Decentralized finance (DeFi) is a rapidly growing sector of the financial industry, built on blockchain technology that enables users to access financial services in a decentralized manner. Touted by proponents as a way to potentially eliminate traditional intermediaries such as banks, DeFi has gained immense popularity in recent years.
However, investing in DeFi projects has risks, including volatility and security concerns. In this guide, we will explore what DeFi is and the different ways to invest in DeFi, including interest accounts, staking, farming, leveraged loans, and more.
- The DeFi space is a rapidly growing industry with many different investment opportunities.
- We’ll go over how to invest in DeFi and 8 investment approaches you can take.
How DeFi Works
DeFi is a system of financial applications built on top of the blockchain. Blockchains are digital, distributed, and decentralized ledgers that record transactions between two parties in a secure and verifiable way.
With DeFi, users can access various financial services, such as lending, borrowing, trading, and investing, without needing traditional financial intermediaries like banks and exchanges. These services are provided by open-source protocols, smart contracts, and decentralized applications (dApps).
The main benefits of decentralized finance are that it is open and permissionless. Anyone can access it, and users do not need to trust any third parties to use it. DeFi is also borderless, meaning users can access its services from anywhere in the world. With DeFi, everyday investors can access new asset types, take greater control over their finances, and get more exposure to financial services.
Popular use cases of DeFi include:
Stablecoins are one of the earliest DeFi apps. They are a type of digital currency designed to maintain a stable value. Unlike other cryptocurrencies like Bitcoin or Ethereum, which can have wild price swings, stablecoins are typically pegged to a specific asset, such as a fiat currency like the U.S. dollar or a commodity like gold.
In other words, for every stablecoin in circulation, there is an equivalent amount of the underlying asset held in reserve. For example, if a stablecoin is pegged to the U.S. dollar, like USD Coin (USDC), then for every stablecoin issued, there should be an equivalent amount of U.S. dollar held in reserve.
One exception is algorithmic stablecoins, a type of stablecoin that uses a combination of algorithmic rules and market forces to maintain their value rather than a centralized entity to hold reserves. In an algorithmic stablecoin system, the supply of stablecoins dynamically adjusts based on changes in market demand.
Algorithmic stablecoins typically use a variety of mechanisms to achieve stability, such as price oracles, incentive structures, and arbitrage opportunities. These mechanisms work together to keep the stablecoin price in line with its pegged asset while providing liquidity and facilitating trading.
Decentralized exchanges (DEXs) are a type of cryptocurrency exchange that operates on a decentralized network. In a DEX, users can trade cryptocurrencies directly with each other without the need for a central authority or intermediary to facilitate transactions.
Instead of using a central order book to match buyers and sellers, DEXs use smart contracts, self-executing computer programs that automatically facilitate transactions based on predefined rules.
One of its main advantages is that they offer greater privacy and security than centralized exchanges, since users do not need to provide personal information or trust a third party to hold their funds. Instead, users maintain control of their own private keys and can execute trades directly on the blockchain.
DEXs also offer greater transparency and censorship resistance, since they cannot be shut down or manipulated by any central authority. However, they are still subject to the limitations of the underlying blockchain, such as scalability and speed issues.
DeFi prediction markets allow users to make predictions about future events, earn rewards for accurate predictions, and hedge against risks. In a prediction market, users can buy or sell shares in a specific outcome of an event, such as the outcome of an election, the price of a commodity, or the winner of a sports match.
The price of each share gets determined by market demand. Shares in the most likely outcome are priced higher than shares in less likely results. When the event’s outcome gets determined, the shares in the winning outcome are redeemed for a payout, while shares in the losing outcome become worthless.
DeFi prediction markets operate on a decentralized network, where smart contracts enforce the rules for the market. The fees tend to be lower, and market participants can bet on anything.
How to Invest in DeFi: A Step-by-Step Guide
Before investing, you need to understand how to use dApps and protocols.
1. Prepare a Wallet
Your crypto wallet is a digital wallet where you store your assets, similar to having your cash and credit cards in a physical wallet. You can choose any wallet you prefer based on your preferences. Popular options include MetaMask, Coinbase Wallet, Crypto.com, and the Ledger Nano.
To choose a wallet, conduct your research to decide which wallet best suits your needs. Once you pick a wallet, you can create an account and transfer crypto coins into it, which you can then use to participate in DeFi protocols.
2. Choose Your Blockchain Networks and Protocols
Once you set up your crypto wallet, look into which blockchain networks and protocols you are most interested in. While people tend to use the terms blockchain network and blockchain protocol interchangeably, there are subtle differences between them.
A blockchain network is a group of computers that work together over the internet to create and validate a redundant ledger of transactions. Protocols are sets of rules that dictate how the blockchain operates and how the network participates and interacts. These rules can include the consensus algorithm, governance structure, incentives, penalties, and application interfaces.
Leading blockchain networks include the Bitcoin and Ethereum ecosystems, which dominate crypto discussions. Popular protocols include Stacks, Uniswap, Optimism, Aave, Sushiswap, and Compound.
3. Purchase Crypto
Similar to how you need cash to invest in stocks or real estate, you need crypto coins and tokens to participate in DeFi investing. If your wallet is hosted by an exchange, like Coinbase, you can purchase crypto there by linking your bank account details. Alternatively, you can use an on-ramp like the Ledger Live ecosystem or an NFT marketplace. Though you will need to use your fiat currency to buy crypto initially. Exchanges like Coinbase and Gemini are popular options to do this.
The 8 Best Ways to Invest in DeFi
There are many ways you can invest in DeFi to maximize your profit potential. We’ve outlined 8 of the most common methods below.
1. DeFi Staking
One of the most common ways to invest in DeFi is through staking. Staking is the process of locking your tokens in a protocol for a certain timeframe in exchange for interest, typically in the native token.
There are two ways you can stake your assets. The first method is through a proof-of-stake (PoS) blockchain like Cardano or Solana. These tokens will get locked in the respective blockchain and used to verify transactions, thus enhancing the blockchain’s security. The second way is through a third-party staking platform, such as eToro or Coinbase, where you will deposit your token into the platform’s smart contract. These tokens would then get used to fund liquidity pools and loans.
Typically, you can expect a higher yield if you stake directly on a PoS blockchain than if you were to use a third-party staking platform. However, using a third-party platform will likely be easier and more intuitive for the average person. And, the more you stake, the higher your rewards. Note that high annual percentage yields (APYs) don’t necessarily mean you’ll always profit. If the token crashes, you could end up losing all your money.
2. DeFi Savings Accounts
DeFi savings accounts operate similarly to high-yield savings accounts at regular banks, but without their protections. For instance, you could deposit your USDC stablecoin into a crypto savings account with an exchange like Coinbase or Binance to earn interest, at rates ~4% APY.
Your deposited crypto gets sent to a crypto lending pool (or potentially invested in traditional assets if it’s a stablecoin). In many cases, you can expect to earn comparable or higher interest rates than a traditional HYSA, which is 4% around this article’s writing. However, the exact rates will depend on various factors, such as the specific tokens or protocols, lock-up period, and platform used.
Keep in mind that DeFi accounts are not FDIC-insured and come with risks, though they may get marketed as risk-free savings accounts. Over the past year, many CeFi lending platforms that touted interest rates of 8% and upwards collapsed, including Celsius, BlockFi, and Hodlnaut. Investors (like me, unfortunately) who had crypto assets on these platforms couldn’t withdraw their holdings as a result, and it’s still unclear whether they’ll be made whole again.
3. Yield Farming
Yield farming is similar to staking but with an extra layer of complexity. Just like with staking, you would lend your crypto or tokens to a decentralized exchange or dApp of your choosing. But the key difference is that you are providing liquidity for them.
As a liquidity provider, you help ensure buyers and sellers can transact without a third party. The exchange uses this liquidity from investors contributing their assets in specific liquidity pools to execute orders created by token swappers. When the transaction is successful, you can earn a portion of the transaction fees as a reward.
Yield farmers may need to provide tokens for a pair of assets instead of staking a single asset. For example, if you want to add liquidity to CAKE/BNB, you would need to deposit an equal amount of both to allow people of the respective exchange to swap CAKE for BNB. In other words, if you want to add $500 worth of BNB, you will also need to add $500 of CAKE. That way, the buyer and seller can make the trade in a decentralized manner. Both sides will pay a trading fee, and you will get rewarded with a share of the fees.
If this sounds overly complicated, there are reputable projects that make it easy for you to yield farm, such as Aave, Compound, and Yearn.
4. DeFi Stocks
If you want to invest in DeFi without buying crypto assets directly, you can gain exposure through the traditional stock markets. That is, if opening new accounts on exchanges or learning how wallets work sounds like a hassle, you can buy shares of stocks related to DeFi investments in a regular brokerage account.
For example, if you find crypto mining interesting, you can invest in companies with large-scale mining facilities like Riot Blockchain Inc (RIOT) or Canaan Inc (CAN). Another popular option is Coinbase (COIN), one of the largest crypto exchanges in the world. If you want to own Bitcoin indirectly, you can buy shares of ProShares Bitcoin Strategy ETF CFD (BITO).
5. Secured DeFi Loans
Another way to invest in DeFi is through crypto loans. Lending protocols typically rely on collateral-based loans where lenders offer their DeFi assets to others, and borrowers lock up some assets as collateral to borrow other assets.
With this method, you won’t go through a bank or other traditional financial institutions. Instead, you will go through a DeFi platform. Unlike banks, you won’t need to do a credit check or provide documentation. That is because, to get the loan, you need to deposit crypto tokens and then use that for leverage. For example, if you deposit $1,000 of Ethereum tokens into Crypto.com and they have an LTV of 50%, you can borrow up to 50% of the value of your Ethereum, or $500, while still maintaining ownership over the assets you deposited.
Getting US dollars from the value of one’s crypto is a big use case for this type of loan, much like how people would borrow dollars by using their stock portfolio as collateral.
Lending protocols usually use an algorithm to calculate interest rates based on supply and demand. So, the higher the demand, the higher the interest rates. Aave and Compound are two popular options for lending and borrowing.
6. DeFi Smart Portfolio
If you’re a beginner and do not want to manage your DeFi investments, you can invest in eToro’s Smart Portfolio. eToro is a popular social trading and investment platform that allows users to trade stocks, crypto, and other assets.
The eToro Smart Portfolio builds a diversified crypto portfolio for you with different assets using machine learning and data science. This feature gives you access to a ready-made DeFi portfolio without needing to handpick assets on your own.
With these portfolios, the eToro team will manage them for you, including regularly rebalancing and reweighing the assets in your portfolio. The minimum deposit required is just $500, and there are no ongoing fees to maintain your account. Additionally, you can cash out at any time or easily add or remove assets.
7. Crypto Trading
The most obvious way to invest in DeFi is by directly buying and selling tokens and coins. Think day trading stocks or forex. DeFi tokens are associated with specific protocols, and each protocol may use tokens differently. Some grant token holders governance rights, while others could get staked to earn interest.
For example, UNI is the governance token of Uniswap. MAKER is the governance token of MakerDAO, which is also behind DAI stablecoin. AAVE is Aave’s token, and SNX is staked in the Synthetix protocol.
Note that you have to pay gas fees every time you make a transaction on the network, similar to paying trading fees for stocks. The fees get paid in the blockchain’s native token. For example, you pay ETH for Ethereum, AVAX for Avalanche, MATIC for Polygon, and FTM for Fantom.
Non-fungible tokens (NFTs) are unique digital assets. They can represent anything from artwork to digital fashion to music to virtual real estate.
Investing in NFTs can yield significant returns, as some NFTs have sold for millions of dollars, such as CryptoPunks or Bored Apes. However, NFTs are a relatively new and speculative market with high volatility and risk. They derive value primarily from the communities backing them and the teams behind the projects, which can be highly subjective.
There are different ways to invest in NFTs, such as buying and holding them, trading them on NFT marketplaces, investing in NFT-focused funds, or renting out your NFTs. For example, popular NFT marketplaces include OpenSea, Magic Eden, Foundation, and Nifty Gateway.
You can also create your own NFT collections to sell using “lazy minting” systems on a platform like Opensea or Rarible. Using this method, you can create NFTs and put them up for sale without them getting directly written on the blockchain until there’s a match for a buyer, thereby passing the fees to them.
Why Use DeFi?
DeFi offers a host of benefits for users, including:
- Accessibility: Not everyone has access to traditional financial services. Many people can’t open a bank account or take out a loan. With DeFi, anyone with an internet connection can access it.
- Transparency: DeFi operates on public blockchains, meaning all the transactions are visible to anyone to review. This transparency ensures the system’s integrity and reduces the risk of fraud (though that doesn’t mean fraud doesn’t exist).
- Speed: Most traditional banking systems operate on a 9 to 5 schedule and have limited service hours. DeFi operates in real-time, 24/7, allowing people to execute trades and transactions quickly and efficiently without intermediaries.
- Low Fees: DeFi platforms generally have little to no physical infrastructure or staff and do not require intermediaries, so they tend to have lower fees than traditional financial institutions. That makes it much cheaper for people to participate.
- Autonomy: Users can control their funds and execute transactions without needing permission from a centralized authority. This gives people greater autonomy and flexibility over their financial lives.
Is DeFi Safe?
DeFi technology is relatively new and rapidly evolving. As with any new technology, it carries inherent risks.
Failure rates among start-ups are high, so if you invest in a DeFi project that doesn’t succeed, you could lose all your funds. One of the main risks is smart contract bugs or vulnerabilities. Smart contracts are self-executing programs that operate on the blockchain and automate transactions according to predefined rules. Programming errors can leave room for nefarious opportunists, such as the $116M Mango hack or $326M Wormhole exploit.
Another risk is the potential for scams or fraudulent activities. Deposits with traditional financial entities, such as banks, are insured by the Federal Deposit Insurance Corporation (FDIC) and are heavily regulated. DeFi platforms have fewer regulations and are not FDIC-insured. So, if something happens to your money, there are limited ways to recover your lsot funds.
Is DeFi a Good Investment?
Many people believe that blockchain technology will revolutionize existing financial systems, and decentralized finance (DeFi) is at the forefront of this change. DeFi providers offer decentralized services for investments, loans, insurance, and more, making traditional lenders and banks unnecessary. It presents a new investment opportunity where retail clients can generate interest in their capital through crypto savings accounts, staking, yield farming, and other methods.
However, investing in DeFi also comes with risks, including regulatory and smart contract vulnerabilities, crypto scams, and no shock absorbers or safety nets. For example, in May 2022, Terraform Lab’s algorithmic stablecoin TerraUSD and its sister token LUNA collapsed, wiping out $40B of assets in the crypto market.
So, while DeFi can be a worthwhile addition to an investment portfolio, it’s crucial to evaluate your risk tolerance and invest appropriately. The way I think about investing in crypto is that I only invest the money I am willing to lose.
The Bottom Line
Investing in DeFi can be a great way to diversify your portfolio and take advantage of the growth potential of decentralized finance. We have covered some of the popular ways to invest in DeFi, such as interest accounts, staking, yield farming, and leveraged loans.
However, as the DeFi ecosystem is continually expanding, it is important to remember that investing in DeFi projects comes with risks, and it is crucial to do thorough research before making any investment decisions. With the right approach and understanding of the market, you can navigate the world of decentralized finance and become a successful DeFi investor.