A Brief History of DeFi — Part 2: Capital Efficiency

Hermetica
3 min readFeb 15, 2024

--

Decentralized finance, or DeFi, has marked a revolutionary shift from the traditional system to a world where finances are permissionless and non-custodial.

A world where financial activities are executed without centralized intermediaries; free of trust and open to all people regardless of geographic boundaries.

Following the inception and rapid growth of the first wave of DeFi primitives, the ecosystem entered its second phase with new products designed to bring capital efficiency and traditional financial services to the peer-to-peer space.

Introducing DeFi 2.0

DeFi 2.0 was, perhaps unsurprisingly, the second generation of DeFi primitives that allowed users to interact with each other peer-to-peer.

This generation produced three main methods to earn a yield on cryptocurrency tokens:

1. Liquid staking tokens

2. Perpetual futures decentralized exchanges (Perp DEXs)

3. Decentralized option vaults (DOVs)

Staking and Proof of Stake Networks

Proof of Stake (PoS) networks operate by allowing token holders to stake their tokens to participate in network validation and governance.

Validators are chosen based on various criteria, including the number of tokens staked, to confirm transactions and create new blocks. As a reward for maintaining network integrity and security, validators receive transaction fees or new tokens as rewards.

To fully utilize a staked token you can lock it in a liquid staking smart contract. This contract earns yield on the staked token while giving the staker an IOU token that can be redeemed for the staked token plus all accrued interest. These IOU tokens can be deployed in the DeFi smart contracts previously mentioned to earn additional yield via lending or liquidity providing.

Liquid staking may sound familiar if you’re following the stSTX liquid staking from Stacking DAO on Stacks.

Perpetual Futures DEXs

A perpetual futures contract is a type of derivatives product that allows traders to speculate on the future price of an asset without an expiration date. This enables positions to be held indefinitely. It employs a mechanism called a funding rate to ensure the contract’s price remains close to the underlying asset’s spot price, allowing for leveraged trading with open-ended contract duration.

Perp DEXs allow users to speculate with perp contracts without a centralized intermediary. These platforms settle perps directly on a settlement layer blockchain, such as Solana, or on the DEXs own proprietary sidechain, such as dYdX. Trades settled to sidechains are eventually rolled up into a single transaction and placed on a settlement layer chain to minimize transaction costs.

Decentralized Option Vaults

DeFi option vaults are innovative financial protocols within the decentralized finance ecosystem. They allow users to earn yield by pooling their assets to sell options contracts.

These vaults operate on smart contract technology, automating options selling and distributing premiums earned as yield to the participants. Users deposit cryptocurrencies into these vaults, which then employ various strategies, primarily around selling options on the assets deposited, to generate returns. Risk management is automated, with strategies designed to minimize potential losses from adverse market movements. However, participants are still exposed to the risks inherent in options trading.

DeFi option vaults democratize access to sophisticated financial strategies, offering a passive income stream to investors willing to accept the associated risks of options selling.

Capital Efficiency

Starting in 2021, the second wave of DeFi primitives brought capital efficiency and TradFi-style markets to crypto.

However, these primitives have not yet been able to provide a wide range of products to investors. In particular, DOVs offer very simple short volatility strategies that have, to date, lost investors' money.

This is where Hermetica’s structured option product vaults bring game-changing innovation to Bitcoin DeFi; all of which we will discuss in our next issue.

In the meantime, check out Hermetica’s current offerings at hermetica.fi.

Stay tuned!

--

--

Hermetica

The first Bitcoin-backed, yield-bearing synthetic dollar protocol.