The Ethereum 2.0 factor: Changing the way DeFi projects operate

The end of 2020 has been huge for the crypto community. Not only was there a spectacular price surge across digital assets, possibly signaling the beginning of another bull market, but there was also the launch of Ethereum 2.0 beacon chain, which has been in development for some time.

The long-awaited update to the Ethereum blockchain transforms the network from a proof-of-work to a proof-of-stake consensus model and is intended to improve speed, security, lower transaction fees and fix the scalability issues that have been holding Ethereum back throughout 2020.

Ethereum 2.0 is still in the very early stages of development – in phase 0, and there is still a very long way to go until a complete transfer from the old chain to the new one occurs. Despite this, its impact on the market has already been felt due to its fast paced development. This is true especially in the DeFi space as Dr. Octavius, co-founder of the OctoFi DeFi protocol told Cointelegraph:

“Most people misunderstand Eth2 and what it means for the industry as a whole, especially DeFi. While other chains are competing to solve some scaling issues on Ethereum, I think the network effects are quite profound and Ethereum is leaps and bounds above the others. If anything, the onset of 2.0 gives people confidence in Ethereum's staying power.”

Booming DeFi

The launch of Ethereum 2.0 caused significant price volatility. The price peaked at around $670 right after the launch on December 1, only to suffer a slight correction over the following days, in tune with the rest of the altcoins. But the hype was most felt in DeFi, as ETH 2.0 was a crucial element driving the growth of total value locked in the projects and, according to Octavius, this trend is likely to continue: “The effects are likely going to accelerate participation in DeFi markets as the DeFi builders will be able to improve their products by an order of magnitude.”

TVL was just below $10 billion at the beginning of November and now sits at $13.4 billion after a slight correction from its all-time high of $14.1 billion, according to data from DeFiPulse. So it has grown significantly after November 27, several days before the launch of the Beacon chain. The growth is fueled by a newfound trust in the development efforts being put into Ethereum and the longevity of DeFi.

Of course, the current bull run in crypto has also contributed to this substantial growth, along with other factors, including the merger of Yearn.Finance with decentralized exchange SushiSwap, which was just the latest in the list of partnerships secured by Yearn.Finance. Also, the liquidation of Uniswap’s yield farming occurred, which caused a big surge in TVL on other protocols such as SushiSwap and Bancor. Ilya Abugov – advisor at dApp statistics aggregator, DappRadar – told Cointelegraph that Eth2 may be crucial to staving off competitor blockchains in the DeFi space:

“It may become important when rival blockchains really start activating. With Polkadot and NEAR becoming more active, good news regarding Ethereum 2.0 may help keep projects anchored to the Ethereum ecosystem.”

But despite the significant growth in TVL, the total transaction volume showed a decline. Surpassing $41 billion in November, transaction volume registered a decrease of 12% compared with the previous month. This may be explained by users deciding not to move their funds and instead stake them on Eth2.

This was one of the necessary steps for the launch of ETH 2.0, as 16,384 validators needed to stake 32 ETH each to signal the launch of the new chain. A total of 524,288 ETH locked up in the deposit contract can easily explain the November decrease in transaction volume.

Another data point showing the dominance of DeFi, besides the billions, in TVL is the fact that 99% of Ethereum transaction volume comes about DeFi protocols. This means that users are still attracted to DeFi’s huge yields which are unlikely to be beaten by ETH 2.0 staking rewards. It is also likely that users will remain in Ethereum throughout this change if promising projects that run on the blockchain continue to perform well. Additionally, it’s also possible that the improvements created by the update will attract a more cautious institutional audience.

Drawbacks of ETH 2.0 on DeFi

Once Ethereum 2.0 is fully operational, the DeFi market will likely benefit from the faster and more scalable network. However, some industry participants argue that there may be some drawbacks.

The move to a PoS consensus will impact the DeFi ecosystem. Stakers who hold ETH in their wallets will earn interest for their troubles. By essentially sharing very similar reward systems, it is possible that the compensation offered by staking may rival the rewards from yield farming and other DeFi products. Even though this may take some time to materialize, potential high rewards in Eth2 may create a conflict and a decreased incentive for DeFi usage. However, innovative solutions to this conflict are already being developed, including tokenized ETH 2.0 bonds.

Validators can receive funds in unlocked original Ether by transferring a token created by a fully collateralized smart contract to a creditor. In return, a promise is made that when the blockchain merger happens and the lockup ends, the creditor will automatically receive the original 32 ETH plus the accumulated staking rewards. Dr. Octavius is optimistic about such developments:

“This concept is interesting in terms of not only futures markets, but prediction markets and how they could be used to enhance project governance. [...] But I'm also really interested in how something like EIP 1559 will influence stock to flow of ETH, giving it a better S2F than Bitcoin. I think there's going to be a whole new dynamic when it comes to assessing investments, especially as DAOs and DeFi projects continue generating attractive revenues.”

Another major risk lies in both the old and the new Ethereum blockchains currently running simultaneously. With succeeding developmental milestones, the full transition to the new chain is scheduled to happen in 2022, but not without significant risks involved. DeFi protocols may undergo a smooth transition, but the potential for minor disruptions or even catastrophic losses is also a possibility. Dr. Octavius told Cointelegraph: “Of course we could see unexpected bugs, or perhaps the outcomes of Eth2 are underwhelming but if developers continue to choose to build on Ethereum, then that's what really counts.”

What the future holds for Ethereum

There seems to be a consensus about the positive impact of Ethereum 2.0. However, like previously mentioned, some drawbacks may occur. From technical risks to a shift in dynamics around DeFi and liquidity. According to Abugov, the latter will not be felt in the near future:

“It doesn’t appear like Ethereum 2.0 will have a meaningful effect on liquidity in the next 9-12 months. It will pull away some ETH, but doubtful that it will be enough to alter the current economics of Ethereum 1.X”

With a successful shift into Ethereum 2.0 presenting a possible risk for DeFi’s growth, some foresee an extremely positive outlook for the NFT market which has been growing considerably throughout 2020 and is not a sector that is in direct competition with the staking model behind Eth2.

Regardless of Ethereum 2.0 progress, 2021 is likely to bring DeFi to the next level as it seeps into legacy finance. Dr. Octavius said: “Consumers will suddenly find they have access to new insured savings accounts with 2% per annum interest, all derived from DeFi, without them even knowing it.”