The meteoric rise of Bitcoin since the second quarter of 2020 has been dominating crypto news headlines for the last year, for good reason. However, a new crypto niche industry blew up in 2020, contributing much-needed momentum and compelling use cases to further the cause of BTC, Ethereum and cryptocurrencies in general.
Unless you don’t follow cryptocurrency markets at all or you’ve been living under a rock (they make great COVID hiding places), you’ll know we’re talking about decentralized finance, colloquially known as DeFi in short.
DeFi is undoubtedly the hottest crypto ticket in town after Bitcoin for 2021, offering a digital financial wonderland of decentralized exchanges (DEX), peer-to-peer (P2P) lending, borrowing and trading and innovations like non-fungible tokens (NFTs) that can soon become a nightmare for the ill-prepared and foolish.
What Is DeFi?
Decentralized finance (DeFi) is a digital ecosystem of novel financial applications that run on several decentralized protocols, aiming to revolutionize and disrupt conventional financial systems. DeFi leverages blockchain technology to remove the need for third parties like banks, insurance firms, brokers, etc. from financial transactions, making them completely obsolete and avoiding their weaknesses such as slow transacting, red tape and outdated centralized operations and systems.
Instead, these third parties will be replaced by smart contracts, which are autonomous and free from human corruption, while fiat currencies, on the other hand, are replaced by digital assets like Bitcoin, Tether (USDT) or Ethereum.
Weighing DeFi’s Risk and Reward
At the time of writing, around $40 billion worth of digital assets is locked in DeFi protocols, a staggering amount considering that this amount wasn't over $1 billion at the beginning of 2020. DeFi’s insane rise has caused many analysts to warn of a potential price bubble and closer regulatory scrutiny, much like the initial coin offering (ICO) industry suffered in 2018.
Considering the amount of capital people are injecting in the DeFi ecosystem, how much consideration is appropriate before investing in these platforms? In plain English: should you invest in DeFi?
While we cannot provide you with financial advice, we can say that it’s important to understand what you’re investing in and educate yourself exactly on how yield farming and other new fields work. There are also significantly higher security risks due to DeFi's new and largely unaudited nature. These variables and the uncertainty they bring is also the reason why profits are so much higher and price swings are so enormous.
Cryptocurrency investments, per se, are already relatively risky relative to other traditional assets, but interacting with DeFi protocols may amplify the risk. For instance, if a user wants to dabble in DeFi staking, most of the available platforms compel users to lock their staked funds for a given period. During this period, crypto prices may rise or fall dramatically while the holder is prevented from selling.
Furthermore, DeFi networks use different mechanisms to calculate the value of tokens locked in their platforms. Unfortunately, these mechanisms may also have negative consequences such as impermanent loss and price slippage.
As with all things crypto, the earliest investors make the highest returns. Those who invested in DeFi in early 2020 reaped the most rewards, especially with DeFi tokens like YFI making 20x-1000x price increases, liquidity mining schemes returning excessively high APYs, and more.
Is DeFi still a worthy investment in 2021? Judging by the fact that it’s still growing strong and that new protocols are popping out from all directions, the answer is definitely yes! However, you need to manage the risks. We need to approach DeFi investing with a mix of cautious optimism and hopeful skepticism.
Are You Ready for DeFi?
The DeFi landscape is so vast that it needs extra attention. However, most investors are usually too caught up with a DeFi scheme’s annual percentage yield (APY), which is the expected return on investment within a year, to pay attention to other important aspects of a DeFi project. But there are many other factors a new user should consider to determine if they’re ready to deal with DeFi, such as:
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.
Custodial or non-custodial – While developers work to fix smart contract vulnerabilities, DeFi users are responsible for the security of their coins. Note that most protocols are non-custodial, meaning that users alone are responsible for safeguarding their cryptocurrencies. This reduces the risk compared to when interacting with custodial networks that require you to transfer funds to their wallets. Not your keys, not your coins!
Governance – Who makes critical decisions on the platform of choice? Some DeFi projects are solely run by the development team, while others employ community governance through decentralized autonomous organizations (DAOs). Key areas requiring community involvement include fees and upgrades. If it’s not community-governed, think again. Rug-pulls have been a common occurrence since 2020, don’t let history repeat itself!
Historical data – Another way to make yourself ready for DeFi is through the available historical data to guide you into making an informed decision. Since the ecosystem is only just gaining momentum, this data may not be enough as of now.
How to Invest in DeFi
Trading DeFi Tokens
DeFi tokens are native virtual assets used by DeFi platforms. For instance, Compound's base asset is COMP while Maker’s native currencies are Maker (MKR) and DAI. And like any cryptocurrencies, DeFi tokens are tradable on exchanges.
Trading these tokens allows users to buy, hold and sell when the price is right, which may win them profits along the way. Another major importance of being in on the action is that these tokens are at the core of DeFi protocols, unlocking their full potential.
However, it’s best to only invest in DeFi tokens with provable real use cases, such as governance, staking, etc. For instance, the UNI token from Uniswap is a governance token and usable as collateral for loans. YFI allows users to participate in yield farming in the Yearn ecosystem. Having use cases like these will cause a demand, which is ultimately the only factor that affects the price of an asset besides supply.
Liquidity mining is the act of injecting liquidity into a DeFi protocol. Liquidity miners interact with a liquidity pool that holds funds. Liquidity providers (LPs) are incentivized to participate in DeFi platforms since they receive a huge share of the collected fees.
For example, if it’s a lending platform, LPs receive a percentage of the fees charged to borrowers. However, most platforms allow LPs to withdraw their funds at any time. Therefore, instead of letting your funds sit idly, maybe it’s time to become a liquidity provider and earn rewards. Just remember that there is always the risk of impermanent loss.
Yield farming resembles liquidity mining but with a twist. Instead of having LPs deposit their funds into a single protocol, yield farmers hunt for platforms with the highest incentives or yields. An excellent example of a DeFi network championing yield farming is yearn.finance.
In Yearn, users deposit their funds on the protocol, and it automatically searches for DeFi projects with good LP rewards. However, the platform looks further than just the APY to include other factors including the risk profile of other platforms.
DeFi is a once-in-a-generation investment opportunity that if done right. However, the industry is also very young and full of not-so-great players looking to exploit new investors due to their lack of technical knowledge. Prices are also currently so inflated that it’s hard to decide if current prices reflect honest price discovery or whether it’s just a concerted “pump” effort that will come crashing down soon. For example, hot new protocols like AAVE have jumped from under $20 to over $520 in only weeks!
Whether you should invest in DeFi ultimately comes down to your available funds and your appetite for risk. Make sure you do a lot of research before investing. Really understand what you’re investing in, make sure that the DeFi project’s team is proven and legitimate and that it’s solving a real financial problem. Where possible, use trusted intermediaries like Binance or hardware wallets to protect your assets. Good luck!