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A Beginner's Guide to DeFi Investing

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A comprehensive guide for beginners, intermediate and expert investors who are looking to get started with Cryptocurrency and DeFi investing

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Research
Max Yampolsky
February 17, 2023
Feb 17

Introduction to DeFi Investing

DeFi, or Decentralized Finance, is a nascent global financial ecosystem built on blockchain technology. The big idea behind DeFi is to re-invent the full suite of core traditional financial (TradFi) services such as lending, borrowing, investing, payments, trading and insurance, with blockchain technology.

With the use of cryptocurrencies and self-executing smart contracts, DeFi provides a transparent, secure, and borderless platform for everyone with an internet-enabled device to access critical financial services. with an internet connection, enabling more accessible and inclusive financial systems.

DeFi first emerged in mainstream media around 2015, when Vitalik Buterin conceptualized the Ethereum Virtual Machine (EVM) as the pioneer smart contract platform for hosting decentralized applications (dApps). 

Since then, several other scalable layer-1 and layer-2 networks have since emerged with EVM compatibility to host smart contracts. Networks like Solana, Avalanche, and Cardano are some of the most prominent platforms hosting a wide range of dApps today. 

How DeFi has been Gaining Traction in Recent Years

In recent years, the returns in TradFi investment markets have been perennially dwarfed by skyrocketing inflation. Consequently mainstream interest in decentralized finance has picked up steam as many investors and traders looking for enhanced yield and alternative investment opportunities.

According to DeFiLlama, the total value locked (TVL) in DeFi protocols has grown from approximately $1 billion in January 2020 to over $45 billion as of February 9th, 2023. This represents a staggering 4,400% growth in less than 3 years —making DeFi one of the fastest-growing sectors in global finance. 

Five Reasons Why DeFi Protocols are Gaining Popularity

Here are 5 reasons why DeFi has gained immense popularity as an investment option: 

1. Decentralization

DeFi operates on decentralized blockchain networks, which allows for a more secure and transparent investment experience. Instead of unreliable terms & conditions subject to human alteration, DeFi is based on self-executing smart contracts, which allow terms of agreements being directly written into code and executed autonomously. 

The result is greater automation and efficiency has enabled new financial instruments to be created. For instance, because there’s no central authority controlling the funds, it greatly reduces the risk of fraud, human error and other malicious activities. 

2. Accessibility: 

Unlike TradFi markets that have geo-political restrictions and minimum financial requirements, DeFi is open to everyone with an internet connection and a digital wallet, regardless of their location or financial status. And this has enabled many people to access financial services that were previously unavailable to them.  With this level of accessibility, DeFi now shows a big potential towards easing financial inclusion barriers for many disadvantaged people around the world.  

3. Higher Market Liquidity & Competitive Yields

Due to the level of automation, DeFi protocols are able to operate and deliver financial products far more efficiently. Hence, DeFi financial instruments are able to offer considerably higher yields on investments compared to their TradFi alternatives. 

Similarly, with fractional ownership, global markets access and lack of stifling intermediaries, DeFi has created a larger pool of liquidity that can be easily accessed 24/7 from anywhere around the world. This has led to the growth of DeFi-based investment products, such as yield farming and liquidity provision, which offer high returns in a short period of time.

DeFi-based investment products provide greater opportunities, such as yield farming and liquidity provision, which offer high returns in a short period of time. With a much lower cost of borrowing and lending, DeFI users get access to  investment opportunities that generate higher yields within a short period of time. 

4. Innovative Use Cases 

Another reason that DeFi has gained so much traction is how it has opened up a wide range of new financial products and innovative services that previously did not exist in the TradFi markets. Examples are, non-custodial & non-kyc decentralized exchanges, prediction markets, and decentralized identity, digitized collectibles, and fractional ownership assets that are traditionally considered illiquid, such as real-estate and art pieces. 

5. Community-driven Development

Unlike TradFi financial products which are often created in obscure board room meetings, Many DeFi protocols are open-source and community-driven. This allows for a more inclusive, iterative and collaborative approach to product development. Furthermore, DeFi protocols allow users and Investors to be heavily involved in key decision-making processes. Community members and token holders can vote on a wide range of subjects including allocation of treasury funds, partnerships, development of new product features e.t.c. 

Overall, the growing popularity of DeFi can be attributed to its transparent, secure, and decentralized platform, as well as its potential to offer high returns and diversify investment portfolios. These factors combine to make DeFi an attractive investment option for many individuals and organizations today. 

II. Types of DeFi Investments

DeFi (Decentralized Finance) offers a variety of investment options for individuals looking to invest in the cryptocurrency market. 

1. Lending

Lending in DeFi refers to the act of lending out cryptocurrency in exchange for interest. DeFi platforms such as Aave, Compound, and MakerDAO provide borrowers with the opportunity to take out loans using their cryptocurrency as collateral. Lenders, in turn, earn interest on their loaned assets. 

This process is facilitated by smart contracts and is typically done without the involvement of traditional banks or financial institutions. And as a result, but the yield earned by lenders and the costs incurred by borrowers are typically far more competitive than alternative TradFi bank loans and Fixed interest products. 

Popular Lending Platforms

- Aave

Aave is an open-source liquidity protocol. It offers decentralized lending and borrowing products that allows users to deposit their crypto assets and earn interest on them. 

Aave.com, DeFi Lending protocol
Aave.com, DeFi Lending protocol

With Aave, in addition to earning yield, users can also take out loans using the crypto assets that they have deposited as collateral. Aave is known for its unique feature called "flash loans" which allows users to take out loans without collateral. However, the loan must be repaid within a single block of transaction. Aave also offers options for customizable loan products with flexible interest rates.

- Compound

Compound is a prominent decentralized lending and borrowing platform that allows users to earn interest on their crypto deposits and take out loans at competitive rates. 

Compound.finance, DeFi Lending Protocol
Compound.finance, DeFi Lending Protocol

Compound uses a unique algorithm to dynamically adjust interest rates in real-time, based on supply and demand for each asset.

Additionally, Compound users can also earn or purchase COMP tokens to participate in the platform's governance by voting on proposals.

MakerDAO

MakerDAO is one of the pioneer decentralized finance platforms that offers a wide range of financial services. Primarily, Maker issues its native stablecoin (DAI) backed by a mix of other cryptocurrencies as collateral. 

MakerDao.com, DeFi Lending Protocol
MakerDao.com, DeFi Lending Protocol

However, Maker also offers unique lending products that deposit crypto assets as collateral and take out loans denominated in the DAI stablecoin —at a low and stable interest rate. MakerDAO also has a governance system where MKR token holders can vote on platform upgrades, and other critical community proposals. 

Curve

Curve is a unique decentralized exchange and lending platform with a focus on stablecoin issuance and trading.

Curve.com, DeFi Lending Protocol
Curve.com, DeFi Lending Protocol

Curve allows users to deposit stablecoins and earn interest on their deposits. The platform uses an algorithm to dynamically adjust interest rates paid out to depositors based on supply and demand for each stablecoin held on the platform.

Pros & Cons of DeFi Lending

Pros
  • Crypto lenders can earn competitive returns on their invested capital higher than what is obtainable in the TradFi money markets. 
  • DeFi lending is done in a quick, relatively simple and transparent process. 
  • Decentralized nature of DeFi lending protocols means users can have full control over their funds.
  • DeFi platforms offer lower fees and greater efficiency in transactions. 

Cons
  • There is a risk of default by borrowers, leading to the loss of invested capital.
  • The volatility of cryptocurrency markets means the value of collateral may decrease, leading to margin calls or liquidation. 

2. Staking

Staking in DeFi refers to the act of temporarily locking a certain amount of a particular cryptocurrency in a wallet to support the operations of the blockchain network. 

DeFi Staking. Source: Pixabay

By doing so, Stakers earn fractional rewards on their staked assets. Staking is an important component of proof-of-stake (PoS) consensus algorithms as it helps to secure the network and validate transactions. Participants in PoS blockchain protocols can lock-up their stake, or collateral, for a chance to validate blocks and receive rewards. Typically, the protocol randomly selects a node that will validate each block. 

The key advantage of the PoS consensus model over Proof of Work and other methods is that it does not require intense energy consumption to run computational equipment. 

According to Vitalik Buterin, The Merge reduced Ethereum's network power consumption by more than 99.9%. 

https://twitter.com/VitalikButerin/status/1570299062800510976?lang=en

Factually, before Ethereum’s September 15th upgrade to the Beacon chain, the energy consumption of Ethereum ranged between 46.31 terawatt hour (TWh) per year to 93.98 TWh per year.

Ethereum Energy Consumption Index
Ethereum Energy Consumption Index. Source: digiconomist.net

Since the merge, the Energy consumed by the Ethereum network has been cut down considerably to 0.01TWh.  Unlike Proof-of-Work (PoW) where participants have to invest in capital intensive mining equipment, PoS only requires validators to stake cryptocurrency to forge blocks. Therefore, it is more inclusive and accessible to anyone wishing to partake, anywhere around the world. 

It is important to note that different PoS protocols require varying stake amounts and lock-up periods.  

Popular Staking Platforms. 

Ethereum launched its staking network in the build-up to the Merge which marked the transition from Proof of Work, to Proof of Stake consensus. However, staking directly on the Ethereum network comes with financial requirements of 32eth (~$50,000) and technological barriers associated with running an Ethereum validation node. 

However, many DeFi staking protocols have now sprung up to help bring down the barriers to staking on the Ethereum network. In recent times, Lido, Rocket Pool, and FRAX are some of the most popular staking protocols in the decentralized finance (DeFi) space. Here is a brief overview of each:

- Lido

Lido is an Ethereum 2.0 staking pool that enables users to participate in staking with a small amount of ETH and earn rewards.

Lido. DeFi Staking Plaftorm.
Lido. DeFi Staking Plaftorm.

 

Lido provides a user-friendly interface and helps users navigate the financial constraint and complexity of participating in the Ethereum 2.0 staking.  Lido users are issued stETH, a form or receipt of units of Eth that they stake on the platform. Lido collects these deposits and pools them into 32ETH staking pools required to participate on the Eth network. 

Stakers automatically receive their share of the Eth rewards in their wallets on a daily basis, through a process called rebasing. They can redeem their stETH for ETH at any time or sell it in secondary markets on various decentralized exchanges. 

- Rocket Pool

Rocket Pool is another decentralized staking pool that allows users to earn rewards for participating in the security and governance of the Ethereum network. It aims to provide a more efficient and scalable staking solution for users. 

Rocket Pool, DeFi Staking Plaform.

Rocket pool users can earn residual income by staking rETH, which its native  token pegged 1:1 to Ethereum. Unlike rebasing on Lido, Rocket pool deploys an increasing exchange rate method to pay out rewards to users. This method is typically best suited to institutional participants who have to keep earnings records for tax purposes and financial reporting. 

Rocket pool also provides custom software, for sophisticated users who wish to run their own nodes and maximize their rewards. 

- FRAX 

FRAX is another prominent DeFi staking protocol. It enables users to earn rewards by staking the FRAX token. FRAX was first launched as a platform for issuing its hybrid stablecoin — a cryptocurrency  backed by collateral and partially stabilized algorithmically. 

The FRAX platform uses its own unique pricing mechanism, called the FRAX Algorithm, to provide a stable price for its stablecoin and maintain its pegged value. Frax has since launched its own decentralized staking product. With FRAX Ether (frxETH) and Staked FRAX Ether (sfrxETH), stakers can participate in the Ethereum network staking process and  earn rewards.

Here’s how it works. 

frxETH — frxETH is a stablecoin that is loosely pegged to Ethereum (ETH). When FRAX users deposit ETH, they get an equivalent amount of frxETH.  However, to be eligible for yield earning, they have to deposit the frxETH into a designated vault, after which they are issued sfrxETH. 

sfrxETH —to participate in Ethereum node staking, FRAX users can exchange frxETH for sfrxETH by depositing it into the ‘vault’. sfrxETH is an ERC-4626 token designed to accrue staking yield for users who validators who stake ETH through the FRAX protocol. Meaning that every sfrxETH holder gets to earn rewards equivalent to the percentage of claim that the have in the total amount held in the vault.  

sfrxETH accrues yield, while frxETH doesn’t. However both tokens can be redeemed 1:1 for ETH at any time. 

In summary, DeFi staking protocols provide a way for individuals to earn rewards by participating in the security and governance of blockchain networks, while also enabling more efficient and user-friendly staking experiences.

Pros & Cons of DeFi Staking

Pros
  • Staking provides a sustainable and environmentally-friendly way to run financial systems and run blockchain networks. 
  • Staking can offer relatively stable returns on investment with very minimal risk.
  • The process of Staking on DeFi protocols is user-friendly, simple and does not require much technical knowledge. 
  • Staking can be a way to passively earn income without having to actively trade.

Cons
  • Staking returns may be lower than other DeFi investment options
  • The value of staked assets may decrease if the underlying blockchain network is not successful. 

3. Yield Farming

Yield farming refers to the act of providing liquidity to a DeFi protocol in exchange for interest or rewards. By providing liquidity, yield farmers help to increase the overall stability of a DeFi protocol and are rewarded with a share of the protocol's trading fees or with interest on their deposited assets.

DeFI Yield Farming. Source: Pixabay

Similar to fixed income and money market instruments, there are different forms of yield farming strategies deployed by DeFi protocols depending on the risk appetite of each user. The main premise is to generate passive income for cryptocurrency holders. 

Popular Yield Farming Platforms

Uniswap

UniSwap is a decentralized exchange platform that allows users to trade any token directly with each other without the need to match trades through an order book. Yield farming on UniSwap involves providing liquidity to the exchange and earning a portion of the trading fees generated by the platform as reward.

UniSwap is a pure decentralized exchange without a governance token. While platforms like SushiSwap and Yearn Finance may offer yield farming opportunities in addition to trading.

SushiSwap

SushiSwap is a decentralized exchange and yield farming platform built on the Ethereum blockchain. 

SushiSwap, DeFi Yield Farming Platform
SushiSwap, DeFi Yield Farming Platform.

Similar to UniSwap, users can earn rewards by providing liquidity to the platform. SushiSwap also has a token (SUSHI) which acts as a governance token and allows token holders to vote on platform upgrades and product modification.

Yearn Finance

Yearn Finance is another decentralized finance platform that aims to simplify yield farming by automatically allocating user funds to the most profitable yield farming strategies.

DeFillama.com, DeFi Analytics Platform.
Yearn.Finance, DeFi Yield Farming Platform

Yearn Finance aggregates liquidity from different DeFi protocols and optimizes returns for its users through a combination of yield farming, lending, and borrowing. Yearn Finance also has a token (YFI) which acts as a governance token and gives token holders the ability to vote on platform upgrades and changes.

Yearn Finance is recognized for offering a more beginner-friendly hands-off approach to yield farming. It automates the process of farming and aggregating liquidity for its users. 

Pros & Cons of DeFi Yield Farming

Pros
  • Yield farming can offer considerably high returns on investment in a short period of time
  • Yield farming has very low barriers to entry and requires a relatively small amount of capital.
  • The process is transparent and automated by smart contracts

Cons

  • Yield farming can be risky as the returns are not always guaranteed.
  • The value of the deposited assets may decrease depending on market volatility. This often leads to impermanent loss. 
  • The complexity of some yield farming strategies may not be suitable for beginners. However, Robo-advisor and auto-Yield Aggregators can be helpful in such situations. 

Important DeFi Investment Tools 

Evidently, Decentralized finance (DeFi) is a rapidly growing industry that offers a new way to invest, trade, and manage cryptocurrency assets.  However, to succeed in this exciting new space, it is crucial for DeFi investors to get familiar with the various tools to minimize risk, maximize gains while also automating part of the process. 

Here’s an overview of some of the most important DeFi investment tools and some prominent examples of each. 

  • Digital Asset Storage Tools
  • Analytical Tools
  • Yield Aggregators
  • Robo-Advisors 

  1. Digital Asset Wallets

To access DeFi investment protocols, typically, you have to connect a wallet where you store your digital assets and accumulate your earnings. 

Digital wallets are software tools that securely store and manage digital assets such as cryptocurrencies and other blockchain-based tokens. In addition to integration into various DeFi investment protocols, crypto wallets they also provide enhanced security features such as multi-sig and backup/recovery options to protect user assets. 

Metamask, Ledger, Trezor and Trust Wallet are prime examples of popular crypto wallets. 

  1. DeFi Analytical Tools

Data-driven insights are crucial to successful investments in virtually every business sector. Blockchain analytics are unique platforms that provide objective data-driven insights and market analysis to help DeFi investors make informed decisions. 

They often use machine learning algorithms, big data analysis, and other advanced techniques to provide real-time information about DeFi protocols and blockchain networks. Examples are DeFillama, DeFi Pulse, Nansen, Santiment and a host of others. 

DeFillama.com, DeFi Analytics Platform.
DeFillama.com, DeFi Analytics Platform.

DeFillama is a typical example of a blockchain analytics tool. The website that tracks the total value locked (TVL) across various blockchain networks and DeFi protocols. TVL refers to the total amount of cryptocurrency or other assets that are locked in smart contracts on a particular DeFi platform, and is often used as a metric to gauge the overall health and adoption of the platform.

These analytical tools collect data from multiple sources, including blockchain explorers and DeFi protocol APIs —to provide users with real-time updates on the TVL of various DeFi protocols, Revenue earned, Fees charged, global protocol rankings, trading volumes, and more.

In addition, they also offer educational resources, news updates on the DeFi industry to help investors crunch the numbers, stay up-to-date with market trends, and assess historical asset performance while making important investing decisions. 

  1. Yield Aggregators

Yield Aggregators are algorithm-assisted blockchain tools that automate the process of investing in DeFi yield-generating protocols. They pool investment capital and distribute it across a variety of DeFi protocols and crypto assets, based on the most efficient trading strategy available on the market at a particular time. 

Yield-aggregators allow DeFi investors to maximize yield without having to manage the underlying investments themselves. Examples are Alpaca Finance, Yearn Finance, Pickle Finance.  They also often provide additional features such as risk management and portfolio optimization, helping investors to maximize returns while minimizing risk.

  1. Robo-Advisors 

Robo-advisors are computer-based portfolio maangement tools that automate crucial parts of the investment management process, including providing auto-generated investment recommendations. Popular examples of Robo Advisors include Cryptosimple and Wealthfont, while OneClick stands out among DeFi investors for its full automation and minimal configuration required. 

Robo-Advisors use big data and advanced algorithms to analyze market trends and make investment recommendations, allowing DeFi investors to invest in a diverse portfolio of assets with ease. 

Oneclick.fi, DeFi Robo-Advisor
Oneclick.fi, DeFi Robo-Advisor

One Click Crypto is one of the leading Robo Advisor tools. It uses AI & machine learning technology to analyze on-chain transaction history related to the particular wallet owner and provide personalized portfolio recommendations based on the data acquired. In addition, it is completely non-custodial and can be used from any web3 wallet like Metamask or Trust Wallet.

Conclusion

In summary, we have identified higher market liquidity, competitive yield and community-drive approach as some of the reasons why DeFi protocols have been gaining popularity among investors in recent years. 

Similarly, we also outlined, Staking, Yield Farming and Lending as the most popular investment opportunities in the DeFi space. 

However, it is important to note that DeFi investments, like all forms of investment, come with a level of inherent risks. Hence, before investing, it's important to thoroughly research and understand the underlying products and protocols, as well as the market and economic conditions that may impact your returns.

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Max Yampolsky

Max Yampolsky is a seasoned authority in the realm of crypto investing and blockchain technology, serving as the guiding voice behind his highly successful, #1 Google-ranked blog on web3 and token economics.

As the co-founder of a thriving AI startup and an algorithmic crypto trading firm, he translates real-world entrepreneurial success into invaluable insights for his readers.

Having immersed himself in the crypto space since 2017 and the DeFi arena since 2021, Max combines his comprehensive market understanding with a keen ability to communicate complex concepts with ease and clarity. His hands-on experience and thought leadership make him an invaluable resource for investors navigating the dynamic world of crypto investing.

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