A Complete Guide to Investing in DeFi

Imagine a world in which the functions of present-day central banks happen on a digital ledger governed by more or less autonomous smart contracts made transparent and available for all to see.

Welcome to the new and increasingly popular world of decentralized finance (DeFi). Come on in; the water is murky, but mostly fine if you’ve got the risk appetite and love to learn new skills.

Anyone who is wondering how to invest in DeFi—or has simply ever thought that the current banking system is overdue for an upgrade—might be eager to learn about the world of DeFi investing. But before we talk about how to invest in DeFi, let’s go over what it is.

Products and services under the DeFi umbrella include crypto and blockchain-based versions of most traditional financial products. Among them are cryptocurrencies, crypto exchanges, crypto loans, crypto wallets, and even crypto savings accounts. Users use a DeFi wallet to send and receive money, which then gets stored on blockchain and becomes accessible without the use of an intermediary. 

In most cases, transactions happen instantly through DeFi wallets. It’s a little abstract to think about, but cryptocurrency is, in and of itself, an actual container of value. The energy invested to make the currency is the proof of its value—no paper bills or metal coins are necessary to represent the value. Therefore, transferring crypto to a friend via a DeFi wallet is akin to showing up at their doorstep with a literal bag of hundos in the fiat world.

Beyond the decentralized rallying cry that motivates millions of DeFi consumers today, there are a hundred other reasons why people like investing in DeFi. 

To start, getting savvy about where to buy and hold crypto can lead to some pretty astounding passive income yields, sort of in the same way that knowing where to keep your fiat cash can lead to higher interest rates and ROIs—but rates can often be 10x more lucrative with crypto. DeFi investing may include lending, trading or staking (aka locking up) your crypto in exchange for rewards and the opportunity to participate in liquidity pools where you can earn money on your participation. 

We know—sounds a lot like normal banks, huh? That’s true; DeFi investing is essentially an opportunity for blockchain users to come together, combine resources, and participate in the same types of financial services as good ol’ Wells Fargo. 

Except, a world without middle men equals more efficiency and fewer fees for everyone and—according to hardcore crypto evangelists—could also open up access to lending for people who are unbanked or otherwise fed up with traditional financial systems.

DeFi isn’t without risks, however. It’s actually full of risk.

Whereas traditional banks require basic customer identifiers known as “KYC protocol” (know your customer), DeFi only relies on the transparency of blockchain. Anyone can see and trace all interactions, but there’s no way to pin one person’s wallet code to a Social Security Number, driver’s license or other identifying information that could help out in the case of theft. While crypto enthusiasts prefer the anonymity this lends them, some people may feel less safe.

There’s also the issue of scams. Crypto scams are on the rise across the fintech industry, but they are particularly ruthless in the crypto world. Since the technology is still so new, bad actors are usually long gone before the victims can figure out what happened. Without well-established oversight from federal regulators, there’s no one watching the backs of DeFi investors—except for the crypto community itself. The best advice is to learn what red flags to watch out for and refrain from ever clicking suspicious links or revealing your wallet key to anyone.

The most popular ways to invest in DeFi include lending, trading and staking. Let’s take a look at what these terms mean.

It’s probably no surprise that, just like in traditional lending, crypto users can earn interest by letting people borrow from them.  And thanks to DeFi, peer-to-peer (P2P) lending is on another level. 

Using what’s called a decentralized app (dApp), you can plug in the size of loan you need and what kind of crypto collateral you have and then follow an algorithm to match with peers who can lend you the money in crypto. The dApp records the transaction in the blockchain, where it gets verified by whatever consensus mechanism is used in that particular ecosystem.

The popular DeFi project Aave, for instance, is known for running a lending pool atop the Etherum blockchain that lets users lend and borrow up to 17 different cryptocurrencies.

The same principles of trading apply to DeFi investing and investing in crypto. 

Using popular crypto exchanges like Binance, Coinbase, Kraken (along with many, many others), you can buy and sell crypto till your heart’s content.

Coinbase is known for being beginner-friendly (for those who need hand-holding), while Kraken has a better selection of altcoins (aka non-Bitcoin coins).

Even the popular stock trading app Robinhood lets you trade cryptocurrency, comparing Bitcoin with the stock market’s ups and downs. And if you think that is bananas, wait till you learn about the best crypto robo-advisors that automate the whole process for you.

Staking your crypto is a common buy-and-hold strategy for profiting off of your crypto.

Generally speaking, staking refers to locking up crypto assets as a means of validating a particular DeFi protocol. Kind of like the old “it takes money to make money” adage—staking addresses a very important need in the crypto world, similar to bonds and/or early investors in any new project. Blockchain ecosystems need crypto resources to spread around and make the protocol functional, and when people stake, they can earn interest and profit from the transactions that are made within the protocol they helped validate.

Staking requires good knowledge of the crypto landscape. It’s highly volatile, but definitely holds the potential for big rewards. Most importantly, know what each coin’s lock-up period is, so you know when you’ll be able to take your crypto back out.

While you can explore DeFi on Coinbase and other exchanges, it makes sense to level up to a DeFi wallet once you’ve got enough crypto to make someone’s head turn. You can choose between a software or hardware wallet, for which you’ll get a public and personal key to access it. Some of the best open source crypto wallets (meaning the infrastructure is available to all) are Electrum, Mycelium, Blockstream Green and Copay for Bitcoin or MyEtherWallet for Ethereum.

Everybody has a different opinion about which DeFi projects to invest in, as well as what the best DeFi tokens and investment funds are. You should definitely do your research before deciding on putting your money into any DeFi protocol or ecosystem. Learn what the potential benefits are for you, plus what kind of utility you could unlock. 

There are a few approaches you could take. Number one, buy coins and tokens within an established project that has a solid community behind it. There’s no better example than Ethereum, according to crypto enthusiasts, thanks to its soaring popularity. However, a number of “Ethereum killers” are popping up and gaining traction, including Polkadot (DOT) and  Cardano (ADA).

Meanwhile, coins like XRP function more as utility tokens, or coins used to transact within a certain blockchain protocol. In XRP’s case, users buy it to transact in the Ripple ecosystem. While utility tokens technically provide use case, they can also be a good investment if the value of their native ecosystem goes up. 

Last, you can look at DeFi projects built in certain ecosystems that provide value or utility as an add-on to an existing blockchain and meant to scale it to reach a better standard. These projects are known as “layer 2” solutions. Uniswap, which is built atop Ethereum's blockchain, is the second-largest cryptocurrency project by global market capitalization.

It’s not worth asking whether investing in DeFi is a good idea, so much as you should consider the future of money. Blockchain and crypto are here to stay, so it’s just a matter of deciding how you want to interact with this new technology. Investing in DeFi can deliver good ROI, but it’s an emerging and volatile space (aka not great for passive investors who just want to benefit from the stock market’s 10% average returns).

However, for those interested in taking an active approach to alternative investments, DeFi certainly has the chops to keep hungry investors engaged.