What is DeFi

DeFi stands for “Decentralized Finance,” referring to financial services and products based on blockchain technology that operate independently of central institutions like banks, loan agencies, or credit card companies.

Products and services within the DeFi sector include blockchain-based versions of traditional financial products, such as cryptocurrencies, cryptocurrency exchanges, cryptocurrency loans, cryptocurrency wallets, and even cryptocurrency savings accounts. Users can send and receive funds through DeFi wallets, which store transactions on the blockchain without the need for intermediaries.

In most cases, transactions through DeFi wallets are completed instantly. Cryptocurrencies themselves act as a form of value carrier, with the energy used to create them serving as proof of their value, eliminating the need for physical money like paper bills or metal coins. Transferring cryptocurrencies through a DeFi wallet is akin to handing someone a bag of cash in the traditional financial world.

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Why Invest in DeFi?

(1) High Yield Potential

DeFi platforms typically offer higher yields than traditional financial markets. Through activities like liquidity mining and lending, investors can earn substantial returns. For example, some liquidity mining projects promise annualized returns of up to tens or even hundreds of percentage points, making them highly attractive to investors seeking high returns.

(2) Hedge Against Traditional Financial Risks

The DeFi market has a low correlation with traditional financial markets, making it an effective hedging tool. When traditional markets experience volatility or crises, DeFi assets may follow different trends, providing investors with a means to diversify risk and preserve value.

(3) Financial Innovation and Flexibility

The DeFi sector continuously introduces new financial products and services, offering investors more choices and flexibility. For example, decentralized exchanges (DEXs) allow investors to trade cryptocurrencies anytime, anywhere, without the restrictions of traditional exchange operating hours or geographical limitations. Additionally, some DeFi projects offer innovative products like synthetic assets and stablecoins, catering to diverse investment needs.

However, investing in DeFi also carries risks, such as smart contract vulnerabilities, market volatility, and regulatory uncertainties. Therefore, investors should thoroughly understand the risks and make informed decisions before investing.

DeFi Investment Methods

(1) DeFi Asset Trading

One of the simplest ways to invest in DeFi is by purchasing DeFi tokens and trading them on decentralized exchanges (DEXs). For DeFi asset trading, you can choose any DeFi protocol, the amount you want to trade, and a specific blockchain network.

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Once you confirm the transaction, automated market makers (AMMs) will facilitate the trade by extracting funds from liquidity pools provided by other DeFi investors. Some top DeFi protocols to consider include Avalanche, Chainlink, Uniswap, Stacks, Aave, and Fantom.

(2) DeFi Index Tokens

A DeFi index token typically covers a basket of DeFi assets or projects to diversify investment risk. For example, the DeFi Pulse Index (DPI) includes top DeFi project tokens like AAVE, MKR, SNX, UNI, YFI, and COMP, as well as smaller DeFi tokens like REN and LRC.

The DeFi Pulse Index (DPI) is a capitalization-weighted index on the TokenSets platform. It is weighted based on the circulating supply value of each token, focusing on DeFi projects with significant usage and ongoing development. Tokens included must meet strict criteria, such as not being classified as securities by government agencies and being listed on DeFi Pulse.

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Most DeFi index tokens track specific DeFi market sectors or asset portfolios according to established rules, without the need for frequent adjustments like actively managed investments. For example, the DEFI Top 5 Index (DEFI5) is a passively managed index that tracks the top 5 DeFi tokens by market capitalization, based on the Ethereum and Polygon blockchains.

(3) DeFi Lending

On DeFi lending platforms, users deposit their cryptocurrency holdings into lending pools, which borrowers can then access. These platforms use smart contracts to manage loan terms, including interest rates and repayment schedules, based on supply and demand.

For example, using platforms like Aave or MakerDAO, users can choose which tokens to deposit into the lending pool. Once funds are deposited, users receive newly minted native tokens, such as Aave’s a-Tokens or MakerDAO’s Dai tokens, which represent the initial deposit plus interest. DeFi platforms offer various types of loans, including:

Overcollateralized Loans: The value of the cryptocurrency collateral provided by the borrower exceeds the loan value, typically 150% to 300% of the loan amount, to protect the lender’s funds in case the borrower defaults.

Flash Loans: Unlike other loans, flash loans do not require collateral but must be repaid within a single transaction block. If not repaid, the smart contract will revert all financial transactions.

Undercollateralized Loans: Some platforms are exploring undercollateralized lending by evaluating credit conditions through decentralized identity or reputation systems.

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(4) DeFi Staking

DeFi staking requirements involve locking digital assets in smart contracts to support network operation, in return for staking rewards. Some benefits that users can expect when considering DeFi staking include higher returns, the ability to contribute to network security, liquidity, and flexibility to unlock tokens at any time. There are several different ways to participate in DeFi staking:

Liquidity staking: Users can stake tokens in a Proof of Stake (PoS) network and participate in other DeFi activities to earn rewards.

Validator Staking: This involves staking tokens to participate in the decision-making process within the blockchain network, granting holders the voting rights for protocol changes.

Governance Staking: Requires users to lock their tokens to become validators, directly ensuring network security and receiving rewards. However, this DeFi staking method requires a significant minimum investment and professional technical knowledge.

(5) DeFi Yield Farming

Yield farming has become one of the primary ways to earn passive income in the DeFi ecosystem. It involves depositing tokens into a DeFi protocol’s liquidity pool for a set period to earn rewards in the form of governance tokens, transaction fees, or newly minted tokens.

In some cases, the deposited assets can be used by borrowers for other trading activities. For automated market maker-driven decentralized exchanges, these assets provide liquidity to facilitate buy and sell orders. Anyone with a compatible wallet and idle tokens can participate in yield farming. However, yield farming can be complex and risky, as rewards may fluctuate based on market conditions and the performance of underlying protocols.

DeFi Investment Risks

(1) Technical and Security Risks

DeFi investments face significant technical risks. Smart contracts, the core mechanism of DeFi, can be exploited by hackers if vulnerabilities exist, leading to substantial losses. Additionally, oracles, which provide external data, can be manipulated, resulting in distorted price information and triggering issues like flash loan attacks. Security risks also include phishing scams and fraudulent projects, which can lead to asset loss.

(2) Economic and operational risks

The DeFi market is closely tied to the cryptocurrency market, which is highly volatile. Asset values can shrink significantly, and liquidity risks can make it difficult to trade assets in extreme market conditions. Leveraged borrowing and trading also carry the risk of liquidation. From an operational perspective, users must manage wallet private keys carefully, as losing or leaking them can result in a loss of control over assets. Additionally, unfamiliarity with DeFi protocols and processes can lead to costly mistakes.

(3) Regulatory and Centralization Risks

DeFi operates in a regulatory gray area due to its decentralized nature. Incomplete and uncertain regulations pose risks, as stricter future regulations could restrict or shut down many projects, affecting investor returns and asset security. Furthermore, some DeFi projects, while claiming to be decentralized, may still have centralization risks, such as super admin rights, which could allow project teams to change rules or misappropriate assets, potentially causing investor losses.