DeFi 2.0 is a new phrase in the blockchain world that refers to a subset of DeFi protocols built on prior DeFi breakthroughs like yield farming, lending and other things. Many on-chain systems with native tokens experience liquidity constraints, which is a crucial focus of notable DeFi 2.0 implementations.^[2]

Overview

Decentralized finance, commonly known as DeFi, has been one of the most impactful and successful waves of blockchain-based innovation. Powered by blockchains with built-in smart contract functionality and secure oracle networks like Chainlink, DeFi refers to the wide range of decentralized applications that disintermediate existing traditional financial services and unlock entirely new financial primitives.^[2]

Fueled by their inherent advantages of permissionless composability and open-source development culture, DeFi protocols are constantly advancing and iterating upon proven models of financial-based agreements. The DeFi ecosystem moves at a lightning pace—over the past few months, a rising movement of liquidity-focused DeFi projects has brought forth a new wave of DeFi innovation, commonly referred to as DeFi 2.0.^[1]

Early DeFi pioneers such as Uniswap, Aave, Bancor, MakerDAO, Compound have constructed a solid foundation for the burgeoning DeFi economy allowing for on-chain yield for deposits and permissionless access to operating capital and adding many critical and composable "money LEGOs" to the ecosystem.

The fundamental problems now preventing the sector from becoming sustainable are the sector's reliance on third-party providers and token incentives to secure liquidity, as well as DeFi's essentially non-existent correlation with traditional finance and the global economy. The entire purpose of DeFi 2.0 and beyond is to address these issues.

Some of the DeFi 2.0 movement's pioneers are focused on developing methods for long-term liquidity.

Building protocol-controlled value mechanisms is another way DeFi 2.0 is expected to help decentralized automated organizations (DAOs).

Limitations of DeFi 1.0 and solutions that helped DeFi 2.0 projects expand

Scalbility

High fees and extended wait times for approved transactions continue to strain the user experience. As we all know, most DeFi solutions are built on the Ethereum blockchain and owing to the enormous number of users on the network, there are considerable delays and transaction costs are skyrocketing. As a result, users with less than a few thousand dollars make using DeFi devices unprofitable.
As a result, the question arises: How can users experience DeFi without dealing with Ethereum's scaling issues?

The cash flowed to BSC, Polygon, and Solana, which are some of the blockchains that can deliver what users require the most. The next market wave could be triggered by solutions to the scalability problem.

DEXs and AMMs without altering the token's price

All cryptos require liquidity. While incentive programs can provide temporary respite, they are far from ideal and pose a more significant underlying risk for small investors.

The simplest solution to the liquidity problem, or to entice additional users and capital into the DeFi market, is to assist them in earning yields. Third-party liquidity providers on AMM protocols provided a partial solution to the liquidity problem, allowing any independent person with sufficient funds to provide liquidity for a token pair.

In the summer of 2020, when yield farming (also known as liquidity mining) became available, there was a rise in DeFi activity, dubbed "DeFi Summer" by blockchain specialists. The concept of yield farming is straightforward. Users offer liquidity for an exchange pair via an AMM protocol, receive an LP token in exchange, and then stake the LP token for returns in the project's native token.

This approach addresses the chicken and egg dilemma by providing a strong economic rationale for third-party liquidity providers to supply a token's higher return. They might earn even more yield by staking and getting more of the project's native token, in addition to generating higher cumulative fees on AMM swaps due to deeper liquidity.

New DeFi protocols were able to bootstrap significant amounts of liquidity to launch and sustain operations and minimize slippage for users entering their ecosystem, thanks to the advent of yield farming. As a result, the number of DeFi protocols has increased exponentially across the board, demonstrating how yield farming has lowered the cost to entry for both users and DeFi project creators.

Yield farming has proven to be an effective means of bootstrapping funding for DeFi projects, but it is not without risks in the long run. Moreover, due to the specific limits of long-term yield farming projects, it does not fully solve the liquidity problem by itself, despite its effectiveness.

Most DeFi projects must undertake yield farming initiatives and bootstrap liquidity since it is necessary and healthy. Still, project teams must be cautious of their token supply and long-term yield farming tactics to avoid negative, long-term consequences.

Centralization

Apart from the fact that people come to DeFi to generate money, they also come to DeFi to pursue independence and be self-sufficient. Nonetheless, a group still controls a large number of DeFi protocols, leading to a loss of faith among DeFi users.

To address this issue, DeFi projects have a propensity to prioritize the decentralized aspect. The DAO, which allows anybody to vote on the project's evolution, has exploded in popularity in recent years.

Inefficient asset use

People, especially in crypto, have short attention spans, and people are moving away from DApps to pursue bigger financial prospects. Yields are not as appealing as they once were, particularly for DeFi's blue chips. This has resulted in a recurrent farm and dump scenario, resulting in unhealthy cash flow for practices and many other issues.

DeFi 2.0 will be able to do the following with projects focusing on capital efficiency:

• Optimize TVL: Allow deposited assets to be used to their full potential.
• Create a sustainable cash flow: As demonstrated by Olympus DAO, the system for exchanging LP tokens for bonds reduces the frequency of farm and dump situations while also providing long-term liquidity. Therefore, maintaining a good cash flow allows projects to expand more sustainably and attract more backers.

DeFi 2.0 vs DeFi 2.0

Currency transactions are required to create a DeFi 2.0 decentralized financial system that is both sustainable and automatically distributed. Decentralized finance in the DeFi 2.0 stage is more likely to connect all community members who supply liquidity. Liquidity incentives are being pushed to connect relationships in all future transactions to build a warm, sustainable and interconnected decentralized financial architecture.

It is committed to breaking DeFi 1.0's cold transaction mode, expecting users to develop close horizontal connections while forming strong vertical ties, as it advocates for close user relationships.

Control of DeFi 2.0

There has always been a decentralization trend with blockchain technology. DeFi is no different. With all these mentioned features and use cases, one of DeFi 1.0's first projects, MakerDAO (DAI), set a standard for the movement. Now, it's increasingly common for projects to offer their community a say. 
Many platform tokens also work as governance tokens that give their holders voting rights. It's reasonable to expect that DeFi 2.0 will bring more decentralization to the space. However, the role of compliance and regulation is becoming more important as they catch up with DeFi.^[3]