The DeFi (decentralized finance) industry has seen a surge in popularity over the past few years, with investors eager to get in on the action. With the rise of innovative blockchain technology and the emergence of new DeFi platforms, the potential for investors to earn returns has never been higher.
But, as with anything in life, the potential for high rewards also comes with the potential for high risks, so it's important for investors to understand the nuances of DeFi before taking the plunge. In this blog post, we'll explain all the DeFi investing basics; what is DeFi, how to research and assess DeFi projects, what are the pros and risks when it comes to investing, and finally, give you some tips to start your DeFi investing journey.
Introduction to DeFi
DeFi (decentralized finance) is a term that refers to the growing number of decentralized financial applications built on top of blockchain networks such as Ethereum.
Unlike CeFi, where centralized financial institutions provide financial services, such as issuing loans, borrowing funds, exchanging stocks etc. Decentralized finance connects parties directly on the blockchain, using smart contracts to enforce financial contracts.
Since its inception, the DeFi industry has rapidly grown, with almost 7 million unique addresses using DeFi today! With the rapid growth of this industry, it's important for investors to understand this exciting new opportunity.
How does Decentralized Finance work?
This all raises some important questions. If there's no intermediary such as a traditional bank or lawyer enforcing financial contracts, how do DeFi applications actually work?
DeFi applications are built on top of decentralized blockchains such as Ethereum. Blockchain technology allows for a unified, code-enforced, settlement layer. In essence, a rulebook which all its users agree on and must abide by. The most important components of these blockchains for DeFi are:
1) Decentralization - This removes the need for trust in a centralized intermediary as decentralized blockchains ensure that all on-chain data is publicly shared and immutable. In other words, they provide a universal source of code-enforced truth which means no arguing over whether X paid Y or not.
2) Smart contracts - A smart contract is a digital agreement between two or more parties that is enforced by computer code. Smart contracts allow for the automation of complex financial transactions and agreements without the need for any centralized intermediary to enforce or operate them. If X paid Y, then Z.
By combing these two elements, DeFi protocols can automate complex financial services on a global scale, without any need for a human middleman. Most DeFi protocols also use DeFi tokens of some kind. Usually as a an exchange fee, but often for other purposes such as governance too.
What are the most Common DeFi Applications?
Before you start investing in DeFi, it's important you understand the different kinds of services and products which DeFi protocols usually provide. That way you can make an informed investment decision.
The most popular DeFi service is decentralized lending, which lets anyone borrow or lend digital assets over a decentralized network. A DeFi lending protocol works through overcollateralization; by putting up their cryptoassets as collateral to cover default risks, borrowers are able to borrow from DeFi liquidity pools, thereby enabling trustless lending. (FYI a liquidity pool just means crypto assets locked into a smart contract).
On the other side of this equation, users can deposit their crypto tokens into a DeFi liquidity pool, where their assets are then lent out to said borrowers.
In return for providing liquidity to a DeFi liquidity pool, investors can earn interest, an investment strategy known as 'yield farming'. There are a number of popular DeFi networks which offer lending, including Aave, Curve, WeTrust, Dharma and Compound, with the most popular DeFi lending platform being Maker DAO.
Another common DeFi application (dApp) are decentralized exchanges or DEXs which enable two market participants to exchange their digital assets directly without needing a centralised custodian, such as a bank or exchange (E.g. Binance, RobinHood etc.).
Decentralized exchanges ensure that users never have to give up custody of their assets to a third party, and they can also save you money on intermediation fees too. In many cases, investors can also provide liquidity to DEX's, specifically, providing liquidity to certain exchange pairs in return for rewards.
We've already outlined the two biggest use cases for DeFi today, but there are tonnes of other cool DeFi projects out there, including decentralized insurance protocols such as Nexus Mutual, or algorithmic stablecoins, although these haven't always turned out so well. If you find something you're interested in, just make sure you DYOR before jumping in!
Why Invest in DeFi?
Despite the current bear market, the number of DeFi users is still around 50% of its ATH, meaning there's still tonnes of opportunity to be had! Indeed, investing in DeFi offers a wide range of benefits to investors. We've outlined some of the key advantages for investors below...
1) Accessibility - DeFi protocols are permissionless and open to anyone, meaning that anyone can access or invest in the same financial services regardless of their location or financial background.
2) Security - DeFi dApps are decentralized and trustless, meaning that users don’t need to rely on a third-party to ensure their funds are safe and secure, instead relying on code to enforce contracts. This removes the counterparty risks associated with human error, fraud or delay in the enforcement of financial contracts and agreements. Nevertheless, smart contracts come with their own set of risks we'll discuss more later.
3) Lower Fees - As there’s no middleman taking a cut from each transaction, decentralized finance is often cheaper than alternatives from centralized financial institutions.
4) High Returns - By locking up tokens in DeFi liquidity pools, many DeFi protocols offer the ability to earn rewards in the form of interest or dividends. These returns can have you easily beating the meagre returns on offer from traditional finance.
How to Research and Assess DeFi Projects
Now you know the basics, you're almost ready to invest in DeFi. Before investing, it’s important to DYOR and assess the project you’re interested in. Researching DeFi projects can be a daunting task, but it’s essential for ensuring your funds are secure. Here are a few tips for researching and assessing new DeFi projects:
Read Whitepaper - Whitepapers provide an in-depth overview of the project, including its goals, progress, and roadmap.
Check out the Website - The website should provide detailed information on the project’s team, roadmap, and technology. Take a moment to look at the team as well. Preferably, they should have a track record of success.
Read Third-Party Reviews - Reviews can provide valuable external insight on the project’s success, challenges, and potential risks. Of course, it's good to be aware that many reviews on social media can be biased.
Follow the Project’s Social Media Accounts - Social media accounts are a great way to stay up to date on the project’s progress and any news or updates.
Try out the platform yourself - If possible, its always a good idea to try out the DeFi protocol yourself to get a feel for the user experience and any potential risks.
By taking the time to research and assess DeFi projects, you can make an informed decision when it comes to investing in DeFi.
Tips for Investing in DeFi
Investing in DeFi can be a lucrative opportunity, but it’s important to understand the risks involved. Here are a few tips for investing in DeFi:
Diversify your portfolio - It’s important to diversify your portfolio to reduce your risk. Consider investing in a range of different DeFi projects to minimize your exposure to any single risk.
Do your own Research (DYOR) - Before investing in DeFi, take the time to research and assess the project you’re interested in.
OPSEC - OPSEC means "operational security". Essentially, make sure you follow best practices when it comes to keeping your identity and wallet safe. One top tip is to always make sure that the links you click are genuine.
Understand the Risks - Despite the theoretical advantages of trustless security, DeFi is a high-risk, high-reward industry. Make sure to understand the risks involved before investing in DeFi. Head to the next section to understand more about the risks of DeFi investing.
Start small - Don't dive in head first. When investing in DeFi, it’s best to start small and gradually increase your investment as you get comfortable. By taking it slow, you'll understand how different applications work, and ultimately, minimize your financial risk.
Don't Invest too Much - This should go without saying, but, with every risky investment, its important never to invest more than you can afford to lose.
Check your Local Regulations - Not every country has laws allowing you to invest in DeFi. Make sure what you're doing is legal so you don't get into trouble down the line.
By following these simple tips, you'll be sure to make the most of your DeFi investments.
Understanding the Risks Involved in DeFi
While investing in DeFi offers the potential for high returns, it’s important to understand the risks involved. And there are quite a few of them. We've provided a concise summary of the risks to help you understand what you're getting into.
Volatility - The DeFi industry is still relatively new, and the prices of DeFi tokens can be highly volatile. This means that prices can go up or down quickly, making it easy to both make and lose money quickly.
Limited user Protections - Given the decentralized nature of crypto, its usually impossible to get your money back if things go wrong. Certainly, there are no consumer protections like the federal deposit insurance corporation (FDIC), or FCA insured deposits to help you if things go badly wrong.
Smart Contract Risks: Smart contracts are the foundation of DeFi protocols, and like any code written by humans, it isn't always perfect. When code is faulty, things quickly can and do go horribly wrong in DeFi, with serious implications for users and investors.
Security Risks: DeFi protocols are vulnerable to various hacks, scams, and other security threats, either through phishing, or through smart contract exploits. Indeed, over $6 billion USD has been stolen in DeFi hacks (with DeFi bridges being the most common target). Therefore it’s important to take steps to ensure your funds are secure and minimise risks. For starters, that means securing your crypto wallets, and verifying any links before you click them or give them any special permissions.
By understanding the risks involved in DeFi, investors can better prepare for the potential risks and maximize their returns. It's also ok to feel uncomfortable investing in DeFi. If that's the case, then maybe you should consider other investment alternatives.
DeFi is a rapidly-growing industry that offers the potential for high returns, but it’s important to understand the considerable risks involved. By taking the time to research and assess DeFi projects yourself, and following our tips for investing in DeFi, you'll be ready to start your DeFi investment journey in no time.