First steps: Basic tips for getting started investing in DeFi

Decentralized finance (DeFi) protocols have diversified investment opportunities in the crypto industry by facilitating novel and innovative passive income generation schemes.

Delving a bit into how they work, DeFi systems are based on blockchain technology and run on programmable chains such as the BNB Chain and the Ethereum Network.

The chains use decentralized peer-to-peer (P2P) finance architectures to cut out the middleman and enable lending, borrowing and liquidity provision. This leads to higher interest rates compared to those provided by regulated financial institutions such as banks.

For perspective, many regulated banks provide interest rates of less than one percent per year, while some DeFi platforms offer interest rates of over 20% per year.

Investing in DeFi provides numerous benefits. Yubo Ruan, CEO and founder of Parallel Finance, told Cointelegraph:

“DeFi has immense potential for users compared to traditional markets. For example, DeFi trading is available 24/7 and 365 days a year, which can create new opportunities and even the ability to trade after hours alongside a full-time career independent of finance.”

“DeFi’s speed and efficiency create immense opportunities for moving in and out of positions very quickly for arbitrage for example. Additionally, no matter what background or money you have access to, you can have access to DeFi,” he said, adding, “There are more than a billion people who are unbanked and unable to use traditional markets. This is a massive benefit for the unbanked to access and invest with DeFi in a world where banks simply don’t exist for them.”

There are over 100 DeFi projects in the crypto sector today. As such, finding the ideal project can be challenging, especially for newbie investors. The following is a breakdown of factors to consider when choosing a well-grounded DeFi project.

Total value locked

Total value locked (TVL) should be considered when looking for an outstanding DeFi project. A high TVL is a strong indicator of investor confidence in a platform and its core drivers.

DeFi projects with significant assets locked in custody are generally perceived to have more upside potential and are deemed to be more secure compared to those with low TVL. Projects with a consistently positive TVL growth rate are desirable.

Total value locked in DeFi markets. Source: DeFiLlama

Check the fully-diluted valuation

It is important to consider a DeFi token’s fully-diluted valuation (FDV) before investing. FVD in DeFi is the theoretical market cap of a token relative to the prevailing market price and the number of coins in circulation.

When the fully-diluted valuation is too low, the consistent increase of new tokens is likely to outpace demand for the token leading to a price drop. In DeFi investments, native tokens are adversely affected in low FDV market situations.

Token price stability

Promising DeFi tokens typically have a consistent long-term uptrend. Of course, rallies of over 30% within a short period of time are enticing at first glance, but they could be unstainable parabolic market reactions that are usually followed by a significant drop.

Pump and dump schemes play a role in some momentary price hikes. These types of ploys are prevalent in the crypto space and usually affect low and mid-cap tokens.

Subsequently, investors should disregard short-term price performances in the absence of other positive indicators and choose tokens backed by projects with stellar long-term growth fundamentals.

Risks

Risks such as platform exploits and rug pulls are common in the DeFi industry. As such, it is important for investors to do significant background research on platform security before investing in DeFi projects.

Security audits by independent cybersecurity firms usually reveal potential loopholes. Investors are advised to take these assessments into consideration.