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

Digging a little deeper 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.

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

For perspective, many regulated banks offer interest rates below 1% per annum, while some DeFi platforms offer interest rates above 20% per annum.

Investing in DeFi offers many advantages. 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 24/7/365, which can create new opportunities and even the possibility of trading after hours alongside a full-time career independent of finance.

“The speed and efficiency of DeFi creates immense opportunities to enter and exit positions very quickly for arbitrage for example. Also, regardless of your background or the money you have access to, you can have access to DeFi,” he said, adding, “There are over a billion people who are unbanked. and unable to use traditional markets. It’s a huge advantage 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 perfect project can be difficult, especially for first-time investors. The following is a breakdown of the factors to consider when choosing a well-founded 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 key drivers.

DeFi projects with large assets locked in custody are generally perceived to have higher upside potential and are considered safer 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 fully diluted valuation

It is important to consider the fully diluted valuation (FDV) of a DeFi token before investing. FVD in DeFi is the theoretical market capitalization 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 steady increase in new tokens is likely to outpace demand for the token, driving prices down. In DeFi investments, native tokens are negatively affected in weak FDV market situations.

Symbolic price stability

Promising DeFi tokens usually have a consistent long-term uptrend. Sure, rallies over 30% in a short period are attractive on the face of it, but they could be unsustainable parabolic market reactions that are usually followed by a significant decline.

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

Going forward, investors should ignore short-term price performance in the absence of other positive indicators and choose project-backed tokens 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 thoroughly research platform security before investing in DeFi projects.

Security audits performed by independent cybersecurity companies usually reveal potential vulnerabilities. Investors are urged to take these assessments into consideration.

Choosing the Right DeFi Investment Strategy

Choosing the right DeFi investment strategy can generate significant returns. Here is an overview of some common DeFi investment strategies.

Staking

Staking is one of the simplest DeFi investment strategies. It involves locking inactive assets into a smart contract for a stipulated duration.

Staking a DeFi asset enables an investor to become a validator in a proof-of-stake (PoS) network. Proof-of-stake systems differ from proof-of-work (PoW) consensus algorithms, which typically require computing devices to validate transactions.

PoS mechanisms are run by validators who earn rewards based on the number of tokens they have.

DeFi projects typically reward investors with governance tokens, which increases investors’ voting power. Coins can also be exchanged for other cryptocurrencies.

In DeFi, platforms that support staking usually also provide lending and borrowing services.

Related: Hhow to stake cryptocurrencies in 2022, explained

Yield farming

Yield farming is a sophisticated way of investing that combines staking, lending, and borrowing to maximize income.

Yield farming protocols usually have high yields. However, they also come with higher risks compared to just holding top-notch cryptocurrencies.

In yield farming networks, users can, for example, use their staked assets as collateral to take out loans and buy tokens with huge upside potential. This is usually done to maximize staking rewards.

However, the use of leveraged products amplifies losses.

Unlike commercial banks, only collateral is required to obtain a loan. No credit check is performed. Indeed, ecosystems are managed via smart contracts, which automatically apply rules written in code.

Besides borrowing and lending, some DeFi yield farming pools support token pairs to earn rewards. Putting money into these investment vehicles allows investors to earn a certain percentage of fees each time the tokens are used in a transaction.

Growing demand for certain token pairs usually leads to more trades and higher returns for investors. That said, investing in volatile cash pairs can lead to temporary losses.

Related: What is yield farming?

DeFi indices

DeFi indices offer stakeholders a diverse portfolio of cryptocurrency assets. Their compound structure is similar to that of exchange-traded funds (ETFs) in traditional finance. S&P 500 ETFs, for example, track the value of 500 major companies listed on US stock exchanges. DeFi indices have a similar framework but track cryptocurrency tokens.

The DeFi Pulse index is an example of a popular DeFi index. It tracks projects with high usage and a committed development team.

Another notable DeFi index is the MetaVerse index. It tracks a basket of chips in various virtual environments such as sports, entertainment, and business. The market capitalization of the token and the liquidity weighting are taken into account when including a token.

DeFi indices with a constant long-term growth rate and low volatility are recommended.

Choosing a Wallet and Buying Tokens

After determining the ideal DeFi protocol and investment strategy, obtaining a crypto wallet will make token purchases easier. Crypto wallets are used to store the coins needed to purchase tokens on DeFi platforms.

When choosing the ideal wallet, it is important to consider factors such as accessibility, compatibility and whether it is a custodial or non-custodial wallet. Software wallets, for example, offer better accessibility and are more convenient than hardware wallets.

However, hardware wallets are more secure due to their sophisticated encryption mechanisms, which are designed to thwart most cyberattacks.

Some popular software, or hot crypto wallets, include MetaMask, Coinbase, Brave, and Fortmatic. Trezor and Ledger are among the most reliable hardware or cold wallets.

Most popular wallets can connect to exchanges where DeFi coins can be traded. The first step in obtaining a DeFi token is to visit the protocol’s website and link the wallet to purchase native coins. You can then invest in the pool of your choice on the platform.