Exploring the decentralized finance markets is not that different from trading cryptocurrencies. Users commit to supporting specific assets but should always conduct the proper research first. Several indicators can prove useful to DeFi investors, as they can contribute to making better decisions.
Table of contents
- Understanding Indicators For DeFi Investors
- The Purpose Of Decentralized Finance
- Using The Right Indicators
- A Few Golden Rules For DeFi Investors
Understanding Indicators For DeFi Investors
It may seem unusual to talk about “indicators” for those looking to invest in the DeFi space. However, with hundreds of projects to choose from, the investing aspect becomes a lot more complicated over time. Not all projects are worth their salt and may not even attain any long-term value. Separating the prominent ventures from those that aren’t worthwhile is a crucial first step.
As more and more projects come to market, potential DeFi investors have a lot of research to complete. Performing fundamental analysis becomes necessary, as it is pertinent to know what a specific project aims to achieve. Many protocols may seem undervalued or overvalued at first, but the situation may look very different after performing basic research.
The Purpose Of Decentralized Finance
For those who have missed out on this new hot trend, a short introduction is necessary. Decentralized finance aims to bridge the gap between blockchain technology and financial services. Enthusiasts can loan, borrow, trade, and mint assets based on their current cryptocurrency holdings.
The vast majority of DeFi projects today run on the Ethereum blockchain. Despite high network fees, it remains the go-to solution for developers and builders to experiment with new ideas. Other blockchains have seen an influx of DeFi ventures too, but none is as “popular” as Ethereum.
Using The Right Indicators
New projects come around virtually every week, making it challenging for DeFi investors to keep tabs on everything. Evaluating projects takes a lot of time, yet the best investment opportunities may be gone by that point. It is a tough balancing act, but there are some indicators to use to your advantage.
Total Value Locked (TVL)
Perhaps the most crucial metric to gauge projects as DeFi investors is to look at the Total Value locked. It indicates how much “trust” people are willing to put into a specific project.
Contrary to what some may hope, decentralized finance is – in its current form – custodial. That means you have to send funds to a third-party smart contract to interface with the platform or protocol. For this reason, fundamental analysis is necessary to gauge if you will ever be able to get your money back.
As such, the total value locked into DeFi protocols and projects depicts how much money the native smart contract(s) control(s) on behalf of users. This amount is calculated by combining the liquidity across different liquidity pools.
If the TVL is on the high end of the spectrum, it may prove worthwhile for DeFi investors. However, just the TVL alone isn’t sufficient. It is merely one of the many metrics representing a current state of affairs. It can rise and fall in the blink of an eye.
Token Supply On Exchanges
As a DeFi onlooker, it is always worth figuring out how many tokens of a project are currently on cryptocurrency exchanges. The liquidity of these native assets can indicate how likely a price is to move up or down shortly. The majority of trading still occurs on centralized exchanges, despite these assets being part of decentralized finance.
The choice for trading on centralized exchanges si simple” much better liquidity to obtain and unload tokens when needed. As a bonus, one can often figure out the supply of that asset on exchanges through various data aggregators such as Dune Analytics, Glassnode, and others.
A vast amount of DeFi assets on centralized exchanges can prove problematic in the long run. With too much liquidity comes increasing sell pressure in the future. It may not be today or tomorrow, but most DeFi investors will sell their holdings and move on to other pastures sooner or later.
Token Supply Changes On Exchanges
Tying into the previous indicator, it proves worthwhile to determine if a DeFi token’s supply changes on exchanges. More specifically, many traders keep their assets on centralized trading platforms. If the balances go up or down for any reason, it may create a buy or sell signal for DeFi investors.
A substantial influx of balances may indicate trades are looking to bail on this market. Simultaneously, a steep decrease in trading liquidity often hints at accumulation. That doesn’t mean the price will go up automatically, as other factors may be at play to keep the price down.
How Many Unique Addresses Are There?
It is often straightforward to see how many addresses hold a specific token or asset. If that token or asset exists in Ethereum, for example, one can look up the token’s contract address. Block explorers like Etherscan will show how many holders exist for the token at any given time. Having more unique addresses is always beneficial but not a foolproof metric either.
Statistics confirming the number of unique addresses can be manipulated. It doesn’t cost money to create dozens of new Ethereum addresses and send a handful of tokens. Doing so makes it seem as if the distribution is more diversified, but it keeps the funds in a few people’s hands. Unique address count is a viable metric for DeFi investors, but only when using it with other data.
Speculative Purposes And Beyond
Anyone who pays close attention to the decentralized finance sector will know the majority of these assets only serve a speculative purpose. No one can determine if DeFi will be around in a few months or years from today. Moreover, a lot of the business models existing today are not necessarily long-term viable either.
One factor to keep in mind is how high returns are often signs of short-term Ponzi Schemes waiting to collapse. Any platform offering returns of over 0.0001% per hour are usually best avoided. These rates will collapse, or the developers may try to scam users shortly. High rates are never sustainable in the financial industry, decentralized or otherwise.
Second, DeFi investors have to figure out if the token can actually “do something.” More specifically, does it give governance rights, offer trading fee reductions, or can you use it for payments? If the answer to all of these questions is negative, you are looking at a speculative asset with a limited price potential.
Gauging the use cases of DeFi tokens is often challenging. New assets are only usable in select scenarios but may experience broader adoption later on. Waiting for that to happen is a risk, yet it can prove worthwhile for some assets. Allocating a minor portion of your portfolio to such speculative investments is advisable if the entire scheme falls apart.
Is There Inflation?
Distinguishing between the current circulating supply of a DeFi asset and its maximum supply is paramount. Developers often choose to deploy their assets in smaller batches, gradually creating inflation. If an asset’s supply goes from 100 million in circulation to 3 billion in the coming years, the price will often go down by a large margin.
Small supplies are often favorable, as they have the most significant price potential from a theoretical standpoint. However, scarcity only works if there is a reason for people to invest in that asset, such as Bitcoin. DeFi investors need to be aware of why the token exists and what it can do, regardless of the limited supply in circulation today.
Inflation is not an inherent evil or anything along those lines. However, it can be a worthwhile trait in an industry where dozens of new tokens come to market every week. It never trumps usability and long-term vision, though.
Is There Any Significant Revenue?
The primary purpose for creating a new DeFi protocol is to generate revenue, either for future development or to reward token holders. Not all projects are equal in this department, which can create a skewed picture. If the revenue is insufficient to warrant a higher market capitalization, there is little room for future profit.
Comparing the current revenue statistics to the market capitalization can often provide valuable insights. If the ratio favors the revenue over the market cap, an asset may seem undervalued to DeFi investors. Simultaneously if the ratio favors the market cap, the price may be limited until more revenue becomes available.
Again, this is just one of the indicators to use in conjunction with the others on this list. None of these ideas can help make smart investments on their own. Conduct the proper research before making any commitments.
A Few Golden Rules For DeFi Investors
DeFi investors have a lot of work on their plate before they can make any investments. Doing thorough research will often help avoid most of the potential dangers, but these markets remain incredibly unpredictable at all times. There is always a chance a project may not gain traction or fail due to insecure smart contract code.
Audits Are A Bonus
It may be worthwhile to verify whether external experts have audited a smart contract. Not just the “pass” the code gets from the compiler, but an official peer review from Certik or other entities. The vast majority of DeFi projects do not go through this process, which leaves DeFi investors exposed to significant risk.
Having a smart contract audit performed does not always guarantee success either. An audit needs to occur every time something changes or is added to the DeFi protocol in its entirety. It can become a very costly endeavor to protect users, so an initial audit is the only step developers will take.
Anonymous Teams Are A No-No
If there is anything one should never trust in the cryptocurrency space, it is a DeFi project with anonymous team members. While putting a face to the name isn’t a guarantee for success, it creates a baseline of “trust” compared to dealing with unknown individuals.
In some cases, developers of these projects may not even have a social media account. They will refer to the project’s account but will never weigh in on an individual basis. To some DeFi investors, this is a minor hassle, yet it isn’t easy to trust these people with one’s money.
The golden rule for investing in financial markets is to diversify as much as possible. Investing in decentralized finance is no different, as there are hundreds of projects to choose from. Putting all eggs in the same basket is a recipe for disaster, especially where cryptocurrencies are involved.
On the topic of diversifying, always remember only to invest what you can afford to lose. DeFi is a cutthroat business, and not all projects will make it. A fair few of them will fail within their first month, and those losses will weigh down anyone’s portfolio. Investing small amounts into various projects can help offset any adverse outcomes along the way.
Being one of the many DeFi investors is not an easy task these days. Competition keeps heating up, yet new projects struggle to gain any significant traction more often than not. Without fundamental research and analysis, it is nigh impossible to make any investment decisions in this industry.
That said, following the procedures outlined above can still yield some success. There is no “guaranteed way to get rich” in this industry other than taking a few risks and hoping everything works out. Always stick to thorough analysis, diversification, and investing money you can afford to lose.