DeFi 1 showed what is possible in the world of decentralized finance, but it also showed some of the space's potential pitfalls in terms of hacks or exploited smart contracts and liquidity. DeFi 2.0 aims to solve those issues, creating a safer and more sustainable ecosystem.
Liquidity and the Money Printing Problem#
Many DeFi, and indeed crypto CeFi companies that offer yields, manage to attract liquidity providers by offering appealing yield percentages however they're not paying the yield in a stablecoin or even the token that the liquidity provider stakes. Instead, they offer it in the form of their own token. In the short term, this can work well when a project is new and exciting. However, it's not a sustainable business plan. We outlined some of the different problems associated with mixing token returns with policy fee returns for DeFi LPs in our article “All that Glitters is not Gold”.
DeFi platforms face a tricky balancing act; they must keep printing tokens to sustain high yields and retain liquidity providers. However, as they print tokens, this devalues the ones already in existence, creating sell pressure for those tokens. Some platforms attempt to mitigate this issue by requiring providers to lock up their funds for a very long time. Crypto.com, a hybrid CeFi platform with a DeFi wallet, sustained demand for its token CRO by requiring users to stake large quantities of the token to access certain benefits. However, as users reached the end of their lockup periods, they chose to sell, creating downward price pressure for the token.
With the DeFi 1 model, platform owners find themselves faced with a difficult balancing at:
- Continue minting tokens to give away, and risk devaluing them and losing liquidity providers as a result, or
- reduce rewards, and lose liquidity providers as they move on to newer projects.
DeFi 2.0 Presents a New Solution#
DeFi 2.0 takes a new approach to liquidity. Olympus DAO pioneered the idea of the Protocol Controlled Liquidity. Rather than relying on liquidity providers, Olympus controls 99.5% of the liquidity in the pool. The concept of protocol-owned liquidity benefits OlympusDAO liquidity pools because it makes them more stable in the long run.
Olympus makes use of a decentralized reserve currency called OHM. Each OHM is backed by, at a minimum, one DAI stablecoin on Ethereum. Currently, the backing is much greater than that, with each token backed by a range of other tokens, including ETH, LUSD, FRAX and DAI. The minimum support provides a stable and predictable floor for the tokens. Users can purchase OHM via a 'bonding mechanism' that lets them convert other pools' tokens to OHM at a discount. This bonding mechanism aims to allow protocols to buy liquidity when they need it and stabilize their pools.
The price of OHM is dynamic and based on demand. This helps prevent excessive supply expansion, and a hard cap on the total liquidity acts as a final safety measure.
Olympus DAO may have pioneered these ideas, but now many other protocols offer similar features, such as Wonderlad, Hunny DAO and Klima DAO. These protocols also hope to improve on DeFi 1 in different ways by providing the following:
- Improved decentralization thanks to the use of DAOs
- Increased scalability
- Reduced reliance on stablecoins
How Neptune Mutual Is Helping DeFi Insurance Scale#
Neptune Mutual is planning to leverage DeFi2 to bootstrap liquidity to fund its expansion in the DeFi Insurance space by leveraging a new bond pool system once the NPM token has been launched. The bond pool will offer fixed-term bonds. These bonds will allow users to purchase NPM tokens for a discount on the market rate at the time of purchase. For example, a Neptune Mutual user can provide liquidity to a DEX by investing an NPM/stablecoin pair into the pool, receive DEX LP tokens in return, and then contribute those tokens to the Neptune Mutual bond pool in return for discounted NPM tokens.
The fixed-term bond pool system encourages LPs to provide liquidity to the DEX pool with NPM/stablecoin, and provides token incentives for LPs that decide to participate in the Neptune Mutual bond pool with the LP tokens they received from the DEX. This mechanism motivates LPs in a way that is sustainable for the Neptune Mutual community and NPM token holders as it does not drive inflationary token price pressure. Similar to OlympusDAO, the bond pools will also fund Neptune Mutual's cover liquidity pools via our partner network in addition to decentralized exchange liquidity pools. Neptune Mutual will transfer protocol-owned liquidity on decentralized exchanges to protocol-owned liquidity on cover pools, which is a significant difference. In the future, a comprehensive explanation of how this operates will be made available.
As the DeFi space grows and the marketplace matures, users are becoming increasingly aware of the risk of hacks and smart contract bugs, as well as rug pulls. Insurance pools can mitigate the risk of smart contract hacks, but for DeFi insurance to work, underwriting liquidity must keep up with the growth of DeFi as a sector.
DeFi 2.0 Is Crucial for Widespread Adoption#
While many tech-savvy and motivated users have already adopted the tools DeFi offers, cryptocurrencies, DeFi and Web3 have yet to reach the mainstream. Some of the slow pace of adoption can be attributed to confusing wallets, poor UX design of DEXes and dApps, and however it is clear in the DeFi insurance space in particular, the sector needs to grow rapidly, and this means adopting a whole variety of scalable solutions including DeFi2 liquidity bootstrapping, a scalable, transparent and fair model to remunerate LPs that underwrite cover pools, and a scalable solution to incident resolution so that cover policyholders get reliable and fast payouts when an incident occurs.
The level of risk associated with DeFi is another factor hampering adoption, however, and insurance pools go a long way towards reducing that risk. For example, the Neptune Mutual project provides parametric insurance for an extensive list of projects on Ethereum and Arbitrum. Those who offer underwriting liquidity stand to earn yields from their contributions, while users of the insured protocols are assured their funds are protected.
If you'd like to learn more about Neptune Mutual's underwriting liquidity pools, check out the app today.
