What to Look for in a DeFi Protocol

DeFi has grown rapidly since the summer of 2020, when Compound launched its governance token, COMP. The total value locked (TVL) in DeFi projects has surged from $1 billion in June 2020 to almost $50 billion one year later, peaking at over $87 billion in mid-May, according to data from DeFi Pulse.

DeFi gives retail and institutional investors the opportunity to leverage a broad range of new yield-generation opportunities that are powered by open blockchain networks.

However, given the young age of the industry and complexity involved, it’s essential to thoroughly review DeFi projects before allocating capital.

A Brave New World

DeFi protocols offer a range of exciting opportunities to earn attractive yields. Users can provide liquidity to pools for decentralized exchanges (DEX), or receive incentive rewards for providing emergency backup liquidity to DeFi insurance policies. Users can also lend crypto or stablecoins on decentralized lending platforms to earn interest.

Some DeFi protocols require users to lock cryptocurrency for a defined period of time to receive a lump sum interest payment, while others pay interest continuously over time. The Total Value Locked (TVL) metric gives an indication of which DeFi protocols offer the best balance between security, convenience, and overall health of the project.

To avoid volatility risks, users can deploy capital to DeFi in the form of dollar digital currencies like USD Coin (USDC). USDC is currently dominating the DeFi space, being the fastest-growing DeFi stablecoin. DeFi users prefer USDC because it has a stable peg, is backed by regulated institutions, and is available across multiple different blockchain networks.

Before deploying USDC in a DeFi protocol, however, it’s important to research the platform you plan to use to reduce the potential risks in this new subset of the crypto ecosystem. 

To help make the best possible decision, here are some of the most important aspects to consider when deploying capital into DeFi protocols.

Has the Project’s Code Been Audited?

DeFi projects are decentralized and thus have no intermediaries running operations and managing user funds. That’s why all transactions are handled by the code itself, and it should be flawless. Otherwise, hackers can exploit vulnerabilities and deplete user funds.

In May 2021, analytics firm CipherTrace reported that a total of $156 million was stolen in DeFi hacks between January and April. It’s already more than DeFi protocols lost to hackers in all of 2020. 

Investors should, therefore, look for DeFi protocols that have been audited by recognized third-party DeFi audit firms, such as OpenZeppelin, Quantstamp, or Certik, among others.

Does It Have a Use Case?

The first thing you should ask yourself is whether the given DeFi protocol has a real-world use case or tries to leverage the industry hype. Many DeFi protocols revolve around borrowing and lending services, decentralized exchanges, insurance, asset management, and other financial services. Some sectors, such as DEXes and lending, are supersaturated with DeFi solutions, so any new challenger has to solve a real problem to stay competitive.

While newcomers may show higher growth rates, it’s much safer to interact with well-established DeFi protocols that dominate their sectors, such as Aave and Compound in lending or Curve and Uniswap for decentralized exchanges.

Does It Provide Relevant Documentation?

Ideally, DeFi protocols should provide relevant documentation, such as a whitepaper, one-pager, guides, fee structure, frequently asked questions (FAQ), roadmap, and so on. This information is helpful to understand the project and assess its maturity and competence.

Is There a Team Behind the Project?

Some DeFi projects might not reveal their team in an effort to pursue the promise of decentralization. Some DeFi protocols are governed by Decentralized Autonomous Organizations (DAOs), leaving the decision-making processes in the hands of the community. 

Today however, most projects have publicly verifiable teams behind them, and you can check their background to get a better picture of their potential. If the team behind a protocol is anonymous, it could raise questions about the long term viability of the project.

Does the DeFi Project Have Reputable Backers?

If the DeFi protocol is backed by reputable venture capital (VC) firms, blockchain-oriented funds, and other institutional investors, that’s a big plus for the project as they do their due diligence before investing large amounts of funds.

Today, some of the most active DeFi investors are Blockchain Capital, Digital Currency Group, Dragonfly Capital, Fenbushi Capital, Pantera Capital, Multicoin Capital, Polygon.

Does It Have an Active Community?

The success of a DeFi project is often reflected in the size of its online community. Thus, it makes sense to check a project’s social media pages and Telegram channels to assess the community sentiment towards the project. 

If the community is active, it typically means that the demand is there, and the protocol may continue to stay relevant. 

Tokenomics

One of the most important things to check during your analysis is the so-called tokenomics, detailing token distribution, inflation, token governance, monetization of the DeFi service, incentives used for different actions performed on the DeFi platforms, and more.

This will help you understand how the funds flow within the ecosystem, who pays the fees, and who gets the stream of rewards.

What Are the Risks of Investing in the DeFi Protocol?

Finally, it’s important to be aware of the risks of deploying capital in DeFi applications. DeFi offers attractive yield-generating opportunities, but you should be aware of the risks. 

We can distinguish four main types of risks when investing in DeFi:

• Coding risk - if the code has errors and vulnerabilities, hackers can exploit them. That’s why audits are important. 
• Oracle risk - oracles are designed to move data from the real world to DeFi protocols, and the reliability of a DeFi project depends on the accuracy of data, which can often come from a single source. 
• Financial risk - the demand and overall success of a DeFi protocol might be impacted by the native token’s performance. Another type of financial risk is impermanent loss, the result of loss from arbitrage in liquidity pools as prices change between two digital assets. 
• Regulatory risk - since DeFi is at a nascent stage, regulators are still working to understand the industry. The expansion of DeFi is imminent, and regulators are working hard to protect consumers. Their decisions could have an unpredictable impact on DeFi protocols.