Understanding DeFi 2.0

JUNE 18TH, 2020

DeFi 2.0 is a new term in the ecosystem that refers to a subset of emerging protocols that are built on top of the initial money LEGOs to advance the current DeFi landscape, primarily in the form of liquidity provisioning and incentivization.

Early DeFi pioneers such as Uniswap, Bancor, Aave, Compound, MakerDAO, and others laid the groundwork for the developing DeFi economy, introducing a slew of critical and interchangeable "money LEGOs" into the ecosystem.

Uniswap and Bancor were the first decentralised automated market makers (AMMs), allowing users to seamlessly swap tokens without giving up custody. Aave and Compound pioneered decentralised lending and borrowing, offering on-chain yield for deposits and permissionless access to working capital. MakerDAO allowed ecosystem users to hold and transact in a decentralised stablecoin, providing a hedge against cryptocurrency volatility.

Users gained access to reliable exchanges, frictionless lending/borrowing, and stable pegged currencies via these protocols—three core financial primitives widely available in traditional financial markets. However, in terms of transparency and user control, the infrastructure underlying these familiar DeFi-based services is vastly different from that of centralised organisations. The various technological implementations that underpin each of these decentralised services form the foundation for DeFi innovations.

Liquidity Provider (LP) tokens in Automated Market Maker (AMM) Decentralized Exchange (DEX) protocols are a key example of a blockchain-specific DeFi innovation. While DEXs serve as an effective substitute for centralised order-book exchanges, the most popular DEXs use an AMM model known as a Constant Product Automated Market Maker (CPAMM).

Individual liquidity providers commonly contribute equal amounts of each cryptocurrency to an exchange pair's liquidity pool in decentralised liquidity pools in AMMs to facilitate token exchanges. In exchange, they receive an LP token that represents their share of the liquidity pool as well as the fees earned from facilitating swaps.

As LP tokens were quickly adopted by other DeFi protocols in a variety of ways, they triggered a cascading flow of DeFi innovation. Lending protocols such as Aave and Compound, for example, iterated on the idea of providing users with receipt tokens that represented an underlying deposit, which are now known as aTokens and cTokens.

The permissionless nature of AMMs and LP tokens also empowered DeFi startups, as they were no longer required to go through a centralised exchange listing process for their launched tokens. With enough liquidity, newly launched tokens could be traded on a DEX right away. However, in the absence of sufficient liquidity, the token exchange function of a DEX loses utility, with users forced to pay exorbitant fees for large swaps due to slippage. This resulted in one of the most visible issues in DeFi today: the liquidity problem.

Since the early days of the DeFi economy, liquidity has been a source of frustration for many emerging DeFi projects. Tokens power the entire ecosystem, serving as a means for teams to align participant incentives, collect rewards from user fees, and become composable with the larger DeFi ecosystem. However, DeFi teams required access to a large pool of funds in order to provide users with a reliable source of liquidity to trade their tokens on AMM protocols.

Third-party liquidity providers on AMM protocols provided a partial solution to this problem, allowing any independent person with sufficient funds to provide liquidity for a token pair. Instead of provisioning liquidity themselves, teams could theoretically obtain sufficient liquidity from others. However, there were few incentives for end-users to bootstrap liquidity for a new token, as doing so would entail exposing themselves to the risk of temporary loss in exchange for a small fee revenue from swaps. They needed a compelling economic reason to take the risk.

This created a chicken and egg situation. Without a sufficient level of liquidity, the slippage caused by swaps discourages users from participating in the ecosystem of a DeFi protocol. There isn't enough fee volume generated without users participating in token transactions to incentivize third-party actors to pool their tokens and provide liquidity.

DeFi 2.0 refers to a few emerging DeFi projects that aim to revolutionise the common problems associated with liquidity provisioning and incentivization. They offer alternatives and supplements to the yield farming model, allowing projects to obtain liquidity that can be sustained over time. But how do blockchain-based projects using native tokens maintain a healthy amount of liquidity that is allocated optimally?

OlympusDAO's bonding model, which focuses on Protocol-Owned Liquidity, has risen to the forefront of the DeFi community in 2021. (POL). OlympusDAO's bonding model flips the yield farming script on its head. Rather than renting liquidity through yield farming initiatives that increase supply, OlympusDAO uses bonds to exchange LP tokens from third parties at a discount for the protocol's native token. This benefits the protocol as well as any project that employs the protocol (e.g. bonding-as-a-service). Protocols can purchase their own liquidity through bonds, eliminating the possibility of liquidity exits and creating a long-term pool that can also generate revenue for the protocol.

Users, on the other hand, are encouraged to exchange their LP tokens through bonds because the protocol provides a token discount. For example, if the price of token X is $500 after a 10% discount, the user can bond $450 in LP tokens to receive $500 in token X. The net profit is $50, based on a short vesting schedule (normally 5 to 7 days) to help prevent arbitrageurs from extracting value.

Another important feature of liquidity-focused bonds is that their prices change dynamically and can have a hard cap. This is useful for the protocol because it allows it to control two levers: the rate at which tokens are exchanged for liquidity and the total amount of liquidity exchanged.

When too many users buy bonds, the discount rate falls and can even become negative, allowing the protocol's token supply to grow at a slower rate. The protocol can also determine the desired amount of liquidity through a hard cap, in which bonds are no longer available, further controlling supply expansion based on precisely determined parameters.

This multifaceted model contributes to the realignment of incentives between third-party liquidity providers and on-chain protocols. Protocols are better positioned than an independent third-party liquidity provider to be exposed to impermanent loss. While third-party liquidity providers face opportunity costs similar to those faced by every other liquidity pool and yield farming protocol on the market, protocols have an additional incentive to maintain liquidity because it helps secure low-slippage swaps for users transacting with their native token, lowering the cost of entering their respective ecosystem.

Finally, OlympusDAO's bonding model enables protocols to better mitigate the risk of low liquidity in the long run. DeFi protocols now have more tools at their disposal, when combined with yield farming, to meticulously plan their growth phases, from initial liquidity bootstrapping to sustainable long-term growth.

Tokemak, a DeFi protocol that seeks to optimise liquidity and liquidity flow, is another liquidity-focused DeFi 2.0 project. To summarise, Tokemak at scale aims to facilitate liquidity via two distinct parties—the Tokemak protocol and liquidity providers (LPs), with the goal of efficiently decentralising liquidity flow via liquidity directors (LDs).

This is how it works. Take a look at the contents of an LP token. Liquidity providers are required to submit equal amounts of both currencies in a given exchange pair, resulting in temporary loss as weights shift and prices fluctuate. To combat this, the Tokemak protocol keeps reserves of stablecoins and layer-1 assets that can be used as base pairs for new tokens. One side of the liquidity pair is made up of this. Tokemak reserves contribute ETH to a Token X-ETH liquidity pool on Uniswap.

The Token X side of the liquidity can then be provided by independent third-party liquidity providers and DeFi projects. The spotlight then shifts to liquidity directors. Tokemak's native token is staked by liquidity directors to control liquidity flow, and both of these single-sided liquidity pools are used to direct liquidity to a variety of AMM protocols. As a result of this system, liquidity flowing through Tokemak contributes to the DeFi ecosystem's goal of efficient, sustainable liquidity direction.

Liquidity directors move liquidity through a voting mechanism, whereas liquidity providers earn Tokemak's native token for providing one-sided liquidity. Each party earns a variable yield that balances with the other to achieve an optimised ratio between liquidity directors and liquidity providers, ensuring that the number of directors is optimal for the amount of liquidity provided.

This can help new DeFi projects, especially those run by DAOs, as well as yield farmers and liquidity providers. To begin with, Tokemak's single-sided asset allocation enables DeFi projects to bootstrap initial liquidity solely with their native token, without the need for liquidity for stablecoins or layer-1 assets. Tokemak reactors can also provide a structure for collective decision-making on liquidity flow for DAO-based projects, while also providing third-party liquidity providers and yield farmers with mitigated impermanent loss.

Another subset of DeFi 2.0 protocols is building novel financial instruments on top of previous yield generation mechanisms and assets.

Alchemix, a self-repaying lending platform with a "no liquidation" design, is a prime example of this. The protocol lends out representative tokens that are pegged to the collateralized asset in a 1:1 ratio. Users, for example, can borrow 50% of the amount as alDAI by posting the DAI stablecoin as collateral. The underlying collateral is then deposited into yield-generating protocols, where it grows incrementally.

Alchemix can provide a liquidation-free lending platform by combining representative tokens and yield-generating collateral, allowing users to spend and save at the same time—with decreasing loan principal amounts as the collateral continues to generate yield.

Another DeFi 2.0 protocol, Abracadabra, uses a similar mechanism, but with a system that is similar to MakerDAO. Users can post yield-bearing collateral and receive the MIM stablecoin in exchange, allowing them to maintain exposure to the collateral while also earning yield and unlocking liquidity.

There would be no liquidity bonding, liquidity flow mechanisms, or yield-generating collateral without the early innovations that gave birth to the decentralised economy—AMM protocols, decentralised stablecoins, and price oracles. Every project, from the early stages of AMM LP tokens and decentralised stablecoins to today's DeFi 2.0 protocols, is a valuable iteration towards building the decentralised economy.