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How to Invest in DeFi in 2022

Thinking of investing in DeFi? Pick up some tips from our investment team in this article.

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We recently caught up with Celia Zeng, our asset manager who covers the investments of Cabital. Her role includes analysing the potential of DeFi investment protocols, researching blockchain projects to understand their use cases, performing due diligence on potential investments, and managing the liquidity of Cabital, handling the daily risk of our investments. 

DeFi, which stands for decentralised finance, covers financial services like borrowing, trading, and lending, that run on blockchain technology without any centralised oversight. 

As of today, the total value locked in the DeFi market is US $75.54 billion. However, one of the biggest challenges faced by DeFi is uptake by the general public, as it’s more complex with numerous factors in play with a different set of risks when compared to its centralised counterpart.

We’ve selected some key points from our conversation with Celia around getting started in investing in DeFi, and you can watch the complete interview here:

What’s the Difference Between DeFi and CeFi?

CeFi refers to centralised finance, which is often linked to banking and traditional finance. It can also refer to cryptocurrency sectors based on a centralised entity, such as an exchange or centralised lending platform. Centralised finance tends to be regulated by governments and authorities, while decentralised finance runs on smart contracts without any centralised regulations. 

DeFi users are responsible for managing their funds and activities in the DeFi world, where they trust that the technology will perform as proposed to execute on services being offered. Almost all of the processes in DeFi are handled by smart contracts, which define what happens with the locked crypto assets based on predetermined conditions. 

 DeFi vs CeFi
Table 1: DeFi vs CeFi

How to Evaluate a DeFi Project

At Cabital, we have some principles that we follow when we invest. 

On the safety side, we do our detailed due diligence on the protocols we invest in, analysing how complex the smart contract is to make sure that our investments are secure.

To ensure we’re able to offer customers the interest rates that we do, profitability is another important concern for us. We run our own modelling around token economics and interest rates to ensure the protocol’s offering is sustainable, while adding on stable yield streams such as swaps or exchanges. 

As an independent investor, you’ll also want to ensure that the maturity of your investment matches up with your withdrawal patterns so that you have adequate liquidity on hand — in our case, we ensure that the maturity of our investments align with our customers’ withdrawal patterns. 

Finally, you want to only consider investing in over-collateralised projects that require their borrowers to put up collateral that is in excess of the amount borrowed, to ensure that your principal is secure. 

Investment Checklist when choosing projects
Investment Checklist when choosing projects

How to Mitigate Risks in DeFi

As mentioned earlier, DeFi has its share of risks, and the responsibility is on the investor to do their due diligence before investing in a protocol. 

The main risks when investing in a DeFi project are: 

  • Smart Contract Risk: The protocol must be audited by at least two independent accounting firms and our independent infosecurity team looking into the smart contract to verify that there is a low risk of hacking. 
  • Credit Risk: The investment team will perform due diligence around the protocol to check its security, continuity and interest model. In Cabital, potential investments will also be presented in risk committee meetings, which consist of team members across compliance, finance, legal, tech, operations, ALM and more. 
  • Interest Risk: This is along the lines of ensuring the protocol is profitable, as mentioned above. As a wealth management firm, we need to find attractive yield generating protocols that match the yield we offer to our clients. 
Mitigating Risks in our DeFi investments
Mitigating Risks in our DeFi investments

Strategies to Consider When Investing in DeFi

With the learning curve constantly expanding and with new projects going live, investing in DeFi can be daunting. If you’re looking for DeFi platforms to invest in, you can look into Aave and Curve, as these two protocols are leading players in the space. They’ve been established in the market for a long time, and are also audited by established firms. 

At Cabital, when it comes to investing our clients’ funds, we generally run market neutral strategies that protect from market volatility to ensure our principal is secure. 

Investment Strategies for DeFi
Investment Strategies for DeFi

On the other hand, we run more aggressive investment strategies around our working cabital, like spot, futures and arbitrage. 

We also allocate our portfolio across the major layer one chains, including SOL and Ethereum. While a constant argument against Ethereum is the high gas fees, as the dominant blockchain, it still offers very good security and returns.

Regulators and DeFi

With some aspects of DeFi — like stablecoins — playing an increasingly important role in the cryptocurrency space, it’s only expected that regulators around the world will start looking into implementing regulatory frameworks that will provide better clarity and protection for investors.

One major concern for regulators is the potential occurrence of a stablecoin “run”, where a large quantity of holders try to redeem them due to concerns around the currency’s viability. This could occur when a stablecoin loses its dollar peg, as in the case of UST (TerraUSD), which fell as low as $0.175 in May 2022. Due to the de-peg, the price of LUNA has plummeted to below that of UST, which puts UST’s stabilising mechanism at risk, since users are currently not being able to redeem their $1 of UST for $1 of LUNA. 

Even before the UST depeg happened, a ranking member of the Senate Banking Committee proposed a new regulatory framework for stablecoins, in particular stablecoins that are are used as a medium of exchange. He sees stablecoins moving from just facilitating trades with cryptocurrencies, to being used for payments of goods and services. By separating payment stablecoins from stablecoins that offer interest rates, this will also clarify the question of whether stablecoins are securities, as only the latter would be subject to securities law. 

To protect users, the plans include subjecting issuers to disclosing the assets that back stablecoins on a monthly basis and and auditing reserves on a quarterly basis. All this ensures that the assets backing stablecoins would have the same market value of the outstanding stablecoins. In preparation of these new rules, some issuers have already started sharing monthly reports to prove that their stablecoins are backed by cash and cash equivalents.

What Does the Future Look Like for DeFi?

As the DeFi space develops, there will be new opportunities. For one, there’ll be more institutional players entering DeFi. In March 2022, Goldman Sachs and Galaxy Digital announced over-the-counter crypto trading

Also, DAO will replace the traditional corporate structure, especially when it comes to allowing voting or moving funds in a matter of minutes. 

And finally, Web3. With the promise of a new iteration of the web based on blockchain technology, incorporating concepts like decentralisation and token-based economics, there is also the prospect of faster communication and an improvement in personalising the user experience. 

If investing in DeFi on your own sounds too overwhelming, let Cabital take care of the heavy lifting. All you have to do is deposit any amount of USDT, ETH, or BTC, and you’ll be able to start earning leading interest rates on your holdings.

This article has been prepared by Cabital Fintech (LT) UAB  (the “Company”) and is general background information about some of the Company’s activities at the date of this presentation.

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