The best ways to participate and operate

Decentralized finance (DeFi) is a concept that has received a lot of attention since the so-called DeFi Summer of 2020 because its usage, often measured in total value locked (TVL), has risen dramatically since that time. In the last year alone, TVL rose by over 240% to a current $209 billion in “value locked” within DeFi projects, according to DefiLlama. Not only has it become interesting for investors to get into promising DeFi projects through their tokens (hoping for capital gains), but also to use these platforms to generate a regular and steady income through various activities. And, it’s been even more attractive in bearish markets.

It is exactly this appeal of solid risk-free returns uncorrelated to crypto market movements that lures many investors out on to the thin ice. Remember: There is no such thing as a free lunch. In this article, we will break down the concept of DeFi and go deep into its ecosystem, strategies and the risks all of which are relevant for private and professional investors considering allocating capital to this space.

All these activities offer a respective annual percentage yield (APY) or fee share split which will vary depending on the platform like Curve or Compound, services such as staking or liquidity provision and underlying tokens like BTC or USDC used. These gains can come in the form of deposited tokens, referenced as “Supply APY,” as well as the platform’s native token, referenced as “Rewards APY.” For example, the SushiSwap protocol would give you SUSHI tokens and the Aave protocol AAVE tokens. Some of these platforms distribute governance tokens, giving owners the right to vote on the direction of the platform, such as receiving the optionality of becoming an activist investor.

What to watch out for

This could be an entire article in itself, so we’ll stick to some key highlights. First, use the house analogy to have a conscious awareness for your risk assessment across the layers and interdependency. With a focus on the protocols, or your counterparty risk, there are some specific levels you will want to review and ask critical questions on:

  • Team. Is the team known or an anonymous group? What is their technical and practical background? Are there any large/well-known backers of the crypto community involved?
  • Technical. Have there been any hacks, are there third-party smart contract audits available and do they have security bounty prizes posted?
  • Tokenomics. Are governance tokens awarded? What is the current total value locked and how are growth numbers regarding assets and active users? Is the project run through a decentralized autonomous organization (DAO) with a community-supported model?
  • Insurance. Is there a treasury to make investors “whole” again in the event of a hack? Are any insurance policies in place?
  • Pools. What are the APYs — are they insanely high? — has the APY been stable, how much trading liquidity is within the pool, risk of impermanent loss, lockup periods or transaction fees?

When you actively “use” your tokens to generate income, you generally are “hot” on these protocols/exchanges and, therefore, much more vulnerable to hacks or counterparty risk. There are institutional providers, such as Copper, offering secure custody not only for buy-and-hold investors, but also for staking of tokens at a cost. These security and custody concerns are a key difference between investing in DeFi through buying tokens, which can then get tucked away into cold storage vs. operating a strategy which is constantly and actively generating income.

In conclusion, this is an incredible space: We have been in and will continue to witness a new trillion-dollar industry being built right in front of our eyes. However, some final words of caution: Watch out for the too good to be true deals/APYs, as there’s usually a catch, for the fees that can suddenly explode, diminishing returns on an active strategy making smaller investments unattractive and be careful with the general safekeeping of your assets as loss of principle is possible.

If you are new to the field, start off with some play money, testing and learning along the way. Alternatively, if you want to participate but not deal with the hassle, you can also invest in professional managers designing, execute and monitoring these strategies in an institutional setting. But, one should use the same nuanced assessment approach provided earlier in your due diligence process of selecting a manager.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Marc D. Seidel started exploring blockchain and crypto back in 2016. Besides starting the crypto hedge fund AltAlpha Digital, he heads up the Alternative Investment practice of the BFI Capital Group. He previously worked at Google and Facebook, where he led the go-to-market ads strategy for the Alpine region. He founded three companies, one each in the health care, law digitalization and sustainability ecommerce sector.