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Rules of DeFi investing
Rules of DeFi Investing
Defi101
07.09.2021
Updated 11.03.2022
14:41

8 indicators each DeFi investor should be aware of
Decentralized finance, better known as DeFi, is rising rapidly and plays an important if not a key role in the modern economy. New projects appear in this field daily: some of them become the leading ones and may consider their investors as rich, while the others are doomed to failure or are aimed at fraud at all. For instance, early investors of Yearn Finance (YFI) could receive more than 30000% of income, and that is within a month only!

The rapid development of DeFi leads to the appearance of a large number of projects, which makes it difficult for inexperienced investors, especially those not familiar with fundamental analysis, to choose among them worthwhile ones and define their value for the community.

Another problem is the uncertainty regarding the rules of projects’ assessment, which complicates their monitoring. Investors have not come up with common approaches and standards for defining the quality of new projects yet: that is why they often face the ambiguity of the perspectives.

What to pay attention to when investing in DeFi? Which indicators should you track when assessing decentralized projects? How to define the fair price of DeFi assets and identify unpromising platforms? In this article, you will get answers to these and other questions.

Introduction: why fundamental analysis is so important 

Fundamental analysis is a method to define the fair price of an asset (for example, security or cryptocurrency) based on internal and external economic factors. Internal factors include the indicators of a project, such as capitalization and the number of active users. External< factors reflect the current condition of a crypto market, that is, its dynamics both generally and sector-specific. Fundamental analysis helps investors understand how undervalued/overvalued that or another project is. To identify key indices, indicators are developed. For instance, cryptocurrency capitalization defines the overall cost of all mined coins. Let us figure out what indicators a crypto investor should pay attention to.

1. General number of locked assets (TVL)

TVL or Total Value Locked is among the most essential indicators of the DeFi industry. In fact, it reflects how much in demand among the investors the project is; however, it is all not that simple. As it follows from the name, TVL shows the total cost of locked in a DeFi protocol assets.

The general dynamics of TVL helps to define how much interest investors show to decentralized projects now; it also demonstrates the tendency and allows to predict the market condition.

High TVL does not always mean that the project is truly promising. It is much more efficient to use a complex approach to evaluate DeFi tokens. For example, when assessing TVL, find out the number of unique addresses interacting with the project’s contract. If there are only a few unique addresses, it means that only large investors (whales) have invested in the project, while the rest of the users simply ignored it. Such projects may turn out to be overvalued.

On the other hand, a low Total Value Locked indicator may actually mean that the project is undervalued. And a detailed examination may show that the platform does not concede other large DeFi protocols by its functionality, or it may even outperform them.

Where to find the TVL indicator

Did you know that: the Defi Pulse service released a special token called DeFi Pulse Index (DPI) that contains the cost of the ten largest DeFi assets. DPI tokens are traded at a decentralized exchange TokenSets.

  1. Annual Percentage Yield or APY

APY reflects the yield of locked assets. New projects, as a rule, offer high yield of investments, which attracts investors. However, in doing so, one should consider the demand for the project: if it is going to grow, then assets will be promising. Otherwise, it is most likely that early investors will simply fix the income and leave the project.

Note: sometimes, you may come across a similar indicator – APR (Annual Percentage Rate). It reflects the same thing as APY does.
The indicator of annual yield may be confusing and does not reflect the real cost of both asset and project itself. In addition to that, this indicator of DeFi projects may change drastically within a short time frame: the higher TVL of the project, the lower APY will be.

When you assess APY, it is essential to track the dynamics of tokens in the long run. If the price continues to grow even when the yield decreases, it means that investors are interested in the project and retain assets.

Where to search for APY indicator

The indicator of annual yield can be found at any DeFi platform, for example, Uniswap or Compound. Some services provide APY data to compare the profitability of tokens in DeFi protocols:

  1. P/S Ratio (price/sales)

A ratio of the price to sales or P/S Ratio is a coefficient known to stock market investors; it reflects how a market cost of a stock relates to annual revenue. With the help of the P/S Ratio, investors define how much overvalued or undervalued an asset is.

If the P/S coefficient is too high in relation to the norm, it means that the cost of a crypto asset is highly overvalued and vice versa. The problem is that it remains unclear for DeFi what value should be considered as the norm in relation to which we should define the fair cost of the asset. For example, the normal value for the stock market is P/S < 2.

To calculate the P/S coefficient for DeFi, it is required to divide the capitalization of the project (TVL) by the annual yield indicator (APY). The P/S coefficient will always be low for new projects due to the high yield: that is why this indicator will be more reliable for already established platforms.

  1. Level of inflation 

It is often that small emission of tokens (general supply) is considered a positive indication for the long-term growth of crypto assets. However, this statement is false since two other factors are more important here:

There is still no reliable way to determine what level of inflation is fair to be considered a normal one when evaluating tokens. The defining value would be the dynamics of the demand for an asset. On the one hand, a deflationary mechanism similar to that Bitcoin has should positively affect the dynamics of the rate in the future, but the yield (APY) of such an asset will be low. And vice versa, if a large number of tokens is generated, the profitability of your investments may decrease considerably or become negative at all. To assess the inflation, indicators APY or APR are used.

  1. General supply of tokens 

Based on this indicator, you may define a strategy, the essence of which is to monitor the supply of tokens at crypto exchanges. You may monitor DeFi tokens at centralized (CEX) and decentralized (DEX) exchanges. The general supply of tokens is the total number of all tokens traded at crypto exchanges.

The idea is that if the number of traded at exchanges tokens increases, it can indicate the growing interest from sellers (bears) and vice versa. It is especially important to track large movements of coins. Usually, big players (whales) store their funds in crypto wallets since that is the most reliable method. If they transfer the assets to an exchange, it could mean they are ready to sell them anytime. Similarly, an active withdrawal of assets from exchanges may mean that whales are storing the balance of funds in their crypto wallets, and it may become a harbinger of the early growth of the rate.

The Whale Alert service available in Telegram and Twitter will help to track large movements of assets. Having subscribed to the Whale Alert channel, you may adjust notifications in such a way as to receive data about large cryptocurrency transfers on time. It will also be useful to consider the ratio of long (long positions) and short trades (short positions) in a futures market because this indicator reflects the current sentiment of investors and may point to an upcoming upward/downward trend.

  1. Number of unique addresses

Active growth of unique addresses interacting with a contract may show the growing interest in a DeFi project. Due to that, a feeling may appear that the community is growing while the platform is gaining more momentum.

But be careful when using this indicator since it may provide false information. In contrast to banks, crypto wallets allow creating an unlimited number of addresses. So, you cannot tell for sure whether created addresses belong to one user or not.

For example, users can create a lot of addresses and carry out transactions at a platform to receive free tokens (AirDrop), similar to how it happened with Uniswap. The exchange granted free UNI for each address that had conducted at least one deal to buy or sell any cryptocurrency. If you see old addresses that made only one transaction, they might not be unique.

  1. Speculativeness

When assessing tokens, one should consider what kind of interest investors show to assets: fundamental or speculative. One of the main tasks of an investor is to evaluate the long-term value of the project by abstracting from volatile price fluctuations. Even a rapid growth of a token may not mean the promise of the project in the long-term perspective.

Let us take YF Link token (YFI) as an example, the price of which dropped more than 20 times within a year and a half. It looks as if the rate has risen due to the popularity of YFI – one of the most fast-growing tokens, which even outran BTC by its price in less than two months. It resulted in many attempts among project creators to recreate the success of Yearn Finance, and there even appeared many projects-clones, the tokens of which skyrocketed in price within a short term but dropped back as quickly, similar to how it had happened to YFL.

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The only goal of such projects is receiving quick profit. But talking from a fundamental point of view, they do not bear any value and most likely will cease to exist in the future. For an assessment, it is required to monitor deals and try to find out why investors make them, especially large ones. If most deals last less than a week, it indicates a high speculative interest and the absence of long-term interest. To develop a DeFi project, as many investors as possible must store their assets for the longest period.

Depending on what blockchain you use, block explorers may be used to monitor transactions. One of the best-known explorers for Ethereum is Etherscan, and BSCScan is used widely for Binance Smart Chain.

  1. Social activity

Equally useful indicator is social activity. In a modern world, where social media is an undivided element of everyday life, it is vital that the community actively discusses the project. If the project has low social activity or it is rapidly falling even when the TVL is high, it means that users do not show significant interest in it.

And the opposite: if users on social media are interested in the project and actively discuss it, it means it is approaching mass recognition. However, a crucial remark is the nature of discussions: users must tell more about the usefulness and practical use of the project instead of price movements only.

Conclusion

The described indicators will help to define the perspectives of the DeFi project. Do not forget to keep an eye on the news: it is sometimes so that even a popular project starts losing capitalization due to problems with a contract or the appearance of a more promising decentralized platform.

Indicators will be the most useful if values are assessed in conjunction instead of being assessed separately. Thus, you will receive more reliable information and will be able to make an in-depth analysis of the perspectives of the project you are interested in.