How to Invest in DeFi
In this article, we are going to get into the differences between investing in Decentralized Finance (DeFi) tokens such as UNI or AAVE or through DeFi products such as UNISWAP or AAVE.
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We will also look at how to invest in DeFi as a speculator or use DeFi networks to earn a passive income. Each has its advantages and disadvantages depending on the desired outcome and appetite for risk.
Before reading on, if you would like to learn more about what DeFi is you can read our article what is DeFi.
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The guide to getting started is here.
Should I invest in the decentralized finance ecosystem?
We could compare the current DeFi cryptocurrency scene to that of the internet craze of the 90s when there was this revolutionary new technology called the internet that promised to change the world. Even in its early stages, the internet presented amazing possibilities, explosive growth potential for investors, a huge amount of innovation, and also plenty of bubbles waiting to burst, and burst they eventually did at the end of the 90s! In much the same way, DeFi protocols promise to radically reshape the finance world just as the early internet disrupted a huge raft of industries, from travel to retail and everything in between. But it's hard to know who the winners will be, and much like in the 90s, we don't have a good framework for analyzing the value of those new companies.
Our society runs on money, whether it´s fiat money like the EUR or USD or crypto, the underlying use case is the same. It literally underpins our daily existence. So any kind of revolution here is something very significant with the potential to affect us all sooner or later. The way things are headed, DeFi could plausibly make its way into mainstream finance very quickly indeed. Currently, though, DeFi is still very much in its infancy and the potential for both risk and reward when making DeFi investments is huge just like with the early days of the internet.
When thinking about decentralized finance as an investment tool, there are two primary ways to invest you need to understand. There is investing in DeFi tokens such as UNI or AAVE, or there is investing through DeFi products, i.e. depositing your crypto holdings into UNISWAP or AAVE liquidity pools to make money.
So what's the difference? Well, investing in DeFi assets such as UNI or AAVE means that you are buying into the token itself, which is a tradable digital asset and you make or lose money based on the price of the token. This is different from investing through a DeFi protocol, where you are using the DeFi platform to make money, by earning interest or other types of fees. UNISWAP and AAVE are currently two very popular examples of DeFi platforms that allow you to make money using your cryptocurrencies. There are others, but for our explanations here, we will stick with the "usual suspects".
Investing in DeFi Projects Directly
Let's begin by looking into how to invest in popular DeFi projects by buying UNI or AAVE tokens. There are many others of course but we will use UNI and AAVE as examples. UNI is the cryptocurrency that powers UNISWAP. AAVE is the token for the decentralized exchange AAVE.
AAVE is a non-custodial and decentralized system of lending pools where, on the one side, deposits that earn interest can be made, and on the other side, borrowers can draw from liquidity pools in return for a fixed or variable interest rate. AAVE started out in 2017 as ETHLend after raising $16.2 million in an initial coin offering (ICO) that allowed it to create AAVE's DeFi protocol lending platform.
UNISWAP is a decentralized exchange platform with no intermediaries. UNISWAP is a DeFi crypto trading exchange that mirrors traditional stock trading exchanges, except that here there is no physical intermediary but rather a software, and a system of fees that pay towards sustaining and growing the UNISWAP network.
Buying UNIs doesn't mean that you relinquish all control. UNI token holders have the opportunity to help shape the direction of UNISWAP by being able to make proposals and vote on them. As an owner of UNI, you benefit from the ability to vote on things like network upgrades and policies with each vote being proportional to the amount of UNI cryptocurrency you stake. It should be noted that to have the opportunity to submit proposals to UNISWAP you must hold at least 1% of the total UNI supply. That ́ is a pretty powerful idea for UNISWAP market participants, and those investors with significant drive actually have the opportunity to influence the direction of UNISWAP rather than just hope for the best and hold on for dear life!
Buying either UNI or AAVE tokens is effectively betting on the actual technology and ecosystem itself. In the world of traditional finance (TradFi) buying UNI or AAVE could be akin to buying stocks in a publicly-traded company like Barclays bank or HSBC bank. As the value of the bank stock rises, investors make money. In much the same way if you are holding UNI or AAVE tokens and their price rises you profit from the increase. However, unlike shares, you don't automatically earn dividends, but you may be able to vote on a proposal to distribute to yourself some or all of the treasury, which could be a little akin to a dividend in the TradFi world.
Investing through DeFi Projects
However, if we are making investments through a decentralized finance project by depositing crypto into UNISWAP or AAVE, the purpose of using these liquidity pools is to make money by earning fees or interest. The process of providing liquidity to the pool in order to earn passive income from one's crypto holdings is known as yield farming.
Using the traditional bank analogy again, depositing your crypto in an AAVE pool could loosely be translated as something like depositing money into an interest-bearing account in a traditional bank. The bank would use your funds within a larger pool for lending in return for paying you interest. Of course with interest rates being so low these days and no banks willing to lend to people who have crypto as collateral, it has created an opportunity for innovative and enterprising DeFi providers to step in and offer those with available capital in the form of digital assets to have a chance of earning a reasonable return on their assets. It should come as no surprise, that investors take advantage of these higher interest rates they get through DeFi staking or DeFi lending, in order to increase the total value of their crypto assets. It's a large part of what makes Defi investments and yield farming so enticing.
The UNISWAP automated market maker is designed to facilitate investors to trade crypto assets in a similar way to a traditional exchange, except there is no intermediary like in the traditional centralized exchanges. The platform connects the two parties in return for relatively low fees using smart contracts which are a set of rules and conditions written in software. The fees generated via financial transactions are then distributed to all liquidity providers proportionally based on their exact contribution to the liquidity pool.
Not the same thing!
It's important to know what you are aiming to achieve as investing your funds in or with UNISWAP or AAVE are two very different propositions with very different risk/reward profiles.
Expanding your DeFi portfolio with tokens is really like buying a traditional stock where the price of the stock - and potential dividends - is the primary issue at play, whereas when using a DeFi project to earn money it's about the level of returns (passive income) you can get by providing liquidity to the protocol.
When providing liquidity on DeFi you are mostly exposed to smart-contract risks and counterparty risks. We have a deep-dive on investing diligently through DeFi in this webinar.
When buying DeFi "company" governance tokens, you are mostly exposed to its price going to 0. One reason that price could go to 0 is that its smart-contract was exploited, so you could say that by buying their tokens you are exposed on all fronts.
How to invest in Defi?
So now that you know a little more about putting your funds into a DeFi investment, say UNI or AAVE, you might be wondering how to actually start doing so. It's relatively straightforward and can be achieved with a few simple steps using a decentralized exchange like UNISWAP or through a broad range of tokens via an index. You could also go to a good old "centralized exchange", but what's the fun in using a platform with central authority?
There are pros and cons with both approaches: with the index approach, you do not need to worry about scam tokens or need to know which are the best tokens to have, and more importantly, you are not putting all your eggs in one basket, on the other hand swapping tokens on UNISWAP gives you full control of what you are doing but it does require some knowledge in terms of which tokens you should be swapping for and holding.
How to use the UNISWAP exchange to buy DeFi assets?
You'll need to buy some ETH to do any of the following. We've got you covered at app.osom.finance.
Step 1 - Connect your wallet (to which you sent your ETH) to UNISWAP from their webpage. You could use TrustWallet, MetaMask or any other supported Ethereum wallet that allows you to sign transactions with smart-contracts (they will usually let you know that they support "Wallet Connect" which is the most universal way of accessing decentralized financial services).
Step 2 - Select which token you wish to swap from the balance of tokens in your crypto wallet and the amount you would like to swap.
Step 3 - Choose from a list the token you would like to swap to, any ERC-20 token can be listed on UNISWAP, so there is a wide range to choose from. Make sure you select the one you want.
Step 4 - You will see the details of the proposed swap and if you are happy you approve the transaction.
Step 5 - If everything works correctly, the transaction gets processed, and you now have your desired token.
An alternative approach could be an index like the DeFi Pulse Index
If you are unsure of which DeFi ecosystem you would like to invest in or would like to spread your risk across several DeFi tokens you could utilize DeFi applications, like the DeFi Pulse Index which is a capitalization-weighted index that tracks the performance of DeFi assets across the market and is weighted based on the value of each token's supply. Additionally, the DeFi Pulse Index aims to track projects that have significant usage and have a commitment to maintenance and further development. We could consider this as something of a "no brainer" and safer investment strategy for beginners but also completely viable for knowledgeable crypto investors who would like to hedge their bets by investing via an index or prefer a slightly more hands-off approach.
We've explained why we don't think the market-cap-weighted approach is best when investing in early-stage companies, but it is an option.
Buying the DeFi Pulse Index can also be done on Uniswap or on their website with your wallet.
The OSOM Crypto Autopilot also contains a lot of DeFi tokens in its universe and Uniswap, AAVE, SUSHI, MKR, and COMP have repeatedly been included in the crypto portfolio in the past. If you are looking at making investments solely in DeFi it's not the best option, but if the objective is to diversify your crypto portfolio with some of these tokens, it might just fit the bill. OSOM Crypto Autopilot is more like a traditional asset manager, but for the crypto world, where the AI-powered Autopilot invests in DeFi amongst other crypto assets. Investment decisions are based on carefully selected risk parameters and through continually monitoring the markets to fine-tune the portfolio to minimize risk.
How to start investing with DeFi platforms
If you are a token holder, you can use DeFi to make more from your otherwise idle assets. You can put those Crypto in a non-custodial wallet - see our article on wallet types - or use a custodian who will broker your interactions with the DeFi services.
If your assets are in a non-custodial wallet, you can then use the "wallet connect" or Metamask functionality to interact with the DeFi protocols to lend your assets or become a market maker by supplying liquidity.
Similarly to the above, it's doable in a couple of steps, so allow us to walk you through the DeFi investment process:
Step 1 - Connect your wallet (to which you sent your ETH) to AAVE from their webpage. You could use TrustWallet, MetaMask or any other supported Ethereum wallet that allows you to sign transactions with smart-contracts (they will usually let you know that they support "Wallet Connect", which is the most universal way of accessing DeFi).
Step 2 - Select which token you wish to deposit from the balance of tokens in your wallet and the amount you would like to deposit.
Step 3 - You will see the details of the proposed transaction and if you are happy you approve the transaction.
Step 4 - If everything works correctly, the transaction gets processed, and you now have a new token that represents your share of the pool.
If you opted for a custodial setup, like OSOM DeFi Earn, you can take advantage of a fully managed service that takes care of your DeFi investing for you via an easy-to-use interface. Rather than staying up to date on the latest happenings and knowing where to get the best yield, DeFi Earn places carefully chosen stablecoins such as USDC and BUSD into platforms such as Binance and AAVE. And you can do it all from a bank transfer in 5 seconds so you don't need to understand how wallets and transaction signing works.
A note: don't forget to take tax implications into account
Depending on where you are located for tax purposes and perhaps how much money you are trading or depositing, it's worth being aware of any tax implications. When buying and selling a digital asset such as UNI or AAVE the profits you make could make you liable for capital gains tax (CGT) whereas when depositing in return for fees or interest there is generally an income tax. It's always worth being aware of the tax implications in your jurisdiction just to be on the safe side.
The world of decentralized finance represents revolution and not evolution in the world of finance. Just like how Amazon turned the world of bookselling and later retail on its head or how Booking.com and Expedia changed how hotels are booked around the world, the DeFi ecosystem is looking to do the same with traditional finance and has already made significant headway within a relatively short space of time. Whether you choose to be a speculator/investor and invest into tokens like UNI or AAVE or use those very same projects to earn passive income in the form of interest or fees is something that depends on your needs and risk tolerance. Fortunately, it is not a one or the other situation, you can spread your risk by investing in some tokens via decentralized exchanges like UNISWAP or lend your coins using something like AAVE or you can use a service like Autopilot or DeFi Earn to identify investment opportunities for you using sophisticated AI-powered algorithms.
It is worth keeping in mind that the DeFi crypto space is very volatile and naturally presents the opportunity for huge gains as well as huge losses. To illustrate this, the DeFi market capitalization dropped from a high of $88.46 billion on 12th May 2021 to $51.47 billion on 1st July 2021, a drop of over 41% in less than two months! Of course, this could completely reverse again in two months' time, but no one knows. Whichever way you choose to invest your funds in this crypto market - with or in DeFi - it is certainly an area of crypto that definitely should not be overlooked. Happy DeFi investing!
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