How to Invest in DeFi: Investment Methods and Risks

How to Invest in DeFi: Investment Methods and Risks

How to Invest in DeFi: Investment Methods and Risks

DeFi has been the fastest-growing industry in the cryptocurrency market in recent years. New protocols appear almost daily, and regulated American and European venture capital funds are actively investing in them.

The reason for this interest is simple, DeFi is virtually the only way to generate recurring fixed income in cryptocurrencies. The annual percentage rate of return (APY) in the top 5 DeFi protocols ranges over 15% per annum.

However, DeFi continues to raise many questions, both inside and outside the crypto market. Let’s see how the profitability of DeFi protocols is formed and what investment strategies and risks this market has.

What is DeFi?

What is DeFi?

The term “decentralized finance” or DeFi refers to a vast range of financial products and services. It includes lending and trading within the cryptocurrency market. A distinctive feature of all products is the lack of centralized management. All rules are written in smart contracts, open for audit, and products are available to the broadest possible range of people.

Typically, products or services in DeFi are represented as a decentralized application (Dapp) on the Ethereum blockchain network. The most popular products in the sector:

  • open lending protocols;
  • decentralized stablecoins;
  • platforms for issuing tokens and investing;
  • forecasting markets;
  • decentralized exchanges (DEX).

What are DeFi protocols?

In general, most of the DeFi protocols are divided into two types:

  • allowing users to lend and borrow cryptocurrencies;
  • providing the ability to exchange one cryptocurrency for another by analogy with decentralized exchanges.

The most popular are the protocols of the first type. They allow absolutely any person to take out a loan in a short time on attractive terms (rate from 2% to 10%), avoiding complicated procedures. However, borrowing from DeFi protocols has two significant disadvantages that limit the number of protocol participants:

  1. Over-collateralization of the loan. At the moment, obtaining a loan in cryptocurrency is possible, subject to collateral in a more significant amount in another cryptocurrency. As a rule, such loans are of interest to a small category of traders involved in arbitrage transactions and margin trading.
  2. The provision and repayment of a loan exclusively in cryptocurrencies that the above-mentioned intelligent contracts can work with.
  3. Accordingly, DeFi is a reasonably highly specialized market that sets new standards for financial products. And, with a high degree of probability, it will soon go beyond the pure cryptocurrency industry.

How to start investing in DeFi?

Currently, the DeFi market is open to the crypto community and investors who have experience with cryptocurrency in the first place. There are several reasons for this:

  1. A crypto wallet is required to interact with any protocol.
  2. When choosing a protocol for investment, expertise, and understanding of the current market situation, considering the protocols existing on the market, are required.
  3. Investments and profitability only in cryptocurrencies.
  4. Cryptocurrency exchanges are used to convert protocol tokens and fix profits.
  5. Investing does not require the conclusion of any contracts, search for brokers or managers.

At the same time, it is almost impossible to compete with the current profitability of the DeFi market, especially when compared with the classic fixed-income market. In this regard, DeFi can become attractive for the crypto community and investors from the classical financial sector.

Investing in DeFi

Let’s take a look at the main ways to invest in DeFi for profit.

Farming

Profitable farming is a way of investing with cryptocurrencies, in which the investor places his funds in a certain protocol based on smart contracts that distribute these funds by issuing loans to other people at interest. The investor receives a portion of the interest income. It looks quite simple, but to get the maximum income, you need to apply different strategies and move funds between different protocols in search of the most favorable conditions.

Staking

Staking is an investment in the form of storing cryptoassets in a special wallet that supports the Proof-of-Stake (PoS) blockchain network. Staking is like a deposit on which a certain amount is locked in order to receive passive income from it.

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Its earnings on P2P lending. In decentralized lending, lenders and borrowers interact through the blockchain. The borrower takes out a loan in cryptocurrency at interest, leaving collateral also in cryptocurrency. On the other hand, the investor invests his assets in a shared pool and earns on interest. P2P lending platforms offer loans to anyone without checking their credit history and without ID. The only condition is a deposit. Usually, it is about 150% of the loan amount. At the same time, the smart contract guarantees that the lender will return his funds with interest even in a fall in the value of cryptocurrencies or non-repayment of the loan by the borrower.

DEX margin trading

DEX Leveraged Trading is a way to trade on an exchange using leveraged funds. Thanks to leverage, a trader can use in the process amounts several times larger than available. It’s where the trader borrows assets from decentralized credit protocols. You can invest by providing your new cryptocurrency to traders at a percentage. Smart contracts regulate the risks of losing funds.

Investment in tokens

A classic investment in DeFi tokens is a typical purchase of assets based on their growth. The attractiveness of this method of investing in cryptocurrency is that a few hours after the release of the DeFi token. It can rise in price by thousands of percent. But there is also a problem – the volatility of new tokens is very high. You can earn a lot quicker, but you can also lose.

DeFi Investing Risks

Before you start investing in DeFi, you should assess the risks. It is worth paying attention to such possible negative factors:

  1. Loss of invested assets as a result of hacker attacks on the project. It’s better to invest in a proven protocol that works for a long time and has time to prove itself to minimize this risk. Usually, such projects pay attention to their safety and are better protected than young ones.
  2. Investments in fraudulent projects. To avoid losing funds in a scam project, you should ensure that auditors have checked the protocol. You can check the registration of a smart contract in particular blockchain browsers and unique sites that track DeFi projects (DeFiPrime, DeFiPulse, DeFiMarketCap). You can read publications and social networks of projects, get acquainted with their environment and audience.
  3. The volatility of crypto assets. Diversify your investments, invest in different projects and protocols. Or invest in projects based on stablecoins – crypto assets pegged to real currencies, for example, to the dollar.