Overview

The evolution of DeFi has gone through three major phases:

• DeFi 1.0 introduced AMM (Automated Market Makers), liquidity mining, and overcollateralized lending. However, it faced low capital efficiency, high fees, and unstable liquidity. Representative projects include Uniswap, Aave, and MakerDAO.
• DeFi 2.0 sought to optimize liquidity management through Protocol-Owned Liquidity (POL), veToken mechanisms, and future yield-backed lending. However, the PCV (Protocol Controlled Value) model carried risks, and veToken mechanisms led to liquidity centralization. Notable projects include Olympus DAO, Curve, and Alchemix.
• DeFi 3.0 introduces modular architecture, cross-chain bridges, AI-driven strategies, real yield models, on-chain derivatives, and RWAs (Real-World Assets), enhancing flexibility and composability. However, it comes with high cross-chain security risks, complex yield optimization, and increased strategy complexity. Key projects include LayerZero, Pendle, Ethena, and GMX.

DeFi 1.0

The concept of DeFi (Decentralized Finance) and its foundational projects began taking shape between 2017 and 2018:

• In 2017, MakerDAO launched DAI, introducing the concept of decentralized lending and stablecoins.
• In 2018, Uniswap V1 was released. It pioneered the Automated Market Maker (AMM) model, laying the foundation for DeFi’s future growth.
• In 2019, Compound introduced its decentralized lending protocol, Synthetix launched synthetic assets, and Yearn.Finance optimized DeFi asset management.

2020 marked the “DeFi Summer”, with the rise of Yield Farming (Liquidity Mining). Aave, SushiSwap, and other projects drove the exponential growth of the DeFi ecosystem, leading to its full-fledged expansion between 2019 and 2020, a period now referred to as DeFi 1.0.

DeFi 1.0 represents the first phase of DeFi’s evolution, primarily centered around decentralized trading, lending, stablecoins, and liquidity mining. The core idea was to give users direct control over their assets, mitigating the centralization risks found in traditional finance.

Despite its early success, DeFi 1.0 faced several growth challenges. The underlying blockchain’s scalability limitations led to fragmented user adoption, and the market’s expansion fell short of initial expectations. Moreover, DeFi 1.0’s liquidity was highly dependent on external capital inflows, making it unstable and unsustainable in the long run.

At its core, DeFi 1.0 was driven by Automated Market Makers (AMMs) and decentralized lending protocols, with Uniswap and Compound as its key representatives.

Source: https://docs.uniswap.org/contracts/v1/overview

Core Features of DeFi 1.0

1. Decentralized Exchanges (DEXs)

Representative Projects: Uniswap, SushiSwap

Key Feature: Replaced order book-based trading with the AMM (Automated Market Maker) model, enabling decentralized asset swaps.

1. Decentralized Lending

Representative Projects: Aave, Compound

Key Feature: Allowed users to borrow funds by collateralizing assets, eliminating the need for traditional financial intermediaries like banks.

1. Stablecoins

Representative Project: DAI (MakerDAO)

Key Feature: Used an overcollateralization model to provide a decentralized, on-chain stablecoin.

1. Liquidity Mining

Key Feature: Utilized incentive mechanisms to attract capital into DeFi protocols, enhancing liquidity.

Source: https://www.sushi.com/ethereum/swap

Challenges of DeFi 1.0

1. Liquidity Shortages & Instability

DeFi 1.0 projects relied heavily on high APY (Annual Percentage Yield) to attract liquidity, but this model was unsustainable in the long term. Many short-term investors (commonly called “DeFi farmers”) moved from one high-yield liquidity pool to another, mining rewards and exiting quickly. This led to massive capital outflows, disrupting long-term protocol stability.

Since liquidity providers (LPs) were highly profit-driven, the market entered a “farm, withdraw, and sell” cycle. When APYs dropped, liquidity providers withdrew funds, leading to token price crashes. The resulting loss of confidence further destabilized the ecosystem.

Although liquidity mining attracted large capital inflows, capital efficiency remained low for liquidity providers.

1. Weak Governance Incentives

DeFi 1.0 lacked strong governance incentives for ecosystem participants.

Governance tokens were distributed inefficiently, failing to establish long-term community engagement.

Users were more focused on short-term profits than contributing to protocol development, making liquidity unsustainable.

1. Blockchain Scalability Constraints

Ethereum was the primary platform for DeFi 1.0, benefiting from stability and user adoption. However, high gas fees and network congestion significantly restricted DeFi’s scalability. As DeFi adoption grew, alternative blockchains such as Fantom, Polygon, Solana, and BSC emerged, laying the groundwork for DeFi 2.0.

1. High Transaction Costs

Ethereum’s dominance in DeFi 1.0 resulted in exorbitant gas fees, making transactions costly for users.

DeFi 2.0

DeFi 2.0 primarily focuses on optimizing the core weaknesses of DeFi 1.0, particularly in areas like sustainable liquidity, capital efficiency, and governance models. Its key innovations include Protocol-Owned Liquidity (POL), smarter incentive mechanisms, and more efficient cross-chain solutions.

Building on the foundation of DeFi 1.0, DeFi 2.0 addresses capital efficiency and protocol sustainability issues. It emphasizes protocol-owned liquidity (POL), intelligent liquidity management, and trustless governance.

Key Innovations of DeFi 2.0

1. Protocol-Owned Liquidity (POL)

Problem: Traditional DeFi 1.0 relied on external liquidity providers (LPs), leading to a “farm-and-dump” problem in which users withdrew funds after earning rewards.

Solution: DeFi 2.0 introduced the concept of POL, allowing protocols to own and manage their liquidity.

Example: OlympusDAO introduced a bonding mechanism, enabling the protocol to acquire liquidity directly, establishing a decentralized central bank model.

Source: https://app.olympusdao.finance/#/dashboard

1. More Sustainable Liquidity Mining

Curve Finance’s veCRV mechanism (vote-escrowed CRV) forces LPs to choose between governance power and yield, discouraging short-term speculation and stabilizing capital inflows.

1. Automated Yield Optimization

DeFi 2.0 also advanced the development of yield aggregators such as Yearn Finance and Convex Finance, which use smart contracts to automate liquidity mining strategies, reducing manual operational costs and improving capital efficiency.

1. Cross-Chain DeFi

With the rise of Layer 2 solutions and other blockchain ecosystems such as Avalanche and Fantom, DeFi 2.0 enabled cross-chain liquidity solutions. Protocols like Synapse and Stargate improved multi-chain interoperability with efficient bridging solutions, enhancing user experience.

Source: https://stargate.finance/

Core Features of DeFi 2.0

1. Protocol-Owned Liquidity (POL)

Representative Project: OlympusDAO

Mechanism: Bonding model, where the protocol owns and manages its liquidity, rather than relying on external liquidity providers.

1. Smarter Liquidity Management

Representative Project: Tokemak

Functionality: Provides sustainable liquidity management, improving capital efficiency and reducing liquidity migration issues.

1. Trustless Governance & Tokenomics Optimization

Representative Project: Curve Finance (CRV locking mechanism)

Mechanism: Vote-escrow tokenomics (veTokenomics) incentivizes long-term holding, reducing short-term speculation.

OlympusDAO: Introduced the POL model, where OHM staking enables governance participation, addressing DeFi 1.0’s liquidity shortage issues.

Curve Finance: The veCRV model optimized governance and sparked “liquidity wars”, attracting a significant DeFi 2.0 ecosystem.

Abracadabra Money: Allows yield-bearing assets (yvUSDC, stETH) to be used as collateral, further enhancing capital efficiency.

Convex Finance: Uses the veCRV model to attract liquidity and optimize Curve ecosystem reward distribution.

Source: https://www.convexfinance.com/

Challenges of DeFi 2.0

1. Sustainability of the POL Model

The bonding model used by OlympusDAO works well in bull markets, but it can lead to mass sell-offs during downturns.

1. Increased Complexity

The design of DeFi 2.0 is more complex, requiring a higher level of knowledge from users, which hinders mass adoption.

1. Cross-Chain Security Risks

Bridge protocols still contain smart contract vulnerabilities, leading to significant financial losses.

• Example: In August 2021, Poly Network suffered a $611 million hack, where attackers exploited smart contract vulnerabilities to steal multi-chain assets from Ethereum, BNB Chain, and Polygon wallets.

1. High-Risk Experiments

OlympusDAO’s Bonding model triggered a market bubble, which eventually collapsed sharply.

1. Increasing Governance Complexity

The veTokenomics mechanism can lead to whale dominance, where a small number of large holders control protocol governance.

1. High Sensitivity to Market Cycles

In bear markets, the attractiveness of DeFi 2.0 projects declines, making it difficult for protocols to sustain high returns.

Source: https://www.reuters.com/technology/how-hackers-stole-613-million-crypto-tokens-poly-network-2021-08-12/

DeFi 3.0

DeFi 3.0 primarily focuses on modular finance, on-chain asset management, and more efficient liquidity allocation, making DeFi more automated and intelligent.

DeFi 3.0 seeks to overcome the limitations of DeFi 2.0, while integrating DeFi into a broader blockchain ecosystem, including AI, Web3 social platforms, GameFi, and Real-World Assets (RWA).

Key Features of DeFi 3.0

1. Modular DeFi Ecosystem

LRT (Liquidity Restaking, e.g., EigenLayer) allows liquidity mining funds to be reused, improving capital efficiency.

Composable DeFi is emerging, promoting seamless integration between DeFi protocols, such as UniswapX and Intent-Based Finance.

1. On-Chain Asset Management

Smart contracts manage DeFi assets, allowing users to earn stable returns without manual intervention.

Protocols like Gamma Strategies and Yearn V3 offer more advanced DeFi investment strategies.

1. AI + DeFi Smart Strategies

AI-driven trading strategies optimize DeFi operations, including prediction markets and automated market maker (AMM) optimizations.

Example: Moralis Money provides AI-powered data analytics, helping users identify high-quality DeFi opportunities.

Source: https://moralis.com/

Core Features of DeFi 3.0

1. Omnichain Liquidity Integration

Representative Projects: LayerZero, Stargate

Functionality: Cross-chain liquidity pools enable seamless asset transfers across multiple blockchains, eliminating fragmented liquidity issues.

1. Integration of RWAs (Real-World Assets) with DeFi

Representative Projects: Maple Finance, Goldfinch

Functionality: Brings traditional financial assets like on-chain bonds and tokenized stocks into DeFi.

Source: https://maple.finance/

1. AI + DeFi

Representative Projects: Numerai, Autonolas

Functionality: AI manages trading strategies, optimizes fund allocation, and enhances automated trading capabilities.

1. Web3 Social & GameFi Integrated with DeFi

Representative Projects: Friend.tech, Galxe

Functionality: Expands DeFi beyond financial tools, integrating Web3 social platforms and GameFi applications to create new use cases.

Challenges of DeFi 3.0

1. Regulatory Compliance Issues

As institutional capital enters DeFi, the sector must balance decentralization and compliance. For example, in August 2022, the U.S. Treasury accused Tornado Cash of assisting illegal money laundering and placed it on the sanctions list. Some developers were arrested, sparking discussions about legal risks for decentralized developers. Many DeFi projects have started exploring compliance solutions, such as Chainalysis providing on-chain KYC solutions and Aave launching Aave Arc, which is only open to regulated institutions.

Source: https://home.treasury.gov/news/press-releases/jy0916

1. Sustainability of the LRT (Liquidity Restaking) Ecosystem

Excessive leverage can increase market volatility risks. For instance, in 2022, UST maintained its peg through excessive LUNA collateralization, but when market confidence collapsed, LUNA’s price plummeted, causing UST to lose its peg. LRT projects need to design more sustainable economic models to prevent single points of failure from collapsing the entire ecosystem.

Source: https://coinmotion.com/terra-luna-and-ust-what-happened/

1. Cross-Chain DeFi Is Still in Its Early Stages

Multi-chain interoperability still needs improvement to prevent liquidity fragmentation issues. For example, Curve Finance operates across multiple chains, including Ethereum, Arbitrum, Optimism, and Polygon. Still, its liquidity pools are not interconnected, leading to insufficient liquidity in certain pools and reduced trading efficiency.

Cross-chain DeFi requires better liquidity aggregation mechanisms, such as LayerZero’s Omnichain Fungible Token (OFT) model or Ethereum Layer 2’s Shared Sequencer model.

Source: https://docs.layerzero.network/v2/home/token-standards/oft-standard

1. Cross-Chain Security Risks

Bridge contract vulnerabilities can lead to significant financial losses. For example, in 2022, the Ronin Bridge was hacked for $624 million when hackers exploited private key access to control validator nodes, stealing ETH and USDC. Cross-chain bridge security remains a critical issue, driving the development of LayerZero, Axelar, and other next-generation cross-chain protocols. Additionally, there is an increasing demand for more secure bridging technologies such as Zero-Knowledge (ZK) proofs.

Source: https://www.elliptic.co/blog/analysis/over-1-billion-stolen-from-bridges-so-far-in-2022-as-harmony-s-horizon-bridge-becomes-latest-victim-in-100-million-hack/hss_channeltw-1344645140

1. RWA (Real-World Assets) Compliance Challenges

Tokenization of traditional financial assets must comply with regulatory requirements. For instance, in 2022, MakerDAO integrated RWA assets, such as U.S. Treasury bonds, to enhance DAI’s stability, but the U.S. SEC may classify them as securities. To address compliance concerns, some institutions are adopting regulated approaches, such as BlackRock’s BUIDL tokenized fund, which follows a fully compliant method to bring U.S. Treasury yields on-chain.

Source: https://securitize.io/learn/press/blackrock-launches-first-tokenized-fund-buidl-on-the-ethereum-network

How Emerging DeFi Protocols Improve Capital Efficiency

As the DeFi ecosystem continues to evolve, emerging DeFi protocols enhance capital efficiency, optimize user experience, and promote integrating crypto finance with traditional finance through innovative mechanisms.

Restaking mechanisms, such as EigenLayer, allow ETH stakers to provide security for multiple protocols, improving capital utilization. Yield tokenization solutions, such as Pendle, enable users to trade future yield, enhancing asset liquidity freely.

In the lending sector, Morpho optimizes interest rates through peer-to-peer (P2P) matching, while Prisma Finance leverages LSD assets to offer low-liquidation-risk lending services. Regarding AMM (Automated Market Maker) innovations, Maverick Protocol and Ambient Finance implement dynamic liquidity management to reduce impermanent loss and increase trading depth.

Additionally, Sommelier Finance utilizes AI to optimize yield strategies automatically, Gearbox Protocol enables decentralized leveraged trading, and Kamino Finance enhances liquidity management within the Solana ecosystem. These emerging protocols enhance DeFi’s sustainability and capital efficiency and explore new directions for compliant DeFi development.

1. EigenLayer: Restaking Mechanism

EigenLayer improves capital efficiency by allowing Ethereum-staked assets to be repurposed. This enables ETH stakers to secure multiple decentralized protocols while maintaining Ethereum’s security.

Dual rewards: ETH stakers earn native ETH staking rewards and additional restaking rewards.

Lower capital lock-up costs: Users can provide security to multiple protocols without supplying additional capital, improving overall capital efficiency.

Extending Ethereum’s economic security: EigenLayer enables new protocols to leverage Ethereum’s security instead of building independent trust mechanisms, significantly reducing the startup costs for emerging projects.

Source: https://www.eigenlayer.xyz/

2. Pendle: Yield Tokenization and Yield Trading

Pendle allows users to split the principal and future yield of DeFi assets and trade them separately, optimizing capital management and increasing returns.

Asset Splitting: When users deposit yield-generating assets (e.g., stETH, aUSDC) into Pendle, the system generates OT (Ownership Token) representing the principal and YT (Yield Token) representing the future yield.

Ways to Improve Capital Efficiency:

• Locking in Fixed Returns: Investors can buy OT to secure stable, long-term returns, avoiding interest rate fluctuations.
• Leveraging Yield: Users can trade YT, enabling them to achieve higher returns with less capital, maximizing capital utilization.
• Enhancing Liquidity: By separating future yields, these assets can be freely traded in secondary markets, increasing liquidity.

Source: https://www.pendle.finance/

3. Morpho: Efficient Lending Optimization

Morpho improves DeFi lending by optimizing the matching process between lenders and borrowers, increasing depositor yields while lowering capital costs.

Mechanism:

Morpho acts as an enhancement layer for Aave and Compound, dynamically adjusting between peer-to-peer (P2P) lending and liquidity pool lending to secure optimal interest rates.

It directly matches lenders and borrowers (P2P lending), offering lower borrowing rates and higher deposit yields than traditional pooled models like Aave/Compound.

Ways to Improve Capital Efficiency:

• Reducing Interest Rate Spreads: Morpho optimizes lending pairs, lowering interest rate gaps and increasing returns for both lenders and borrowers.
• Increasing Liquidity Utilization: By minimizing idle funds, Morpho maximizes the efficiency of deployed capital.
• Seamless Conversion: Fully compatible with Aave and Compound, allowing users to switch back anytime without losses, ensuring liquidity security.

Source: https://morpho.org/

4. Ambient Finance: Impermanent Loss-Optimized DEX

Mechanism:

Implements concentrated liquidity and bi-directional liquidity design to enhance LP (Liquidity Provider) efficiency and reduce impermanent loss (IL).

Allows single-sided liquidity provision, eliminating the need to deposit two assets simultaneously.

Ways to Improve Capital Efficiency:

• Minimizing LP Capital Waste: Concentrating liquidity in the most active price ranges improves trading depth.
• Optimizing Liquidity Distribution: Reduces slippage and improves trade execution efficiency.

Source: https://ambient.finance/

5. Sommelier Finance: AI-Driven Automated Yield Management

Mechanism:

Combines AI and smart contracts to create actively managed DeFi strategy vaults, automatically optimizing returns on deposited funds.

Enables users to access complex yield strategies without manual management.

Ways to Improve Capital Efficiency:

• AI-Optimized Asset Allocation: Dynamically reallocates assets to secure the best returns.
• Minimizing Idle Capital: Ensures that funds are always utilized efficiently.

Source: https://www.sommelier.finance/

6. Prisma Finance: Ethereum LSD-Staked Lending Protocol

Mechanism:

Allows users to collateralize LSD assets (e.g., stETH, cbETH, rETH) to mint the stablecoin mkUSD.

Utilizes an overcollateralization + stability fee model to enhance stability and decentralization.

Ways to Improve Capital Efficiency:

• Unlocking Liquidity: Users can access capital without selling stETH.
• Low-Liquidation-Risk Lending: Reduces the cost of borrowing for users.

Source: https://docs.prismafinance.com/

7. Gearbox Protocol: Decentralized Leverage Trading

Mechanism:

It enables users to leverage across DeFi protocols like Uniswap, Aave, and Curve, unlocking higher yield strategies.

Uses trust-minimized Credit Accounts, enabling trustless leveraged trading.

Ways to Improve Capital Efficiency:

• Leveraged DeFi Trading: Amplifies potential returns by allowing capital-efficient leverage.
• Low-Collateral Leverage: Minimizes capital lock-up and improves capital utilization.

Source: https://gearbox.fi/

8. Kamino Finance: Automated Yield Optimization on Solana

Mechanism:

Uses dynamic asset management vaults to automate liquidity management.

Primarily serves the Solana ecosystem, improving returns for liquidity providers (LPs).

Ways to Improve Capital Efficiency:

• Auto-Rebalancing LP Positions: Minimizes impermanent loss for LPs.
• Leveraging Solana’s Low Gas Fees: Further optimizes DeFi trading costs.

Source: https://app.kamino.finance/

9. Maverick Protocol: Adaptive AMM (Automated Market Maker)

Mechanism:

Uses a dynamic liquidity AMM mechanism, allowing LP positions to adjust with market price movements, improving capital efficiency automatically.

Enables liquidity providers to set price ranges and dynamically adjust asset allocations.

Ways to Improve Capital Efficiency:

• Minimizing Liquidity Waste: Ensures capital remains in the most optimal price zones.
• Automated LP Position Adjustments: Eliminates the need for manual rebalancing.

Source: https://www.mav.xyz/?panels=solutions,ecosystem,about,community

Future Development Trends

DeFi 3.0 will continue to evolve toward greater security, compliance, and intelligence, driving the integration of DeFi with traditional finance (TradFi).

Key trends include Regulated DeFi, incorporating KYC mechanisms and RWA tokenization to meet institutional and regulatory requirements; the expansion of Ethereum L2 ecosystems, which reduces transaction costs and improves cross-chain interoperability; the growth of LRT & LSDfi, introducing new staking yield models to enhance capital efficiency; the convergence of AI and DeFi, enabling smart trading, automated asset management, and AI-driven prediction markets; and RWA tokenization, which accelerates the on-chain adoption of traditional financial assets, facilitating DeFi’s entry into mainstream finance.

Conclusion

As a groundbreaking innovation in decentralized finance, DeFi has evolved from DeFi 1.0 to DeFi 3.0, with each stage refining liquidity mechanisms, yield models, governance structures, and cross-chain interoperability.

• DeFi 1.0 introduced AMMs and lending protocols, marking the beginning of on-chain finance.
• DeFi 2.0 improved capital efficiency and sustainability through protocol-owned liquidity (POL) and veTokenomics.
• DeFi 3.0 integrates AI, liquidity restaking (LRT), and modular architecture, driving smarter and more efficient asset management.

Despite DeFi’s continuous evolution, the industry still faces regulatory compliance, security, and capital efficiency challenges. DeFi will likely shift toward stronger compliance frameworks, more intelligent governance mechanisms, and deeper integration with real-world assets (RWA). As technology advances and the market matures, DeFi has the potential to revolutionize the global financial system, ultimately realizing the vision of fully decentralized finance.