Decentralized finance (DeFi) protocols have diversified investment opportunities in the crypto industry by enabling novel and innovative passive income generation schemes.
Digging a bit into how they work, DeFi systems are based on blockchain technology and run on programmable chains such as the BNB chain and the Ethereum network.
The chains use decentralized peer-to-peer (P2P) financial architectures to cut out the middleman and enable lending, borrowing and liquidity provision. This results in higher interest rates compared to those provided by regulated financial institutions such as banks.
For perspective, many regulated banks offer interest rates of less than 1% per year, while some DeFi platforms offer interest rates in excess of 20% per year.
Investing in DeFi offers numerous benefits. Yubo Ruan, CEO and founder of Parallel Finance, told Cointelegraph:
“DeFi has immense potential for users compared to traditional markets. For example, DeFi trading is available 24/7, 365 days a year, which can create new opportunities and even the ability to trade outside of business hours alongside a full-time career that is not finance-related.”
“The speed and efficiency of DeFi creates immense opportunities to enter and exit positions very quickly, for example for arbitrage. Furthermore, you can access DeFi regardless of your background or money,” he said, adding, “There are more than a billion people who are unbanked and unable to use traditional markets. This is a tremendous benefit for those who are unbanked to access and invest with DeFi in a world where banks simply don’t exist for them.”
Today there are over 100 DeFi projects in the crypto space. Therefore, finding the ideal project can be difficult, especially for new investors. The following is a breakdown of factors to consider when choosing an informed DeFi project.
total locked
Total Locked Value (TVL) should be considered when looking for a standout DeFi project. A high TVL is a strong indicator of investor confidence in a platform and its core drivers.
DeFi projects with significant assets held in custody are generally considered larger and considered more secure compared to those with low TVL. Projects with a consistently positive TVL growth rate are desirable.
Total value locked in DeFi markets. Source: DeFiLlama
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It is important to consider the fully diluted valuation (FDV) of a DeFi token before investing. FVD in DeFi is the theoretical market cap of a token relative to the prevailing market price and the number of coins in circulation.
If the fully diluted valuation is too low, the steady influx of new tokens will likely outstrip demand for the token, resulting in a price drop. In DeFi investing, native tokens are adversely affected in low FDV market situations.
Token Price Stability
Promising DeFi tokens typically show a consistent long-term uptrend. Of course, rallies of over 30% in a short space of time are tempting at first glance, but they could be unsustainable parabolic market reactions, usually followed by a sharp drop.
Pump-and-dump schemes play a role in some momentary price hikes. These types of tricks are widespread in the crypto space and usually affect low and mid-cap tokens.
As a result, investors should ignore short-term price developments in the absence of other positive indicators and opt for tokens backed by projects with outstanding long-term growth fundamentals.
risks
Risks like platform exploits and rug pulls are common in the DeFi industry. Therefore, it is important that investors conduct extensive background research on platform security before investing in DeFi projects.
Security audits by independent cybersecurity firms usually uncover potential loopholes. Investors are advised to take these views into account.
Choosing the right DeFi investment strategy
Choosing the right DeFi investment strategy can generate significant returns. The following is an overview of some common DeFi investment strategies.
Mark out
Staking is among the simplest DeFi investment strategies. It involves locking unused assets in a smart contract for a set period of time.
Staking a DeFi asset allows an investor to become a validator on a Proof-of-Stake (PoS) network. Proof-of-Stake systems differ from Proof-of-Work (PoW) consensus algorithms, which typically require computing devices to validate transactions.
PoS mechanisms are run by validators who earn rewards based on the number of tokens they have.
DeFi projects typically reward investors with governance tokens that increase investor voting rights. The coins can also be traded against other cryptocurrencies.
In DeFi, platforms that support staking usually also offer borrowing and lending services.
Related: How to use cryptocurrencies in 2022 explained
yield farming
Yield farming is a sophisticated investment mode that combines staking, lending, and borrowing to optimize yields.
Yield farming protocols typically have high yields. However, they also come with higher risks compared to just holding premium cryptocurrencies.
For example, in yield farming networks, users can use their staked assets as collateral to borrow and buy tokens with great upside potential. This is usually done to maximize wager rewards.
However, the use of leverage products increases losses.
Unlike commercial banks, only collateral is required to obtain a loan. No credit checks are carried out. This is because the ecosystems are managed via smart contracts that automatically enforce rules written in code.
Aside from borrowing and lending, some DeFi yield farming pools support token pairs to earn rewards. By investing money in these investment vehicles, investors can earn a certain percentage in fees each time the tokens are used in a transaction.
Increasing demand for certain token pairs usually leads to more trades and higher returns for investors. However, investing in volatile liquidity pairs can result in temporary losses.
Related Topics: What is Yield Farming?
DeFi Indices
DeFi indices offer stakeholders a diversified portfolio of cryptocurrencies. Their composite structure is similar to that of Exchange Traded Funds (ETFs) in traditional finance. For example, S&P 500 ETFs track the value of 500 large companies listed on US exchanges. DeFi indices have a similar framework but track cryptocurrency tokens.
The DeFi Pulse Index is an example of a popular DeFi index. It tracks projects with significant usage and a dedicated development team.
The MetaVerse index is another notable DeFi index. It tracks a basket of tokens across various virtual environments such as sports, entertainment, and business. Token market capitalization and liquidity weighting are taken into account when including a token.
DeFi indices with a consistent long-term growth rate and low volatility are recommended.
Choosing a wallet and buying tokens
After determining the ideal DeFi protocol and investment strategy, sourcing a crypto wallet helps make token buying easier. Crypto wallets are used to store coins needed to buy tokens on DeFi platforms.
When choosing the ideal wallet, it is important to consider factors such as accessibility, compatibility and whether it is custodial or non-custodial. For example, software-based wallets offer better accessibility and are more convenient compared to hardware-based wallets.
However, hardware wallets are more secure due to their sophisticated encryption mechanisms designed to thwart most cyberattacks.
Some popular software or hot crypto wallets are MetaMask, Coinbase, Brave and Fortmatic. Trezor and Ledger are among the most trusted hardware or cold wallets.
Most major wallets can connect to exchanges where DeFi coins can be traded. The first step to getting a DeFi token is to visit the protocol’s website and link the wallet to buy native coins. You can then invest in the pool of your choice on the platform.
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