How to Analyze DeFi Projects

Introduction:

This article focuses on explaining the thought process and not on commenting on or analyzing any specific project.
Before diving into a deep analysis, understanding the fundamentals of a DeFi project is extremely important.
Tracking popular metrics of DeFi protocols can help investors assess the health of the project and evaluate whether it is undervalued or overvalued.
By understanding token economics, investors can make wiser decisions about which tokens to buy, sell, and hold.
The technology underpinning DeFi projects is a key factor in determining its feasibility and effectiveness.
The team’s pursuit of security is of paramount importance.
Investors need to be able to identify projects that align with the use cases they believe in and evaluate the team behind them.
The strength of a project’s community and the extent to which it is adopted by users are also important indicators of success.

Introduction to DeFi

The explosive growth of Decentralized Finance (DeFi) has fundamentally transformed the financial field, offering a variety of innovative products and services. As a result, individuals can now access unprecedented financial services and products without having to go through intermediaries like banks or traditional financial institutions.

DeFi has made finance more accessible, allowing anyone with an internet connection to participate in activities like lending, trading, and earning interest on their digital assets. However, as more and more projects enter the market, understanding how to effectively analyze DeFi projects has become crucial. This means that investors should conduct thorough due diligence on a project before acquiring its tokens.

Understanding the Basics of DeFi

Before diving into a deep analysis, understanding the fundamentals of a DeFi project is essential. DeFi refers to financial applications built on blockchain networks, aiming to offer open, permissionless, and trustless alternatives to traditional financial services. These projects usually provide services like lending, decentralized exchanges, and liquidity mining.

Considering the open and permissionless nature of this technology, various individuals and teams are building applications that cover many use cases, such as giving users unprecedented control over their personal data and complete ownership of their digital assets. For those new to the DeFi field, they should approach these projects with caution and prudence.

Why is Due Diligence (Risk Management) in DeFi Important?

Due to the unique nature and risks of the rapidly evolving field of DeFi, conducting due diligence before investing or purchasing tokens is extremely important. DeFi investments often come with risks such as potential scams, hacking attacks, and the loss of part or all of the investor’s principal. By thoroughly evaluating a project’s fundamentals, team, technology, and security measures, one can avoid potential scams or bad projects. By conducting due diligence, investors can make decisions, reduce risks, and identify investment opportunities that align with their investment goals and risk tolerance. Moreover, it will help build the necessary knowledge and understanding foundation to invest in the complex and rapidly growing field of DeFi.

This requires individuals involved in the DeFi field to consider the following factors when engaging with new projects.

Fundamentals of the Project

Understanding the core aspects of a project, such as its purpose, utility, value proposition, and roadmap, is key. Assessing the market size and growth potential of the project is also essential. Reading the whitepaper can provide insights into the project’s objectives, use cases, and technology. The track record of team members reveals their ability to build and scale the product. Finally, the roadmap can be used to judge whether the project is proceeding as planned. It can serve as a supplement to other research, determining the likelihood of the project reaching its milestone goals.

Popular metrics of DeFi Protocols

There are several popular indicators that can provide valuable references to understand the performance and potential of a DeFi project. These include the token’s Total Value Locked (TVL), 24-hour trading volume, inflation rate, price, and market cap.

Total Value Locked (TVL)

Total Value Locked (TVL) is the total amount of funds locked in a DeFi protocol. You can view TVL as the total amount deposited by liquidity providers into a protocol. For example, as of July 2023, Uniswap’s TVL exceeds 3.8 billion USD, meaning users have deposited more than $3.8 billion into Uniswap. You can review TVL to assess the overall interest in a specific DeFi protocol or use it to compare which DeFi protocols have “locked” more value. Attracting substantial TVL is often a sign of a strong project.

Market Cap

The market cap reflects the total value of circulating tokens in a DeFi protocol. It is calculated by multiplying the current price of the token by the number of tokens in circulation. The market cap provides an overall assessment of the protocol’s size and prominence. However, it must be considered in conjunction with other factors such as the utility of the protocol and competition.

24-hour Trading Volume

The 24-hour trading volume measures the total value of transactions executed in a specific DeFi protocol over a 24-hour span. A high 24-hour trading volume indicates that the project is more active and has better liquidity, reflecting an active ecosystem and increased market interest. Conversely, a low 24-hour trading volume shows less buying and selling of the protocol’s tokens, and lower liquidity. Low 24-hour trading volume may signify a lack of interest or participation from traders and investors.

Inflation Rate

Another important indicator is the inflation rate, referring to the rate at which new tokens are generated within the DeFi protocol. A lower inflation rate might be favorable, as it indicates a more controllable token supply, possibly increasing in value over time, such as ETH transitioning to a deflationary state after moving to POS, and BTC halving, where the new BTC output will be halved. However, assessing the overall token economy and allocation model to ensure a balance between incentivizing participants and maintaining token scarcity is crucial. This topic will be further explored in this article.

Market Cap to Total Value Locked Ratio (TVL Ratio)

The Market Cap to TVL ratio provides investors with information about the relationship between a DeFi project’s valuation and demand. For example, if a protocol’s token market cap is low but its TVL is high, it may mean that the token is undervalued. If a token’s TVL ratio is below 1, it may be more attractive, suitable for potential investors.

Number of Addresses

The number of wallet addresses is an indicator that measures the number of DeFi protocol participants. Similar to the user numbers of traditional Web2 applications, it is used to gauge user engagement. An increase in address numbers may be a good sign of growing popularity and adoption. It should be noted that this metric might be manipulated, as in the case of airdrops where an investor might have multiple addresses. Investors should use this metric in conjunction with other indicators.

Tokenomics

Tokenomics is a term that originates from the fusion of “token” and “economics.” It is a key concept in the cryptocurrency domain, referring to the economic principles and incentive systems for managing the creation, distribution, and value of tokens within a specific blockchain system.

Here are some aspects that tokenomics considers:

Token Supply and Issuance: This involves the total number of existing or to-be-issued tokens. Some tokens have a fixed supply, while others may have a mechanism to mint new tokens. Issuance mechanisms can significantly influence the price and overall economy of the tokens. Fixed supply may lead to scarcity and possibly increase the price but might limit the system’s flexibility. Mintable tokens offer greater flexibility but could lead to inflation if mismanaged. For example, MATIC originally had a fixed supply cap of 10 billion, while the POL white paper allows for a specific rate of annual increase beyond the initial supply of 10 billion (all converted from MATIC).
Token Distribution: How tokens are distributed among users can greatly impact the health and sustainability of the token economy. Fair and reasonable distribution helps maintain a healthy and active user base. Additionally, tokens may be distributed according to a vesting schedule, meaning they can be used within specific periods. This can encourage long-term holding and contribute to the token’s stability.
Token Utility: Tokens usually serve specific functions within their ecosystem. They can provide services, voting rights, or other benefits to users. The utility of a token is a key factor in determining its value. Tokens that provide services, voting rights, or other benefits are more likely to retain value than those without clear use cases.
Mining and Staking Incentives: Many blockchain projects reward users for contributing to network security and stability with newly minted tokens, a practice known as mining or staking. Participation in incentive measures like staking rewards can encourage user engagement. However, this must be balanced to avoid vicious inflation or other unintended consequences.
Token Burning: Some projects may choose to periodically “burn” tokens, permanently removing them from circulation to reduce supply and potentially increase the value of the remaining tokens.
Governance: Many tokens also serve as governance tokens, granting holders voting rights over the project’s future decisions.
Economic Policies: Tokenomics involves implementing economic policies at the protocol level, influencing how tokens are issued, distributed, and managed.
Security: The security of tokens and their underlying blockchain technology is crucial. This includes the security of smart contracts managing the tokens and the overall security of the blockchain.

Tokenomics is vital as it shapes the dynamics of digital assets and projects. By understanding tokenomics, investors can make more informed decisions about buying and holding particular tokens. It can also help project developers design more sustainable and successful token economies. Equally important, remember that the above-mentioned aspects are just things to consider; the “best” token economy may vary depending on the specific goals of the project. For instance, tokens aimed at incentivizing participation in decentralized applications may have different requirements compared to tokens intended to act as stablecoins.

Assessing DeFi Technology

The technology that underpins DeFi (Decentralized Finance) projects is a critical factor in determining their feasibility and effectiveness. One of the key aspects to consider is the blockchain platform on which the project is built. For example, Ethereum is a popular choice, providing a robust and mature infrastructure for DeFi applications. Meanwhile, with the development of Layer 2 solutions, more and more projects are seeking collaboration with OP and ARB. Other Layer 1 blockchain have also emerged, offering promising options for scalable DeFi applications. Investors seeking to acquire DeFi tokens should weigh the pros and cons of the underlying blockchain to make an informed decision.

Another crucial aspect is the assessment of the smart contracts that drive the DeFi projects. Smart contracts are self-executing contracts on the blockchain, with the terms of the agreement directly written into code. Although audits may not necessarily guarantee security, it is vital for DeFi projects to regularly audit their smart contracts to reduce potential vulnerabilities and protect user funds. Reviewing the smart contract audit history of a project can give insights into the team’s efforts to protect users.

Interoperability is another key aspect of DeFi tokens, ensuring seamless communication and interaction between different platforms and protocols. It allows tokens to be easily transferred, traded, and used across multiple decentralized applications (DApps) and blockchain networks. Investors should check the interoperability of DeFi tokens before deciding to invest.

Security

Given the frequent occurrence of security vulnerabilities in the DeFi (Decentralized Finance) sector, assessing a project’s security measures is crucial. Regular audits by reputable third-party companies, which indicate that the project is actively identifying potential vulnerabilities to ensure the security of smart contracts, are a positive sign. Considering the history of DeFi projects being targeted by hackers and the subsequent panic that ensues, robust security measures are a necessity.

In addition to audits, incentives similar to bounty hunters exist, such as bug bounty programs, which serve as another indicator of the project’s serious commitment to security. In a bug bounty program, the organization sets specific standards, guidelines, and rewards for individuals who discover and responsibly disclose valid security vulnerabilities. When bug finders identify vulnerabilities, they can submit a detailed report to the organization, outlining the issue, its impact, and the steps to reproduce the flaw. The organization then verifies the reported vulnerability, and if valid, offers a bounty or predetermined monetary reward to the bug-finder. This proactive approach to security encourages a community of security researchers to help improve the overall safety and resilience of the DeFi project.

Team

The following are common points to consider in team assessment for stock investments, which may be enlightening for evaluating teams within DeFi (Decentralized Finance) projects:

Assessing the Skills, Experience, and Qualifications of Team Members: Look for signs of success in similar enterprises or industries. The collective ability of the team should align with the company’s mission and goals.
Researching the Team’s Compensation Structure: This includes salary, bonuses, and stock options (or token allocation in the context of DeFi). Stock options can inflate compensation figures and affect shareholder value. High compensation that doesn’t align with the company’s performance might be a warning signal.
Observing Insider Buying and Stock (or Token) Repurchases: If management is purchasing company stock (or tokens), it might indicate their confidence in the company’s future. Conversely, if management is selling stock (or tokens), it may signal potential problems.
Paying Attention to How Management Communicates with Shareholders and the Public: Transparency, regular updates, and a clear vision for the company’s future are all signs of strong leadership. Questions can be asked through social media, community channels, and AMAs (Ask Me Anything sessions).
Company Policies and Mission Statements: These can provide deep insights into management’s values and strategic direction. Look for evidence of ethical practices and a focus on long-term profitability.
Being Alert to Potential Red Flags: Such as past fraudulent activities or ongoing legal issues.

In the context of DeFi projects, these traditional considerations take on new dimensions, given the decentralized and often pseudonymous nature of blockchain projects. Still, careful analysis of the team’s background, alignment with project goals, compensation structure, and communication strategy can provide valuable insights into the project’s credibility, alignment with stakeholders’ interests, and long-term viability.

The strength of a project’s community and user adoption is a key indicator of its potential success. These metrics provide valuable insights into the project’s viability, future growth prospects, and overall market acceptance.

**Emotions and Engagement: ** Emotion is an essential factor in trading and also a reflection of the strength of a project’s community. Engaging with the project’s community is vital to deeply understanding their sentiment, active participation, and overall enthusiasm. This interaction allows you to assess the levels of support, engagement, and trust within the community.
**Social Media Platforms: ** Platforms like Twitter, Telegram, Discord, and even WeChat provide abundant information about the project community. Investors should monitor discussions, comments, and activity levels on these platforms, looking for signs of positive sentiment, active discussions, and growing follower numbers.
Positive Sentiment: Positive sentiment indicates community trust and enthusiasm for the project. It’s often reflected in the tone and content of discussions within social media channels.
Community Activities: Participation in community forums, AMAs (Ask Me Anything sessions), and active community channels often indicates a thriving community that is engaged and supportive of the project.
Warning Signs: On the flip side, investors should be cautious about manipulated sentiment, paid influencers, or unnatural spikes in activity that could be signs of artificial hype or misleading marketing strategies.
Importance of Community in DeFi: In the world of decentralized finance (DeFi), community plays an even more significant role. Decisions related to the development and direction of a project often involve community voting and active participation from the stakeholders. A strong community can foster innovation, support the project through challenges, and contribute to the decentralized ethos that underpins these projects.

Evaluating the community and social media presence of a DeFi project is a multifaceted task. It requires a nuanced understanding of various platforms, the ability to discern genuine sentiment from manipulation, and an appreciation for the role of the community in driving project success. Combined with other assessment factors like technology, security, and team evaluation, community analysis offers a holistic view of a project’s potential and can guide wise investment decisions.

VC investment

Venture Capital (VC) investment in a crypto project can have substantial impacts, both positive and negative. Here’s an analysis of how VC investment may affect a crypto or decentralized finance (DeFi) project:

Positive Impacts

Increased Capital: VC funding provides the necessary capital to scale the project, develop technology, hire talent, and execute the roadmap. It can accelerate growth and enable the project to reach milestones more quickly.
Network and Expertise: VCs often come with vast industry networks and strategic insights. These connections can help in forming partnerships, gaining market insights, and providing mentorship to the team.
Trust: Backing from renowned VCs can bring trust to the project. It signals trust and often attracts further institutional and retail interest.
Marketing and Community Building: VC investment can facilitate more substantial marketing efforts and community engagement, which can result in better visibility and adoption.

Negative Impacts

Control and Decision-making: Depending on the terms, VC investment may come with conditions that affect control and decision-making within the project. VCs might seek seats on the board or have a say in major decisions, potentially leading to conflicts with the original vision of the founders.
Token Distribution and Economics: If not managed carefully, the token distribution to VCs might affect the token economics, potentially leading to an oversupply or concentration of tokens with a few entities. This can impact price stability and community dynamics.
Exit Pressure: VC funds usually seek returns on their investment within a defined period. This can lead to pressures on the project to deliver financial results, sometimes at the expense of long-term innovation or community interests.
Potential Misalignment with Decentralization Ethos: In some cases, VC involvement might be seen as contrary to the decentralized ethos of crypto projects, especially if there’s significant control exerted by the VCs. This could lead to community backlash or a shift away from the project’s original decentralized mission.

VC investment in a crypto project is a multifaceted aspect that carries both opportunities and challenges. While it provides much-needed capital and potential strategic advantages, it also introduces complexities related to control, token economics, and alignment with the project’s vision and values.

Projects considering VC investment must carefully assess and negotiate the terms to ensure alignment with their long-term goals, community interests, and decentralized principles if they pertain to the specific project. Transparency with the community and stakeholders about the nature and terms of the investment can also be vital in maintaining trust and alignment.

Conclusion

Analyzing DeFi projects is a critical process in making informed investment decisions in the rapidly expanding field of decentralized finance. While the factors outlined above are essential for making wise choices, what’s even more vital is that investments should never exceed what one can afford to lose. Investors should proceed with caution, not only fully understanding the technical foundation, security measures, team competence, community engagement, and social media impact of the project but also scrutinizing potential risks and market volatility. VC investment may bring new opportunities and challenges, and this too requires careful assessment. Ultimately, investing in DeFi or any crypto projects should be based on comprehensive research and understanding, coupled with clear investment strategies and risk management plans. While pursuing returns, maintaining caution and responsibility is of paramount importance.