DeFi 2.0 Part 1: problems, solutions, plus a deep dive into Tokemak and OlympusDAO

Move over Play2Earn games – DeFi 2.0 is about to become the hottest topic of the crypto season. Projects like Olympus, Alchemix, and Tokemak already have hundreds of millions of dollars locked in their smart contracts. What attracts users to DeFi 2.0 – better usability, real innovation, or simply marketing hype?

What is DeFi 2.0?

DeFi 2.0 refers to a new generation of decentralized finance protocols that explore new ways to attract liquidity and users and make DeFi tools easier to use. But is it really such a radical improvement on ‘DeFi 1.0’ or mostly a marketing trick?

When a brand-new technology appears, we don’t call it ‘1.0’ – rather, we see it as disruptive and much better than what came before (which automatically becomes ‘legacy’). But after a while, the excitement of novelty wears off and we start to get annoyed with the bugs and UX flaws - until someone comes up with a 2.0 edition. The cycle of excitement, hype, and disillusionment begins again.

Examples are all around us. The original Nokia phones from the 90’s (cell phones 1.0) were replaced by smartphones; DVD rentals (home movies 1.0) gave rise to Netflix; and Bitcoin, with its hour-long processing times, now seems incredibly sluggish compared to Solana or Avalanche.

The first generation of DeFi protocols, such as MakerDAO, Uniswap, and Compound, also seemed brilliant and very disruptive when they appeared. Now, a couple of years later, it’s clear that decentralized finance 1.0 definitely has major problems; let’s look at them in some detail.

Low liquidity

The term ‘liquidity’ is sometimes used instead of ‘capital’, but it’s not the same thing. Liquidity is the ability to convert one asset into another without the price being affected too much; a market is liquid when for any seller there is a ready buyer.

Low liquidity is a perennial problem for smaller crypto assets, especially on decentralized exchanges where an algorithm calculates the price based on the asset ratio in a pool. A single large transaction can cause serious slippage (price change).

You can see the importance of deep liquidity from one simple fact. Uniswap remains the biggest DEX by trading volume, even though it doesn’t pay liquidity mining rewards the way many other DEXes do: users still flock to Uniswap because that’s where liquidity is.

Traditionally DeFi projects have tried to solve this through liquidity mining: encouraging users to supply assets to liquidity pools in exchange for rewards. But this way you are still limited to the assets in the pool; plus, users normally have to supply two assets in equal amounts (say, ETH and an ERC-20 token), and for many it’s inconvenient.

In DeFi 2.0: liquidity is procured from multiple sources in a decentralized way - and carefully directed where it is needed. This allows to minimize slippage.

Impermanent loss

Impermanent loss (IL) is the loss of value that liquidity providers face when depositing tokens on AMMs as opposed to simply holding or staking them.

In AMMs like Uniswap, an LP is entitled to a certain share of a two-asset pool (such as USDT and ETH). The asset ratios in a pool constantly change, and so do the prices. As a result, when the LP withdraws their funds, they get a different amount of each token versus what they deposited in the first place – and the USD value is different, too. If the assets in the pool are very volatile, the difference can be significant.

IL is more of a missed gain than actual loss, and it is called impermanent because it only becomes 'real' when tokens are withdrawn. The trading fees earned by LPs are supposed to compensate for the IL, but in case of strong volatility you can actually lose money investing in trading pools. In fact, a recent study shows that more than 50% of Uniswap v3 users suffer actual losses. One user even reported losing (or, rather missing out on) $400k.

In DeFI 2.0: there is no single clear solution to the problem of IL yet. In fact, only Bancor, a DeFi 1.0 protocol (and the first-ever AMM), offers a remedy with its IL insurance tool. But as the DeFi 2.0 narrative unfolds, we'll likely see new alternatives to traditional AMM pools, such as OlympusDAO's bonding program, for example (see below).

Capital inefficiency

Even when a DeFi protocol has a high TVL (total value locked), a lot of the deposited capital usually remains unused.  For example, in Uniswap v2 liquidity is distributed evenly across the whole price range from 0 to infinity – but since actual trading is concentrated within a certain price range, most of that liquidity never participates in trading. Uniswap v3 tries to fix the problem by allowing liquidity providers to select ranges where their assets will be traded (so-called concentrated liquidity), but few can manage to monitor and tweak the ranges as required.

Another aspect of inefficiency is low capital mobility: the funds locked up in one project can’t be utilized anywhere else; and if you decide to withdraw tokens from one Ethereum protocol to move them to another, you’ll have to pay a high mining fee.

In DeFi 2.0: all available liquidity is used and flows freely between markets - and even different blockchains – depending on where it’s needed. This way users can extract maximum gains out of their investments.

Farm-and-dumps

As projects scramble to attract liquidity, they have to offer higher and higher yield farming returns. The result is a very vicious cycle:

• farmers flock to the project with the highest returns →
• TVL (total value locked) grows rapidly →
• token price keeps growing →
• huge amounts of tokens are distributed as rewards →
• farmers dump the tokens to cash out the gains →
• token price and TVL collapse as farmers move to the next project
  

Many yield farmers are after short-term gains and don’t care about project fundamentals; they flip between projects on a weekly basis. Such rented liquidity is fickle and inflationary, because if you pay out 100% or more in rewards, you end up flooding the market with your tokens, and they lose value.

In DeFi 2.0: There is a move away from rented liquidity (i.e. yield farming) to protocol-controlled value (PCV), where projects own or at least have long-term control over the resources.

DeFi 2.0: a radical re-haul or meme?

Ultimately DeFi 2.0 may not be as radically different from 1.0 as iPhone 13 from the legendary Nokia 3310. And sure, projects do think of the marketing hype that the ‘2.0’ bit can help create around their tokens. But once you look beyond the meme value, you’ll see that these platforms offer some very interesting innovations.

There are already over a dozen protocols that position themselves as part of DeFi 2.0, including Tokemak, Alchemix, OlympusDAO, Ribbon Finance, Abracadabra Money, Klima DAO, Dot Finance, Rari Capital, etc. The majority run on Ethereum: as the home to the biggest DeFi 1.0 protocols, it’s also the natural place for the next generation of services to emerge.

It will be very interesting to see how DeFi evolves on next-generation blockchains like Solana, Kusama, Avalanche, Fantom, etc. Will they jump straight to DeFi 2.0, integrating all the useful features proposed by Olympus, Alchemix and others?

For us, the team of Pontem Network, this is more than an idle question. Pontem is an incentivized testnet for the Diem blockchain, which in turn is backed by Meta (formerly Facebook company). With Pontem, developers of Diem-compatible dApps will be able to gain initial traction and tap into liquidity across the ecosystem of Polkadot. The liquidity part will mean interacting with DeFi protocols – so if DeFi 2.0 becomes reality on Polkadot and Kusama, liquidity will be more readily available, making our task far easier

We plan to cover all major DeFi 2.0 protocols in a series of articles, but this time we’ll focus on just two of the most talked-about: Tokemak and Olympus DAO.

Tokemak

Why the strange name?

According to the official Medium blog, Tokemak is a ‘DeFi primitive designed to generate sustainable liquidity’. The website’s meta description reads simply ‘The Token Reactor’. What does all this even mean?

A bit of physics first. A tokamak (with an ‘a’) is a machine in the shape of a donut (torus) that uses powerful magnetic fields to confine plasma. It was invented in Russia, and the funny word ‘tokamak’ in Russian is an abbreviation of ‘toroidal chamber with magnetic coils’. In the future, tokamak reactors may be able to produce enormous amounts of energy through nuclear fusion.

Now you should see where the ‘Token Reactor’ part comes from. ‘Tokemak’ is a clever pun: it combines the concept of a powerful generator of energy (or, in our case, liquidity) with the word ‘token’. By the way, you shouldn’t confuse the Tokemak protocol  with Tokamak Network, an interoperability solution for Layer-2 protocols.

About DeFi primitives

Now let’s decipher the ‘DeFi primitive’ part. A DeFi primitive is a building block – a ready module designed for a specific task that you can integrate into a DeFI app. The key DeFI primitives include liquidity, margin (leverage), swaps, custody (escrow), oracles, flash loans, wrapped assets, auctions, arbitrage, etc.

Tokemak reactors

Tokemak is a liquidity primitive that aims to solve a whole host of DeFi problems. It should supply liquidity that is sustainable (i.e. doesn’t come from inflationary yield farming), fluid (moves between markets), decentralized, and capital-efficient (i.e. fully used).

Tokemak achieves this through a network of reactors (liquidity pools). Users deposit a single asset into a reactor and earn rewards in TOKE. The funds accumulated in a reactor are distributed across different trading platforms and currency pairs.

The DAO of TOKE holders decides which projects should be whitelisted to get their own reactors, as well as where the funds should be deployed. You need to stake TOKE in a particular reactor to become a Liquidity Director (LD) and get voting power for that reactor. TOKE also serves as collateral for the whole network.

Tokemak has a system for balancing the reactors. If there are a lot of assets deposited in a pool but not many TOKE, the APY on TOKE staking for that pool is increased to attract more liquidity directors. And the other way around, if there are many LDs but not enough capital, the APY on the reactor’s main asset is increased to attract liquidity providers.

Available pools

Tokemak started out with several Genesis Pools: USDC, DAI, ETH, and sUSD. Next it launched a series of so-called Collateralization of Reactors Events (C.O.R.E.), where TOKE stakers voted on a list of 36 assets to decide which ones would get their own reactors. They chose the following five:

• Frax (FXS)
• Alchemix (ALX)
• Tracer DAO (TCR)
• Olympus DAO (OHM)
• SushiSwap (SUSHI)
  

If you’re not familiar with any of these except for SUSHI, don’t worry: these are all DeFi 2.0 protocols, and we will cover them in this and the next article on the subject.

The second C.O.R.E. vote began on November 9. The list of 45 candidates includes mostly well-known projects like Aave, MakerDAO, Compound, Fantom, and Axie Infinity.

How to get involved

1) Connect your wallet on https://www.tokemak.xyz/

2) Choose which asset you want to deposit: ETH, USDC, TOKE, FXS, OHM, ALCX, or TCR. Alternatively, you can buy and deposit TOKE in a liquidity pool on Uniswap or SushiSwap, get corresponding liquidity provider tokens (LPs), and stake those on Tokemak in the TOKE SUSHI LP or TOKE UNI LP pool.

3) Start earning rewards. The highest APR among the reactors is currently OHM (185%), while the highest reward rate overall is for the SUSHI LP and UNI LP pools, with 206% APR.

Tokemak runs on Ethereum, so be ready to pay a high gas fee on each transaction (currently $50). Also, if you decide to withdraw the funds, note that there is a cooldown period of up to 24 hours.

As of November 2021, Tokemak’s TVL (total value locked) stood at a whopping $1.4 billion, out of which $400M were in TOKE and $1BM in other assets. This is a very impressive result for a project that launched the first pools just weeks ago.

OlympusDAO

OlympusDAO is a pioneer of protocol-owned liquidity (POL). Instead of incentivizing users to deposit funds in external OHM liquidity pools and stake LP tokens, it does something very different: sells its own tokens to liquidity providers at a discount in exchange for LP tokens. This process is called bonding. OHM can also be staked to earn additional rewards.

Bonding in Olympus

Here’s how bonding works. You start by adding liquidity to the OHM-DAI pool on SushiSwap. In return, you’ll receive OHM-DAI LP tokens that prove your right to a share in the pool. The LPs are also needed to get the OHM and DAI back from SushiSwap if you want to leave the pool (see here for an explainer).

Now, if this was a standard yield farming scheme, you would stake those LPs on a smart contract and get regular payouts. But in Olympus, you sell the LPs to the treasury and get OHM cheaper than the market price. As of the time of writing, the discount was 1.5%, but it changes all the time. There is a 5-day vesting period before you actually receive the OHM.

Make no mistake: when you sell LPs, you give up the right to your original funds on SushiSwap, so you won’t earn any income from trading fees there. That income will go to Olympus, which now owns your LPs. That’s what it means for OlympusDAO to control its liquidity: the project’s treasury holds 99.88% of all LP tokens for the OHM-DAI pool – and, therefore, gets almost all the trading fee rewards.

Apart from OHM-DAI LPs, several other tokens can be bonded:

• wETH, or wrapped Ethereum  (not LPs, just wETH itself): a 2.4% discount on OHM (as of November 13, 2021);
• OHM-WETH LP: a negative discount of -0.74%, so you’ll actually get OHM at a price slightly higher than the market price;
• OHM-FRAX LP: a negative discount of -8.77%;
• FRAX: -9.68%;
• DAI: -28.63%.
  

If you want to understand how discounts are calculated (and why some of rates are negative), read the official bonding primer.

OHM staking

Staking in Olympus is much easier to explain than OHM bonding. Simply go to the staking page, connect a wallet, and send some OHM to the smart contract. You’ll receive special sOHM tokens; if you decide to unstake the funds at some point, you’ll need to return those. The rewards also accrue in sOHM, which can be redeemed for OHM at any point.

The staking APY is incredibly high: at the time of writing, it stood at an incredible 7,886% - yes, that’s 8 thousand per cent.

If that seems crazy, how about this: back in June 2021, the APY was 50,000%! How can Olympus sustain such high reward rates? Apparently the protocol makes enough money from trading fees in the OHM-DAI pool on SushiSwap and from selling bonds to keep minting new sOHM, used to pay staking rewards.

According to the Runway chart on the website, the project has enough resources to keep paying rewards for around 10 more months at the current APY. Considering that the APY is going down slowly, and the protocol continues to earn money, staking should remain nominally profitable for a long time.

To understand the difference between nominally profitable and actually profitable, consider this example. Let’s say 1 OHM trades at $1 and you spend $100 to buy 100 OHM. Let’s also imagine that the weekly reward rate is 100%, so after a week you’ll have 200 OHM. But in the meantime, BTC tanks and the market price of OHM collapses by 60% to $0.4 (such things can happen easily in crypto). Now the market value of your 200 OHM is just $200*0.4=$80 instead of the initial $100.

OHM: a decentralized reserve currency

Now let’s look at OHM itself. Every OHM token is backed by 1 DAI stablecoin in the Olympus treasury. An algorithm prevents OHM’s price from going below $1: if it deviates below, some OHM are automatically bought back and burned. There is no upper limit to the price, though: in November 2021, OHM was trading at $890.

Olympus calls OHM an ‘algorithmic reserve currency’ and claims that it’s superior to stablecoins like DAI or USDT. Indeed, a USD-pegged stablecoin is always worth $1, but as the US Federal Reserve keeps printing dollars, their purchasing power diminishes – and so does the real-world value of stablecoins. By contrast, OHM’s purchasing power can grow with time.

Olympus Pro: Bonds-as-a-service

Bonding on Olympus has proven so popular that the project decided to offer it to other DeFi protocols. With Olympus Pro, any project can integrate bonding and own its liquidity, instead of renting it from yield farmers.

A few protocols have already joined the Olympus Pro marketplace, including Alchemix, Premia Finance, Frax, Float, and Scream.

Many people initially feel cautious about Olympus because of the sky-high staking APY. But the system of bonding and staking is actually well balanced, and it helped Olympus to reach a market cap of $3.66 billion in just 10 months, while the TVL has almost reached $3.3 billion.

One thing to note in the chart is how high the OHM price is ($881.4) relative to the backing per PHM ($161.6). This makes OHM susceptible to high price swings, especially in case of a market-wide drop. Therefore, investing in OHM remains relatively risky at this stage, even though technically the protocol is quite sound.

OlympusDAO and Tokemak are just two of many interesting DeFi 2.0 projects to keep in your radar. As the DeFi 2.0 trend unfolds in the coming months, Pontem Network will bring you updates and explainers on more protocols. Join us on Twitter and Telegram and don’t miss Pontem’s fresh content!