Everything you need to know before investing in DeFi

Seth Goldfarb on 20 May 2020

In order to be successful, you have to do things nobody else is doing, go places nobody else is going, and say things nobody else is saying.

If the things, places, and messages from those building DeFi are any indication, DeFi is certainly an excellent place to look for investment opportunities. Maybe you’ve heard of people getting rich on early investments in Bitcoin and Ethereum, receiving +10% interest using DeFi lending protocols, or developing their own unique investment opportunities using various DeFi legos.

If you’ve ever been curious about terms like “staking” or “decentralized lending” or wondered what sort of tokens the DeFi community finds useful, we’ll cover the basics of DeFi investment opportunities and then dive into the do’s and don’t’s of investing with DeFi.

Exploring DeFi Investment Opportunities

What does it mean to invest in DeFi? Great question! Investment opportunities in DeFi often mirror those in the traditional financial world but come with their own unique twists. In traditional finance, lending generally involves giving money to a borrower willing to repay the loan with interest. The borrower gets access to money now and the lender gets interest in addition to the amount loaned.

Decentralized lending works exactly the same way; it just involves using smart contracts to hold collateral from borrowers and programmatically deliver interest to the lenders. In the traditional financial world, banks and credit unions typically offer interest to individuals and businesses who open savings accounts with them in exchange for allowing the bank to use their deposit to conduct other transactions.

Staking means depositing digital assets into a special type of account that rewards the depositor for letting the system use those digital assets to validate transactions and help secure the network.

In the same way those seeking traditional investment opportunities often capitalize on specialized knowledge about things like real estate, commodities, or business, DeFi investors typically leverage their unique insights to find valuable opportunities.

Familiar with finance and the intricacies of liquidity? Perhaps you would be interested in tokens supporting decentralized exchanges, derivatives, or other financial contracts like the Kyber Network token (KNC), Synthetix (SNX), or the Universal Market Access token (UMA).

If decentralized governance is more your speed, the MakerDAO token governing MakerDAO’s DAI stablecoin might be a project that would catch your attention.

The Do’s

Here’s what you definitely need to know before making your first DeFi investment:

Do Your Research (Always!)

If you wouldn’t buy a used car without having a mechanic take a look at it, why would you make an investment in a DeFi token or protocol without checking out what’s going under the hood? If you’re not sure about a DeFi project, the easiest way to check whether or not it may be a scam is to simply Google the name of the project along with the word “scam.” If the project is a scam, chances are good you’re not the first person to catch it.

Here’s an example of a scam that fell apart at the beginning of 2020 and can now be easily Googled. Just because the project you’ve searched doesn’t come up as a scam doesn’t mean it might not still have critical bugs or other vulnerabilities to consider.

One of the benefits of working with open-source technologies is that anyone can view the code used to operate DeFi tokens and protocols. If you’re familiar with smart contracts and comfortable evaluating their coding, it’s all there for you to dissect.

If you’re not a security-savvy programmer, here are some other signs to look out for:

What have other people said?

The easiest way for non-technical investors to evaluate the security of a DeFi project is to see what trusted security professionals have to say about the project.

No matter how good a developer or group of developers may be, DeFi projects that take security seriously subject their smart contracts to manual security audits from reputable security auditors like Certik, Quantstamp, and OpenZeppelin.

In addition to looking for (and actually reading!) security audits, seeing what other people, as well as the project’s team members themselves, have to say about the project on channels like their website, project forums, Reddit, and Twitter can provide valuable insights.

While it’s certainly worth checking out a project’s website when conducting due diligence, relying on information from communications channels moderated by the project’s team members isn’t an effective way to get the full picture on what’s really going on behind the scenes.

Checking whether or not projects are listed on websites like DeFi Prime, DeFi Pulse, and DeFi Market Cap is another helpful indicator of a reputable project.

Whatever sources you use, it’s critical to evaluate whether or not the information you’re getting comes from independent sources or whether it’s possible for it to be a result of paid advertising.

Has the contract been verified on Etherscan?

Projects that have verified their smart contracts on Etherscan have essentially demonstrated that the code you see when viewing a contract is the code you’ll get when using it.

Being verified on Etherscan doesn’t mean that a smart contract isn’t free of vulnerabilities or part of a scam but it does mean that the code can be publicly evaluated without fear of the code being altered in some nefarious way.

Etherscan also offers a service (currently in beta) called ETHProtect that allows people to report suspicious and fraudulent activities on the Ethereum blockchain. Reports of suspicious activity get reviewed by Etherscan’s security analysts as well as their Taint Inference Analysis Engine and the addresses associated with confirmed reports now receive a “Red Shield” to indicate the address has been tainted.

Funds associated with tainted addresses can be traced all the way to the source of the problem. If you start coming across tainted addresses while investigating whether or not a contract has been verified, exercise caution before going to the project’s website or interacting with their smart contracts.

Watch out for the old bait & switch!

While most decentralized exchanges allow people to exchange any ERC20 token using their smart contracts, only certain exchanges like Uniswap make a point of not prominently displaying those tokens on their website.

Many DeFi projects mint ERC20 tokens to support their operation but hiding among these tokens are a myriad of shitcoins and scamtokens aiming to lure in investors so eager to get in early they’re willing to invest without investigating what the token does.

Many scammers create tokens with names that might appeal to investors like DeFi token or CannabisCoin. Those looking to invest in DeFi can easily be forgiven for imagining the DEFI token might be a DeFi index of sorts; not a bad investment opportunity, right?

Upon closer inspection, however, it’s easy to tell from the GitHub repo as well as the dead links to the project’s website and white paper that the token isn’t actually attached to any sort of project.

Another easy way to tell whether or not a project might be questionable is to see what exchanges its token trades on. Many unsavory projects only list their token on decentralized or smaller exchanges and some exchanges are best avoided altogether.

The Don’t’s

Now that we’ve covered what you do need to know, here’s what you should look out for in order to protect your investments.

Don’t Get Caught Slippin’

Let’s say you do decide to get that used car. You wouldn’t just leave your keys or other valuables sitting in your brand new used car, would you? If you’re going to invest any significant sum of money into digital assets, you need to take self-custody seriously.

Purchase a hardware wallet directly from a reputable manufacturer like KeepKey or Ledger to store your digital assets and keep it in a safe place. Consider this your “crypto savings account.” Mobile, desktop, and browser-based wallets may be useful for using or spending cryptocurrency but shouldn’t be trusted for long-term storage.

Don’t invest more than you can afford to lose

Perhaps the most important don’t, which can’t be overstated enough, is: DO NOT invest more than you’re willing to lose in DeFi tokens and protocols. It’s easy to lose yourself in the world of novel and fascinating technologies emerging from DeFi but critical to remember who they’re intended to serve; decentralization is currently more about serving individuals who need or profit from privacy than those who simply find it interesting.

Decentralized technologies can occasionally be great investment opportunities but for investors who don’t need them for privacy-related purposes, they should always be approached with caution.

If you still need motivation to stop yourself from investing irresponsible amounts of money into high-risk opportunities from emerging technologies, here are several horror stories offered by Redditors who failed to heed this advice:

Discover DeFi

Ready to set off on your journey into DeFi investing? Great!

Our list of DeFi Projects will introduce all of the projects you need to know about.

Good luck and thanks for reading!


DeFi is coming. Don't get left behind

About the author
Seth Goldfarb
Seth Goldfarb is a Seattle-based writer who helps businesses working with blockchain and distributed ledger technology understand and convey the stories of their success. Seth is not an investment advisor and couldn’t give you anything constituting “investment advice,” even if you asked for it.

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