some elements of centralisation. With most DeFi protocols, customer funds are stored in smart contracts, which are often controlled by a particular group of individuals, such as core devs and project founders.

Flavours of centralisation also became evident when a strew of DeFi protocols, such as Celsius, Three Arrows Capital, and Lido began freezing customer funds in the last couple of months.

To address this issue, the second generation of DeFi projects has started to turn towards Decentralized Autonomous Organizations (DAOs) to govern project operations. With a DAO, anybody can vote on the project's evolution.

DeFi 2.0 protocols also look to unlock the value of staked assets. For instance, with the first iteration of DeFi, users who staked a token pair in a liquidity pool would receive liquidity provider (LP) tokens in return.

These LP tokens could again be staked (a process called yield farming) to earn even more returns. However, this is as far as one could go in terms of value extractions. DeFi 2.0 takes things a step further, allowing users to submit LP tokens as collateral for loans.

Another benefit that DeFi 2.0 brings to the table is self-repaying loans. Usually, when you take out a loan, there is always the issue of interest payments and the risk of liquidation. However, with DeFi 2.0, the collateral you offer could be used to earn returns and pay off the loan. Once the lender has collected the loan amount plus some extra premium, the deposited collateral is returned to the borrower.

DeFi provided several breakthroughs and was also hit with many blunders as well. DeFi 2.0 aims to build on the breakthroughs and address the blunders to provide simplified and more democratised finance offerings.