WHAT IS DeFI
DeFi, short for Decentralized Finance, refers to a type of financial system that operates on blockchain networks, predominantly Ethereum. DeFi aims to provide an open, transparent, and permissionless alternative to traditional financial intermediaries such as banks, brokers, and exchanges. It leverages smart contracts to create and execute financial agreements and applications without relying on centralized authorities
How to Analyze DeFi Projects
Analyzing decentralized finance (DeFi) projects requires a comprehensive approach that considers various factors. Here are some steps you can follow to analyze DeFi projects:
Understand the Basics: Familiarize yourself with the fundamental concepts of DeFi, such as decentralized exchanges (DEXs), lending and borrowing platforms, yield farming, liquidity provision, and smart contracts. This foundational knowledge will help you evaluate projects effectively.
Research the Team: Look into the team behind the project. Check their experience, expertise, and track record in the blockchain and DeFi space. Assess whether they have a transparent and credible reputation, and consider if they have successfully delivered on previous projects.
Evaluate the Project's Purpose: Determine the problem the project aims to solve and whether it has a compelling value proposition. Assess whether the project brings innovation or offers unique features compared to existing DeFi platforms. Consider how the project aligns with your investment goals and risk tolerance.
Analyze the Whitepaper: Read the project's whitepaper to understand its underlying technology, the problem-solving approach, and the project's roadmap. Look for clear explanations of the protocol, consensus mechanism, security measures, tokenomics, and governance structure. Analyze if the project's goals and technical implementation are feasible and well-documented.
Assess Tokenomics and Economic Model: Examine the tokenomics of the project, including the total supply, distribution mechanism, inflation rate, token utility, and how the token interacts within the ecosystem. Evaluate whether the token has a clear purpose and whether its value is directly tied to the project's success and adoption.
Review Security Measures: Security is crucial in DeFi projects. Assess the project's security measures, including smart contract audits, bug bounties, and insurance coverage. Look for a transparent and well-documented security protocol. Check whether the project has experienced any major security incidents in the past.
What Are DeFi Protocols Used For?
Decentralized Exchanges (DEXs): DeFi protocols offer decentralized exchange platforms where users can trade cryptocurrencies directly with each other without the need for intermediaries. DEXs provide liquidity pools and utilize smart contracts to facilitate secure and transparent trading.
Lending and Borrowing: DeFi lending protocols enable individuals to lend their cryptocurrencies and earn interest on their holdings. Borrowers can use their crypto assets as collateral to secure loans without the need for traditional credit checks. These protocols provide opportunities for individuals to access capital or earn passive income.
Stablecoins and Decentralized Stablecoin Issuance: Stablecoins are cryptocurrencies that aim to maintain a stable value by being pegged to a reserve asset, such as a fiat currency. DeFi protocols allow for the issuance, management, and trading of stablecoins, providing a means of conducting transactions and hedging against volatility within the decentralized ecosystem.
Understanding DeFi Fundamentals
DeFi aims to create financial systems that are decentralized, meaning they operate without central authorities or intermediaries. Instead, they leverage blockchain technology, smart contracts, and consensus mechanisms to enable peer-to-peer transactions and governance. Smart contracts are self-executing agreements written in code that automatically execute predefined actions when specific conditions are met. DeFi relies on blockchain technology, typically utilizing public blockchains like Ethereum, to create a transparent and immutable ledger of transactions. DeFi projects are often designed to be interoperable and composable, meaning they can seamlessly integrate and interact with other projects within the ecosystem.
Why Is DeFi Due Diligence Important?
Conducting due diligence in DeFi is essential due to the unique characteristics and risks associated with this rapidly evolving sector. DeFi investment often involves risks, such as potential rug pulls, hacks, and the loss of a portion or all of the investorâs capital. Thoroughly assessing the project's fundamentals, team, technology, and security measures allows investors to make informed decisions and possibly avoid potential scams or poorly executed projects.
By conducting due diligence, investors can make informed decisions, mitigate risks, and identify investment opportunities that align with their investment objectives and risk tolerance. It helps establish a foundation of knowledge and understanding necessary to navigate the complex and dynamic DeFi landscape.
This requires individuals looking to get involved with the DeFi space to approach new projects while keeping the following factors in mind.
Popular Metrics That Help Evaluate a DeFi Protocol
There are several popular metrics that can provide valuable insights into the performance and potential of DeFi projects. These include the tokenâs 24-hour volume, inflation rate, price and market capitalization.
Total value locked (TVL)
Total Value Locked (TVL) is a metric used to measure the total amount of assets (usually in the form of cryptocurrencies) that are locked or held within a specific decentralized finance (DeFi) protocol or ecosystem. It provides an indication of the level of activity and capital deployed in a particular DeFi platform. TVL is an important metric as it gives insight into the adoption and popularity of a DeFi protocol. Higher TVL generally indicates a larger user base, more liquidity, and increased confidence in the protocol.
Market capitalization
Market capitalization, or market cap, calculates the total value of a DeFi protocol's circulating supply of tokens. It is obtained by multiplying the current price of a token by the number of tokens in circulation. Market capitalization offers an overall assessment of the protocol's size and prominence. However, itâs essential to consider market cap in relation to other factors, such as the protocol's utility, adoption, and competition.
24-hour volume
The 24-hour volume measures the total value of trades executed within a specific DeFi protocol over a 24h time span. A high 24h volume indicates active trading and better liquidity, suggesting a vibrant ecosystem and market interest. A low 24h volume, on the other hand, signals low buying and selling of the protocol's tokens, indicating lower liquidity. A low 24-hour volume can have several implications, including a lack of interest or participation from traders and investors.
Inflation rate
The inflation rate of a specific DeFi project depends on its tokenomics and economic model. DeFi projects can have varying approaches to token supply and inflation, and it's important to evaluate each project individually. Some DeFi projects have a fixed or capped token supply, meaning there is a predetermined maximum number of tokens that will ever be created. These projects typically do not have an inflation rate since the token supply remains constant over time. Additionally, it's important to consider the purpose and utility of the token within the DeFi project. Some inflationary models may include mechanisms to incentivize specific behaviors or participation in the ecosystem, such as staking or providing liquidity. These mechanisms can impact the overall token inflation and distribution.
Price-to-sales ratio
Price-to-sales ratio is used to determine whether a DeFi protocol is undervalued or overvalued. To calculate the price-to sales ratio, divide the fully diluted market cap of a DeFi protocol by its annual revenue. The lower the ratio, the more undervalued the protocol may be, and vice versa. This works similarly to how the price-to-sales ratio is used in traditional financial markets to see if a stock is undervalued or overvalued. Â
Unique address count
The unique wallet address count is a metric that measures the number of participants in a particular DeFi protocol. Itâs a measure similar to unique users for traditional Web2 apps that calibrate user engagement. An increasing number of addresses could be a good indicator of growing popularity and adoption. Itâs important to note that this metric can be manipulated and investors should use this metric in combination with other indicators.Â
Evaluating the DeFi Project Team
Evaluating the team behind a DeFi project is a crucial aspect of assessing its potential and credibility. Here are some key factors to consider when evaluating the team:
Experience and Expertise: Look into the team members' backgrounds and experience in the blockchain and DeFi space. Assess their track record, technical skills, and understanding of the industry.
Core Team and Advisors: Evaluate the core team responsible for the project's development, including the founders, developers, and key personnel. Assess their qualifications, roles, and responsibilities within the project.
Transparency and Communication: Assess the team's transparency and communication practices. Look for clear and accessible information about the team members on the project's website or official channels.
Remember, while evaluating the team is important, it should be considered alongside other factors such as the project's technology, tokenomics, market fit, and overall potential for adoption. A strong and experienced team can significantly contribute to a project's success, but it is not the sole determinant of its viability.
Assessing DeFi Technology
The technology that underpins a DeFi project is a crucial factor in determining its viability and effectiveness. One of the key aspects to consider is the blockchain platform on which the project is built.Â
Ethereum, for instance, is a popular choice, offering a robust and established infrastructure for DeFi applications. Other layer 1 blockchains have emerged as promising alternatives for scalable DeFi applications too. Investors looking to acquire DeFi tokens should weigh the pros and cons of the underlying blockchain to make an informed decision.
Another critical aspect is the evaluation of the smart contracts that power the DeFi project. Smart contracts are self-executing contracts on the blockchain with the terms of the agreement directly written into code.
Analyzing the Tokenomics of DeFi Projects
Tokenomics refers to a project's token economy and the incentives it offers. Investors should begin by understanding the token's purpose within the ecosystem and its distribution model.Â
This involves examining factors such as the total supply of tokens available and how they are allocated to different parties. These parties can include team members, community members, advisors, or other stakeholders. The distribution model helps determine the initial distribution of tokens and can impact factors like decentralization, governance of the project, and the potential for market manipulation.
Token issuance mechanisms are also important to consider. These mechanisms can include mining, staking, or other methods by which new tokens are created and distributed over time. Evaluating these mechanisms can help investors understand if the token is inflationary or deflationary, its scarcity, and the incentives provided to participants.
Closing Thoughts
Analyzing a DeFi project is a critical process to make informed investment decisions in the rapidly expanding decentralized finance space. By considering factors such as the project team, technology, tokenomics, security, and community engagement, investors can gain a comprehensive understanding of the project's potential.
Even so, itâs critical to never invest more than you can afford to lose. While the above factors are crucial to making informed decisions, this list isnât exhaustive and investors should practice caution and approach DeFi projects with skepticism.