This article focusses completely on “How to invest in Decentralized Finance (DeFi)”. It can be treated as a guide for investments in DeFi-How to invest in DeFi? What are the Principles or Strategies of investing in DeFi? Is DeFi investing safe? What are the various risks involved in DeFi investments? What are the measures to mitigate these risks involved in DeFi? Let us see one by one.
But what is DeFI? To make it simple, DeFi or Decentralized Finance is referred to the ecosystem of financial applications built on top of Blockchain technology. Examples of these financial systems include loans, insurance, lending and borrowing, derivatives, crowdfunding, bonds, etc. Building the financial systems on top of a blockchain platform eliminates the need for any third party such as banks, financial bodies, etc. to verify and record transactions. The primary motive of a DeFi is the elimination of any third parties to record and verify financial transactions. On the other hand in the traditional financial system, you need a third party like bank or other financial institutions to record and verify each transaction. A popular use case of DeFi is lending applications which connect lenders directly to borrowers. No third parties are involved hence no extra transaction fees are incurred. Lenders lend crypto money directly to a borrower. Other use cases of DeFi include Decentralized Exchanges (DEX), betting, prediction markets, Stablecoins, etc. Learn more about DeFi here.
Note: Majority of the financial applications in DeFi are built on the Ethereum blockchain.
How to invest in DeFi?
Certainly, the question is how to invest in DeFi? Or what are the various options available for investments in the DeFi space? Let us see.
Trading DeFi Assets
(Tokens are somewhat like cryptocurrencies. One major difference is that cryptocurrencies have their own blockchain while tokens are built on top of other blockchains. For example, Ether, Bitcoin and XRP have their own blockchains. Whereas, tokens such as ChainLink and TetherUSD are built on top of Ethereum Blockchain. Refer this article if you want to understand Blockchain).
One of the most popular ways of reaping out profits in DeFi is from token trading. This means buying, holding and selling tokens at the correct price to gain profits.
There are Decentralized Exchanges (DEX) for trading of tokens. Decentralized Exchanges unlike Centralized Exchanges give all the power in the hands of the traders. There is no intermediary to manage the transactions (as it happens in Centralized Exchanges). Instead self executing Smart Contracts (codes) facilitate the trading.
A list of Decentralized Exchanges (DEX) by trading volumes and market capitalization can be found here.
Top DeFi tokens or Decentralized tokens can be found here.
DeFi allows lenders to directly connect and lend crypto to borrowers on platforms like Aave and Compound. Lending platforms like Aave offer both variable and fixed interest rates. Variable interest rates are constantly changed based on the asset’s (crypto) demand. On the other hand, fixed interest rates retain the same rate under all market conditions.
Pro tip: you can use variable interest rates on Aave in a bull market to maximize your profits. Once a bearish phase hits the market, switch to fixed interest rates and stabilize your income.
Yield farming is about lending and locking your cryptocurrencies to different DeFi platforms to earn interests. This means you lock your cryptocurrencies to different DeFi platforms like Compound, Aave, Curve Finance and Badger DAO. These DeFi platforms lend it further to borrowers who pay interest. A share of this interest is given to you as reward. This looks a simple strategy. But it gets more fun when traders hop among different DeFi platforms to gain the maximum returns. In case you know about staking, yield farming is somewhat similar to it. Staking if about locking your cryptocurrency in one blockchain platform for its security. Whereas, yield farming focusses on gaining maximized profits by locking your funds in a blockchain.
DeFi investing Principles || How to invest in DeFi
People have made mountains of money investing in DeFi. The opposite is also true. People have lost their life savings investing in DeFi. My personal advice will always be to not to pour in all your life savings in DeFi (in fact in any single type of investment). Last few months I have been closely watching the DeFi space. I have come up with certain core Principles or Strategies to follow when investing in DeFi. The principles are listed below.
(1) The More the Merrier: The success of a DeFi product is strongly governed by the number of people who have adopted the product. See, DeFi are built on top of Blockchains. Blockchains are a network of people using it. The more people will join a Blockchain, the more value the Blockchain will have. Hence the first principle for investing in DeFi should be to see its adoption and popularity. This is just like other products which rely on network of people like Facebook or Twitter. Their value is driven by the number of people active in the network. But unlike Facebook and Twitter, DeFi show real time data which can act as an indicator of the number of people using the product. Whereas in Facebook and Twitter, you need to wait for their quarterly reports for gauging the same. Some of the tools where you can see the real time reports on market capitalization, adoptions, etc. of DeFi products are, Etherscan and Dune Analytics. Pages like this give you a real time analysis on the number of active users of different DeFi products.
Note: There can be cases where the number of users is a result of a giveaway gimmick or throwaway accounts. These are not quality users of the DeFi product and hence do not translate into the higher value of the DeFi product.
Below are some metrics you can use to gauge the adoption curve of a DeFi product.
(a) Total number of users of the DeFi product. This is the most accurate metric to gauge the value or adoption of a DeFi product. Use this site to find out the number of users of the DeFi product. Do not confuse it with the number of active users. Treat this number just like the customers of a company.
(b) Total number of active wallets of the token. This shows the number of active wallets of a DeFi token. This is the second-best indicator of the value of the DeFi platform which hosts the token. Use this site to find out the number of active wallets (Unique Active Wallets (UAW)).
(2) DeFi investment should be a fraction of your total investment portfolio. In fact, I suggest investing only 5-10% of your investment funds in DeFi. The rest should be invested in traditional investment products like stocks, bonds, index, FDs, etc. This is because DeFi is volatile and comparatively new. You never know what new changes might affect your investments.
(3) Watch out for Fees. Fees is a silent killer when you invest in DeFi products. You are charged “Gas Fees” which is like a service charge for using the Ethereum network on which most of the DeFi products run. If you are investing $1000 to buy tokens and paying $50 as Gas Fees, then you already lost 5%.
You can avoid this higher fees. The higher fees on an Ethereum network (or any other blockchain which is hosting the DeFi product) is analogous to the higher or surged prices of Uber at peak times. This means more people are using the services at that time which results in surged prices. Similarly, when more and more people are using the DeFi platform, its Fee rises. These occur at FOMO (Fear of Missing Out) and FUD (Fear, Uncertainty and Doubt) situations. In FOMO more and more people are buying the DeFi product and in FUD more and more people are selling the DeFi product.
Hence the simple strategy will be to take a breather at the time of a FOMO or FUD and invest later when the Fee goes down.
(4) Understand the underlying principle: We have learnt it in Value Investing. Always invest in DeFi products you understand. You should be able to explain the business or services of the DeFi product you are investing into. Does it add any value to the human life? Is using the product easier as compared to the competitors? For example, Uniswap is very user friendly and makes it very easy for exchange of tokens, cryptos and fiat money. Henceforth, we have witnessed a spike in its adoption. Likewise, Ethereum makes it possible to develop DeFi products on top of it. Hence Uniswap and Ethereum should be top picks for investments (just an example).
Is investing in DeFi safe?
If you want to go deep into “How to Invest in DeFi” you should also understand whether investing in DeFi is safe? No, it is not safe as compared to other investments like cryptocurrencies, traditional stocks, bonds, etc. Though DeFi promises larger returns (even returns of 3000% have also been recorded). Hence DeFi investments should be a fraction of your total investment portfolio. Let us see some of the risks involved in investing in DeFi products. This will be followed by the steps we should take to mitigate these risks.
- Technical Risks: These are risks of failure or issues in the software, hardware, protocols or Smart Contracts being used in a DeFi product. These are of paramount importance as these can compromise the entire functionality of the DeFi product or platform, which may result in you loosing all your funds.
- Financial Risks: DeFi products are too volatile in nature. Add to it, most of the DeFi products have just seen the dawn. Hence there is a large financial risk involved with DeFi products. As I say it always, one should only invest a fraction of his/her total investment money in DeFi.
- Security Risks: The most common form of Security risks involved in DeFi space is of the phishing attacks by malicious parties. These parties mirror the look and feel of a known DeFi platform or offer giveaways or large returns to attract investors to share their sensitive information. They can also use phishing emails which can take you to malicious websites or even run malicious programs on your browser. Other common forms of Security risks include:
- Pretexting: This involves a hacker or a malicious practitioner posing as a representative of a popular DeFi platform and convincing users to share sensitive information. The hacker could then use your sensitive information to transfer funds or conduct illegal transactions, without your knowledge and consent.
- Baiting also referred to as Bait and Switch: This involves a Baiter purchasing an ad space in a website. The ad has a link that takes you to a page that contains malicious software or virus. Once you click on the link you download a malicious software that might give the baiter/attacker, access to your computer.
- Quid Pro Quo: In this malpractice, the attacker offers something of value to the victim. The victim in return is convinced to act as the attacker wants him/her to do. For example, the attacker may contact the victim as a Customer Service Representative and offers help for a problem that the victim is unaware of. In return the attacker makes the victim run certain malware programs or download certain malicious software.
- Sim-Swapping: This is an extended version of the phishing attack in which the attacker, once he gets sensitive information from the victim, convinces the telecom operator to add a new SIM card to the victim’s user account. This gives the attacker full access to the smartphone of the victim.
- Spear Phishing: This is a form of phishing in which new and junior level employees esp. in the finance departments are targeted. They are convinced to share some sensitive information of the organization, which result in huge losses to the company and its customers.
Precautionary measures to mitigate the risks
What are the certain parameters we should be watchful for when investing in a DeFi product? Let us see.
- Custodial or non-custodial: Non-custodial DeFi platforms or protocols allow users to hold custody of their cryptocurrencies. This means the cryptocurrencies will be the responsibility of the user. You can keep the crypto in your own hard wallet. Whereas, custodial DeFi platforms require you to transfer your cryptocurrencies to their wallets. This is a dangerous practice as it calls for frauds, hackings, etc. Hence, always go for non-custodial DeFi platforms.
- Governance: This is yet another important parameter, which defines who makes critical decisions on the DeFi platform. Is it a group of developers who take all the decisions like fees, upgrades, etc.? Or is it a community that governs all these decisions through Decentralized Autonomous Organizations (DAOs). The later is a safer bet as it requires consensus of a large community including you (yes this is also possible), to take vital decisions.
- Smart Contract Security: Smart contracts sit at the heart of DeFi. Although their security has come a long way since the advent of the crypto sub-space, many projects remain unaudited. Within the DeFi space, hackers have already found several ways to infiltrate DeFi protocols and get to funds by exploiting vulnerabilities.
- Choosing trustworthy DeFi products: Always see the reviews and recommendations before investing into a specific DeFi product.
- Multi-Factor Authentication: Email confirmation, two-factor authentication, or multi-signature authentication are some of the proven recommendations to avoid DeFi risks.
- Backups and updates: New updates and patches are important to enhance the security of the DeFi solution. Furthermore, backups of the digital assets in a separate drive or copying it to a diary will help in not loosing the digital assets.