DeFi is evolving quickly and presents interesting opportunities to make money by investing in new projects. This is a summary of what I wish I’d done before starting to invest more seriously and my current diligence process before backing a project. As always, I’m writing this all up to be helpful to others, clarify my own understanding and get feedback to refine my approach.
DeFi Set Up
Before you get started I’d spend a bit of time getting set up — I did not do all of this in the beginning and am much calmer now that I have some of these bases more covered.
- A sounding board: Build a network of friends who are more experienced that you can ask about projects and share experiences. All of this is incredibly confusing as a new person, and so it’s important to give and get help. It is also helpful to have early warnings if risky projects look like they are heading for trouble.
- Start small: I usually start with a smaller amount for new projects and if the user experience with the DApp (Decentralized Application) after a few weeks is good, and I like the risk/return profile, I make it a “core position”. I aim to have no more than 10-15 core positions at any point in time or it it’s very hard to track.
- Understand risk: Understand that there are layers of risk – new chains, new projects, new tokens all have compounded risk compared to established projects (protocol hacks, centralized tokens, logic bugs). For example, supplying USDC-DAI on UniSwap Liquidity pool (LP) on Ethereum is way less risky than a RAY-SOL LP on Solana. Another example is using multiple platforms like Beefy to autocompound your DPI/ETH LP on QuickSwap creates layers of risk vs. investing in a single token.
- Secure your DeFi environment: Spent the time securing your wallets and trading platforms (See this article from the CEO of Nexus who had $8m stolen from him). I use a password manager (1PassWord, LastPass), MetaMask, and write down my codes on paper which are torn in half and kept in separate and secure places. I also use two-factor authentication for everything using products like Google Authenticator/Authy over text where possible. I also use a separate email and browser profile for all my crypto projects.
- Impermanent loss: Understand impermanent loss before providing liquidity. Impermanent Loss occurs when an automated market maker rebalances the pool to get to a 50/50 ratio of value. Impermanent loss can mean that you actually make less money by providing liquidity than just holding tokens if the price of the underlying tokens changes. This video is great and this article from Bankless and this from Bancor are also excellent.
- Fees: When executing on strategies especially in Ethereum there are often layers of fees involved (both putting money in and taking money out) – e.g. Token Transfers, Transaction Approvals, Swaps, Pooling Tokens, Staking LP Position, Claiming Rewards, Pooling and Staking to Compound Claimed Rewards. Each of these has a gas fee and can seriously eat into your returns. Good article on holding ETH vs. Active Strategies.
- Portfolio trackers: You’ll need to use some portfolio trackers like Zerion, Zapper and DeBank (DeBank better for cross-chain) to help you visualize your portfolio and your trading history. The newer projects will likely be excluded so you may have to use a spreadsheet as well.
You need to get comfortable knowing that you’ll never precisely be able to calculate your expected yield – rewards are constantly changing, fees are hard to estimate, and you never know how impermanent loss will affect your returns.
Before Backing a (New) Project
New projects are riskier than established projects (higher risk of logic bugs, hacking risk or rug pulls) so do extra research before investing in these projects even if the yields are enticing. In particular, projects with very high XXX%+ yields are inherently very risky and need more work / or less capital at risk.
For thse newer projects, you need to do extra research and I usually go through the following steps to help you derisk:
- Research: Read the medium/announcement posts, join the project Discord and follow their Twitter account — look for good English, signs of a strong community, and engagement from the project developers.
- Hacks: Check to see if they’ve been hacked in the past (https://rekt.news/leaderboard/) and avoid projects that have been hacked.
- Audits: Check to see if they’ve passed audits – Certik and Perk shield are common but this does not guarantee against hacks.
- Understanding: Don’t just ape in (go in big, hard, and fast) to chase yield without actually understanding the project. If you can’t describe it in one sentence, don’t invest — I’ve been greedy and gotten burned many times including a front-row seat to Iron Finance where I just managed to get out with my original investment.
- Rewards: New projects are particularly fun because you can get rewarded for being an early user and supporter in a very meaningful way, much like early equity investors (e.g. early UniSwap users got $12k of tokens awarded to them).
Understand the terms
For all your DeFi investments you should read through and understand the terms of your investment as well as the circumstances for each situation. Here are the things I usually look for before making an investment:
- Fees: Deposit and withdrawal fees.
- Lock-up periods: Some farms don’t even let you take out your capital or are subject to high fees if you pull out before the lockup.
- Vesting: Vesting of rewards or hurdles before you get your liquidity provider rewards.
- Source of Yield: Yield can come from trading fees, liquidity pool tokens, or additional third-party staking fees. All of these are usually volatile and require active tracking.
- Total Value Locked (TVL): I only consider investing if there is at least $1M in pools and there is active trading in those pools else you expose yourself to more slippage and liquidity risk.
- Liquidity to trading volume ratio: When Trading Volume > Liquidity that feels particularly dangerous (volatility/pumping/dumping etc.)
- Price slippage: Particularly important for small pools where you are a significant % of the pool which impacts both your deposit and withdrawal.
- Difference between APR and APY: APY assumes compounding which is usually inflated as most people are not manually compounding and rewards don’t stay stable over the course of a year.
This guide (Part 1, Part 2) is BSC (Binance Smart Chain) specific but the concepts are all solid in case you’d like to dig in further or get alternative perspectives.
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