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How to Invest in DeFi: A Beginner's Guide

April 17, 2024

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Decentralized finance (DeFi) is a rapidly growing sector that attracts investors looking to get into the crypto space. It’s also an emerging financial technology that has the potential to generate investment income. 

This guide explains decentralized finance and shows different ways to invest in DeFi and the risks involved.

What Is Decentralized Finance (DeFi)?

Decentralized finance (DeFi) is an Internet-native financial ecosystem that leverages blockchain technology to offer services such as buying, selling, lending, borrowing, and more without a central authority.

DeFi aims to become a peer-to-peer financial system that eliminates intermediaries and allows people to make transactions using blockchain-powered smart contracts. Smart contracts are software that specify the operating rules and conditions to execute a transaction. Decentralized applications (dApps) in DeFi rely on smart contracts to allow users to transact with each other without needing an intermediary. 

DeFi exists on blockchains that support smart contracts like Ethereum, Solana, and Polkadot, as well as on some Bitcoin layer 2 protocols. It is accessible to anyone with an internet connection.

How to Invest in DeFi: Here Are Your Options

DeFi has various financial services that give investors a range of investment opportunities. Let’s look at four prominent ways to invest in DeFi.

Invest in DeFi Protocol Tokens

One of the most straightforward ways to invest in DeFi is by adding DeFi protocol tokens to your portfolio. 

DeFi tokens are cryptoassets that give you access to DeFi protocols offering financial services like lending, borrowing, and insurance. The tokens are native to blockchains operating through smart contracts and directly involved with DeFi projects. 

DeFi tokens are an easy way to get exposure to projects in this emerging sector, but you need to choose your ideal investment with discretion and a lot of research. You can buy and sell DeFi tokens on decentralized exchanges (DEXes) like Curve and centralized exchanges (CEXes) like Binance. Examples of leading DeFi protocols include Uniswap, Aave, and Marker.

Investing in DeFi protocol tokens is subject to risks beyond market risks, such as rug pulls, smart contract risk, and regulatory risk, making any DeFi investment a high-risk investment. 

Lend Your Digital Assets in the Decentralized Lending Markets

Lending and borrowing are integral to the financial system. Crypto loans work similarly to traditional loans, except without credit checks or documentation. 

DeFi lending replaces traditional intermediaries like banks with smart contracts that set the rates and conditions for the loans. It offers a more simple, permissionless, and transparent loan acquisition process that helps lenders earn interest on their assets.

You need to lock your cryptoassets in a DeFi lending platform using a smart contract to earn interest through lending. The loans are usually over-collateralized to protect your investment since the borrower provides collateral valued more than the loan. 

DeFi lending has higher interest rates than traditional lending, and loans are processed faster with less documentation. For instance, while many traditional financial institutions like banks typically offer up to 5% interest rate on high-yield savings accounts, DeFi lending can offer rates up to 10% or more annually. 

Once the borrower meets the requirements, loans are accessible almost instantly. Additionally, transactions are visible on the blockchain, increasing transparency.

However, cryptoassets are volatile, which makes it difficult to price loans and set collateral. DeFi is also highly unregulated and relatively new, with limited liquidity, which can affect loan acquisition.

Stake Your Tokens and Earn an APY

DeFi staking refers to locking up cryptoassets for a specified time to earn rewards. 

Decentralized financial services offer staking to investors to incentivize them to hold their tokens on the platform to reduce asset volatility and improve liquidity. Your yield will depend on how long you lock your assets, the amount of tokens staked, and the platform's reward program. 

For instance, you can stake 10,000 tokens and lock them for a year or several months to earn an APY of 75%. At the end of your staking term, the 10,000 tokens are deposited into your wallet with an additional reward of 7,500 tokens, totaling 17,500 tokens for the year. However, APYs tend to fluctuate. Some platforms also add native token rewards as an incentive for stakers.

However, locking your tokens in a staking smart contract means you may not have access to your funds until the staking period ends. The volatility of the cryptoasset affects the value of your tokens and staking income at the end of the staking term. 

Participate in Yield Farming 

Yield farming works similarly to staking. The difference is that in yield farming, you deposit your assets into a protocol’s liquidity pool and get rewards in the form of interest or a share of transaction fees. The process is automated using smart contracts, and rewards are usually paid out in the protocol’s governance tokens. 

Yield farming is supplying cryptoassets to a decentralized exchange’s liquidity pools to earn compensation based on your share in the pool. To participate, you need to deposit your tokens in a dApp to provide liquidity to the platform and earn an annual percentage yield. You can switch liquidity pools at will but must pay transaction fees every time. 

Liquidity providers earn compensation for depositing their assets in a liquidity pool through rewards and transaction fees. Yield farming is also a viable way to provide liquidity to decentralized exchanges and applications. The process can also generate higher returns than traditional finance.

However, crypto volatility can reduce the value of rewards and compensation you receive, thereby incurring losses. Swift trading pair price changes can also lead to impermanent loss in platforms that rebalance a pool by buying cheaper assets and selling expensive ones. 

Top 4 Tips for Investing in DeFi

Here are a few factors to consider when starting your DeFi investment journey:

  • Do your own research. Leverage informational platforms, such as community forums and industry publications, to learn about trends and emerging protocols. You should look into the project’s reputation and history, including the development team’s previous projects.
  • Don't invest more than you can afford to lose. DeFi is a volatile market that can take a downturn without warning. Only invest what you’re ready to lose in speculative projects and assets. 
  • Understand what you’re investing in. DeFi is an emerging industry that comes with complex technology. You must have a basic understanding of the blockchain underlying the project, tokenomics, and reward structure. Different projects have varying degrees of security, interest rates, utility, and sustainability.
  • Have a risk management strategy. Find a strategy to mitigate the losses that you may incur in your investment. Different strategies work for different people; pick a plan that works for your investment.

The Risks of Investing in DeFi

DeFi, like any other kind of investment, comes with risks that you should look out for. Here are some prominent risks in the sector:

  • Software vulnerabilities. DeFi protocols risk coding errors that may lead to system malfunctions or security loopholes that hackers can exploit. The open-source code of DeFi protocols means anyone can see the underlying technology and its bugs. Smart contracts are also vulnerable to coding errors that malicious actors can use to steal funds.
  • Lack of regulation. DeFi is an emerging ecosystem that usually operates without any entity oversight or regulation. DeFi protocols operate mostly outside traditional regulation which might lead to legal uncertainties.
  • Operational risks. Many DeFi protocols are experimental and haven't built a reputation for reliability and security. Many platforms experience network congestion, system downtime, and malicious attacks. User error, phishing attacks, and rug pulls are also prevalent in the sector.

The Bottom Line 

Decentralized finance is an emerging blockchain economy that has the potential to transform the financial industry. 

While DeFi investments have the potential to generate high returns for investors, investing in this sector comes with higher risks than traditional investments. You can mitigate your losses by doing your own research before investing, having a risk management plan, and diversifying your portfolio. But remember to never invest more than you can afford to lose. 

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Disclaimer: None of the information in this article should be considered investment advice. Investors should consult their financial advisors to determine if any of the financial products and services mentioned in this article are a potential fit for their portfolios or not.