Decentralized finance (DeFi) has exploded in popularity over the last few years. How to invest in defi has become a hot topic as more investors look to tap into the high growth potential of this new sector. This article will walk through the key steps for investing in decentralized finance and provide tips for managing risk.
What is Decentralized Finance (DeFi)?
How to invest in defi starts with understanding what decentralized finance is. DeFi refers to financial applications built on blockchain networks, primarily Ethereum. These applications aim to replace traditional financial intermediaries like banks and brokerages with smart contracts, decentralized protocols, and cryptocurrency.
Some key characteristics of DeFi include:
- Decentralized – No central authority or middleman controls DeFi apps. Everything is managed by code and decentralized networks.
- Transparent – Transactions are recorded on public blockchains like Ethereum, enabling transparency.
- Accessible – Anyone can access DeFi services as long as they have an internet connection. No paperwork or permission needed.
- Interoperable – DeFi apps are composable, meaning they can connect to each other like building blocks.
- Programmable – Customizable financial services can be created using smart contracts.
DeFi is still in its early stages but has grown rapidly. As of November 2022, there was over $41 billion locked in DeFi protocols, up from just $1 billion in February 2020 . Leading categories include decentralized exchanges, lending, derivatives, asset management, and more.
Why Invest in DeFi?
How to invest in defi has become compelling for several key reasons:
- High growth potential – DeFi is still nascent and expected to see massive growth, with one forecast predicting over $1 trillion locked by 2027 . Early investors could benefit.
- Yield opportunities – Many DeFi protocols offer high interest rates for activities like lending and staking tokens. Yields of 5-15% can provide nice passive income.
- Protocol revenue – Fees, inflationary rewards, and governance tokens allow capturing value from popular DeFi protocols.
- Support innovation – Investing in DeFi supports open financial systems and potentially disruptive technology.
- Manage risks – DeFi allows managing portfolio risks differently than traditional finance.
Of course, DeFi also comes with risks like technology bugs, hacks, regulatory uncertainty, and volatility. But the growth outlook remains strong.
How to Gain Exposure to DeFi
There are several ways for investors to gain exposure to decentralized finance:
1. Buy DeFi Tokens
Purchasing governance and utility tokens from DeFi protocols directly is the most straightforward approach. Leading DeFi tokens include:
- Uniswap (UNI)
- Aave (AAVE)
- MakerDAO (MKR)
- Compound (COMP)
- Yearn Finance (YFI)
These can be purchased on centralized and decentralized crypto exchanges and held in a secure digital wallet.
2. Use DeFi Protocols
Using DeFi lending, trading, staking, and other services actively can provide direct exposure to the sector. Yield opportunities can enhance returns. This requires some technical know-how.
3. Invest in DeFi Indexes
Tokenized index funds like the DeFi Pulse Index (DPI) provide diversified exposure to a basket of DeFi tokens in a single investment. No need to select individual tokens.
4. DeFi Mutual Funds
Actively managed mutual funds focused on DeFi are starting to launch. These provide another diversified, passive exposure option without having to actively manage a portfolio.
5. DeFi ETFs
Several applications for DeFi-focused exchange-traded funds (ETFs) have been filed with the SEC. Approval could offer exposure through regular brokerage accounts. No timeline yet on approvals though.
6. Blockchain Equities
Publicly traded companies with DeFi exposure provide more indirect exposure for stock investors. These include crypto exchanges, custodians, miners, and financial institutions involved in DeFi services.
|DeFi Tokens||Direct exposure, full upside||Complex, risky, technical|
|Using Protocols||Earn yields||Time-consuming, risky|
|Index Funds||Diversified, simple||Fees, risky|
|Mutual Funds||Professionally managed||High fees, new|
|ETFs||Easy access, liquid||No options yet|
5 Tips for Investing in DeFi
Here are 5 key tips to consider when exploring how to invest in defi:
- Start small – Only risk what you can afford to lose and start with small positions as you build knowledge.
- Diversify – Spreading investments across various DeFi protocols and assets can help manage risk.
- Use trusted platforms – Be selective in choosing reputable exchanges and DeFi platforms.
- Manage risk – DeFi comes with technology, governance, regulatory, and volatility risks to consider.
- Keep learning – Follow DeFi actively as the industry is changing rapidly. Sign up for newsletters and follow thought leaders.
The Future of Investing in DeFi
How to invest in defi will likely evolve and mature over the coming years. Wider adoption and innovation in DeFi could support growth opportunities. But expect continued volatility as the technology decentralizes global finance. Regulation will also play a key role.
While risks remain, DeFi presents a compelling new paradigm for finance. Investing in decentralized financial systems could provide nice portfolio diversification and exposure to the growth of digital assets. As with any emerging opportunity, applying sound principles around education, diversification, and risk management remains key for long-term success.
- DefiPulse. Top DeFi Markets. https://defipulse.com/
- Binance Research. Decentralized Finance (DeFi) Explained. https://research.binance.com/en/analysis/defi-1