DeFi 2.0, 3.0 And DeFi Crypto Innovation

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Disclaimer: Crypto is a fast-paced economy and things change quickly. Information on this post might be outdated even if written today. Do your own due diligence and stay safe. I might get affiliate commissions for purchases made through links in this post. Read the disclosure.

Alpha Gained:

In DeFi 1.0, crypto space introduced the concept of swapping, transferring, mining, farming, etc. different monetary assets or tokens without an intermediary. DeFi at its core is a way to do monetary transactions trustlessly and without a third party.

With great innovations comes a new set of problems. Problems that the next generation of blockchains and dApps try to solve. Ethereum has performance problems that show up as slowness and high gas fees. Uniswap, while being the biggest DEX out there still suffers occasionally from liquidity problems with different token pairs and also limits itself to a few blockchains.

The Fiat Money

For us to understand the innovations behind DeFi, we have to understand what is money and why it has or hasn’t value. The very first sign of “money” was when coins were used as a medium of exchange roughly 5,000 B.C. Gold was used as a medium of exchange in roughly 1500 B.C. by the Egyptians. This kind of behavior later created the economy of the current day. Exchanging something valuable to either good or to something else that is considered valuable for a person.

Paper Money – The Gold Standard

All the way, until 1971 the USD was backed by gold. Meaning that instead of holding heavy gold coins with you, you were able to carry lightweight paper currency and that paper holds the same value as gold coins. However, after 1971, paper currency and gold weren’t exchangeable anymore at the same rate it was previously possible. Later on, the paper currency started to suffer inflation as the good price was increasing and the dollars you had, didn’t give you the same results it had previously given. Thus the value of the currency declines and that has been the case from the 1930s for the USD. And it doesn’t help that the currency is printed more and more, making the USD lose its value even more while giving people the opportunity to buy more stuff.

Role Of The Treasury

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Role of the U.S. treasury visualized

The U.S. Department of the Treasury’s mission is to maintain a strong economy and create economic and job opportunities by promoting the conditions that enable economic growth and stability at home and abroad, strengthen national security by combating threats and protecting the integrity of the financial system, and manage the U.S. Government’s finances and resources effectively.”

Key functions of the treasury are to print bills (decides how much money will be printed to the circulation), postage, and federal reserve notes, mint coins, collect taxes, enforce tax laws, etc. Almost anything related to money and economic health (if there’s such).

Decentralized Finance Money

First, we need a blockchain where a developer can create a token. Blockchain is always a coin in crypto terminology and the token is a crypto dApp using a blockchains network. However, whenever you are minting a token, you need the blockchain’s native asset to pay the transaction fees (gas fee). Creating a token for example to BSC (Binance Smart Chain) can only cost like $50, but if you are creating a serious project with a long-lasting effect on the crypto world, it can cost thousands (marketing, token development, etc.), but the actual token minting still stays ridiculously cheap.

DEX 1.0 Liquidity

When a token is launched to the public either through a launchpad as an initial coin offering or through DEX’s (Decentralized Exchange) as an initial dex offering, the results are the same. The token is released to the public and people like you and me can start trading that token. And by doing this activity, we slowly but steadily set the price for the token. More demand for the token, and the price goes up, less demand and the price goes down.

Liquidity Pools

And so what it comes down to is that in decentralized exchanges, liquidity is provided by the users voluntarily. Anyone can create a liquidity pool. A liquidity pool is asset storage that holds a token pair e.g. USDC and ETH. These pairs can be traded inside the liquidity pool, and this transaction happens through swaps. So when a liquidity pool has the tokens you want to trade then a swap is possible. However, there are a few problems when it comes to liquidity pools and one is that a liquidity pool can’t exist if no one is offering a certain token pair in a dex.

CEX Liquidity

Centralized exchanges (CEX) have deep liquidity but they also do have a deep user base. Millions upon millions of users log into their KuCoin, Binance, or Coinbase account and start trading tokens to tokens and the trading experience is fast, efficient, precise, and pretty easy to do. Liquidity is simply said money, how much money reserves the exchange has and it seems they have a lot. And the reason for this is simple. When a token is launched in a cex, they already have plenty of USDT, and so they only need the token e.g. DREAMS to their exchange. When the token is up for trades, the liquidity is there and thus the trading can begin.

When we think about CEX’s there are a plethora of USDT trading pairs available. And this massive selection of trading pairs makes CEX’s more enticing than what DEX’s currently offer. And it does not help that DEX’s are a bit blockchain specific, though SUSHI and ANY are making headway on integrating different blockchains into them, creating a web of blockchains to bridge and swap assets. However, the liquidity problem is still present no matter how many blockchains you integrate with. You still need the liquidity and the more DEX’s there is the more split the liquidity becomes.

Transferring assets from one chain to another or making a swap needs liquidity inside the dex, and that liquidity is given by people (willing to offer a trading pair). So when there’s no liquidity, transactions don’t go through and you might lose your money bridging or swapping assets, as there’s no liquidity to pull tokens for you or transfer tokens for you.

TVL (Total Value Locked)

So then we come to the total value locked part, and this number tells you how much money is locked into a DeFi protocol. Naturally, the more TVL a DeFi protocol has the better chances you have of finding your token and the needed token pair to trade. This, however, creates the problem of liquidity mercenaries. As different DeFi protocols offer different incentives to entice the money being locked up in their protocol, we get people who jump from one protocol to another, taking the liquidity with them. This is also the reason why TVL changes rather than goes up infinitely. At one point Fantom blockchains DeFi might be growing measured in TVL value, but next week, that liquidity might be moving to Avalanche instead.

Stablecoins

In DeFi 1.0 stablecoins were presented to the world. Stablecoins that would hold their value at $1, regardless of how much there was price volatility in the crypto world. Stablecoins are pegged to the USD and this means that the USDC, USDT, or some other USD pegged stablecoin is following the value of the real USD currency. However, here lies the whole issue, when a stablecoin follows the price of USD, and we know USD’s value is decreasing then also the value of the stablecoin is decreasing and thus we shouldn’t own stablecoins in the first place, except if you can stake it to a protocol that offers high yield like Anchor protocol for UST staking.

UST Stablecoin Mechanism

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UST – LUNA Seigniorage mechanism visualized

UST is the stablecoin of Terra (Terra is built by using Cosmos SDK and uses PoS consensus mechanism) and pegged to USD. When the price of UST goes up for example to $1.02, you can sell $1 worth of LUNA for 1 UST, making a $0.02 profit. Doing this brings the value of LUNA up as now it’s more scarce and thus more valuable. 

When the price of UST goes to $0.98, UST holders can sell it for $1 worth of LUNA, bringing the scarcity of UST back to the normal level of $1, while also making a profit of $0.02.

All of this is possible with mining incentives. When the UST price goes through contraction (UST is less than 1), the mining power is diluted. The system gives more mining power to buy back and burn LUNA. This will be done in the short term, however, in the long term, the system continues to buy back mining power and gives greater mining rewards for the miners. All in all, the miners bear the cost of volatility in the short term but will be rewarded in the long term. Miners stake LUNA to mine Terra transactions.

Token Burn

Whenever a token is burned, it makes the supply go down the amount it was burned. When a token has a fixed supply, it creates scarcity and if there’s a natural demand for the token, the token price should go up as there’s less of it available. A token with a fixed supply is naturally deflationary (limited supply), but to make it more deflationary, you can burn tokens and raise the price that way.

DeFi X Innovation

As the first iteration of DeFi has given us a lot of promise and new ways to interact with each other, it also has its shortcomings as stated previously. Most of the stablecoins are dollar-backed and thus they are not immune to inflation as the USD is decreasing in purchasing power.

However, a new era in DeFi is starting to rise, with the introduction of Olympus DAO (the decentralized reserve currency). The idea behind OHM is that it creates a true store of value. The reason why stablecoins can’t be seen as stores of value is that they are (currently) mostly pegged to USD and thus are affected by the physical world’s inflation. Bitcoin on the other hand suffers from market crashes and manipulation (until true mass adoption has occurred). Thus OHM tries to create a true store of value that is immune to the before-mentioned cases.

OHM is designed to grow in value despite market prices, and also presents two new concepts called POL (Protocol Owned Liquidity) and floating-market-driven price. OHM is aiming to become a reserve currency protocol. The backing does not happen directly with the USD or with the physical world assets or currencies but using DAI. So each OHM token is backed by DAI, 1:1.

OHM Mechanism

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Olympus DAO Treasury mechanism visualized

When OHM is trading above its backed asset (DAI), the OHM protocol mints and sells new OHM’s to the market, increasing supply, driving the price of OHM down. When OHM’s value is below its backed assets the OHM protocol buys back tokens and burns the tokens, decreasing the overall supply and bringing the OHM’s price back to the needed level. This way the OHM’s value is always the same as its backed assets value or more.

OHM also expands its treasury through bonds. A buyer can sell different assets to the protocol to get OHM at a discounted price. This event locks in liquidity to the protocol through different assets. Bond sales are also used to create the rebase staking rewards. The reward rate is set by the monetary policies and can vary.

The general idea behind the high APY is that the person would not withdraw his/her funds even if the OHM price fluctuates. If a huge bank run would happen (massive unstaking and selling and everything), the OHM protocol makes sure the high APY reward is one that will make people buy OHM again and stake it to the protocol, and start earning massive APY rewards again.

The rewards are given 3 times a day or at every 8-hour epoch (characteristic of Ethereum chain) and are called rebase rewards. The rewards will also auto compound (mechanism presented in PancakeSwap) so that you don’t have to do anything but stake and “forget”. The beauty in OHM protocol is that even if the price of OHM drops drastically, the high APY covers the loss in price value, but in this case, the staking period needs to be longer than shorter.

The DAI

The DAI is a stablecoin created and governed by the Maker DAO community. Dai is a decentralized, unbiased, collateral-backed cryptocurrency soft-pegged to the US Dollar. Resistant to hyperinflation due to its low volatility. Every Dai in circulation is directly backed by excess collateral, meaning that the value of the collateral is higher than the value of the Dai debt, and all Dai transactions are publicly viewable on the Ethereum blockchain. To generate Dai, the Maker Protocol accepts as collateral any Ethereum-based asset that has been approved by MKR holders.

The High APY

At the time of writing: 7,371% with $3,648,556,814 TVL and an index of 36.8OHM.

The usual APY calculation formula, where everything comes down to the rewardRate which is rarely information given to the public.

OHM Forks

With the high interest in OHM protocol and the massive value locking that OHM garnered a new wave of OHM forks hit the market. There are new OHM forks being made daily and they all bring in higher and higher APY’s. One of the reasons these forks have been pretty successful is that they are built on either Avalanche or Fantom network. These blockchains offer faster transactions and lower fees, making the staking process that much more pleasant compared to Ethereum (which lacks on both fronts).

Wonderland (TIME) Fork

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Wonderland ($TIME) treasury mechanism

Wonderland is more or less a direct copy of Olympus DAO with the exception that it is launched in the Avalanche network and offers massive APY. With Wonderland, you stake TIME and receive sTIME (staked TIME) and each TIME token is backed (not pegged) to a basket of assets like e.g., MIM, TIME-AVAX LP Tokens, etc. So in a sense, it cannot fall below 1MIM, though that is not clearly stated on the documentation. MIM (Magic Internet Money) on the other hand is pegged to USD but backed by interest-bearing tokens. And the MIM mechanics is pretty much the same as in Terra UST.

APY at the time of writing: 82,632.4% with $1,888,873,153 and index of 3.94 TIME

What makes TIME special is that you can buy TIME with MIM, and you can trade AVAX for MIM, but you can also borrow MIM with AVAX and then things get interesting. Let’s assume you are long on AVAX, you could just buy a lot of AVAX, borrow MIM with the AVAX you put to Abracadabra protocol, and then buy TIME with the MIM you got and get double profit with only 1 capital.

DEX Owned Liquidity (DOL)

As mentioned before, one of the shortcomings of current DeFi protocols like Uniswap is the liquidity pools are created by people and all the trading pairs available are limited to the amount people are willing to put into the pool. When a certain trading pair pool doesn’t exist a trade can not be done. As the DeFi space is going through an evolution, so is the liquidity pool and Babylon DAO is one of the first ones to present a DEX-owned liquidity pool, and rather than being a fork, it’s built from the ground up on Solana.

The mechanics are pretty much the same as in Olympus Dao and in Wonderland. The main idea is to build a large treasury that holds multiple interest-bearing tokens and from that protocol-owned liquidity, you can create a decentralized owned liquidity.

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Written By Juha Ekman

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