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How to Analyze DeFi Projects the Correct Way

EG 920 Analyzing DeFi Projects the Correct Way

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To analyze DeFi projects correctly, it’s first important to understand the basics. DeFi stands for decentralized finance and refers to financial applications created on blockchain networks. Their goal is to provide inclusive, secure, and transparent alternatives to traditional financial services. Typical features include decentralized exchanges, lending, and borrowing, and yield farming.

Because of the open and permissionless nature of this technology, many people, and teams are creating different applications that serve various purposes. Some examples include enabling users to have more control over their personal data and owning their digital assets entirely. If you’re new to DeFi, it’s important to be careful and suspicious when analyzing new projects.

The importance of due diligence before investing in DeFi projects

To make informed decisions about investing in DeFi, do not forget to conduct due diligence because of the sector’s unique characteristics and associated risks. There is a risk of potential rug pulls, hacks, and loss of invested capital. By carefully analyzing the project’s team, technology, security measures, and fundamentals, investors can avoid scams and poorly executed projects.

Investors can make informed decisions, identify investment opportunities, and reduce risks by performing due diligence. This establishes a foundation of knowledge and understanding required to navigate the complex and dynamic DeFi landscape, aligning with the investors’ investment objectives and risk tolerance.

Individuals who want to enter the DeFi space should consider the following factors when approaching new projects.

9 metrics that can help you analyze DeFi the right way

You can analyze DeFi projects the right way by using various helpful metrics. Remember that these metrics are not to be used as standalone criteria. Rather, you will benefit the best from them by combining different metrics while analyzing projects.

24-hour volume

The 24-hour volume is the total value of trades completed in a particular DeFi protocol over a 24-hour period. If the 24-hour volume is high, it means that many trades are taking place, and there is better liquidity, which indicates a strong market interest and a dynamic ecosystem. Conversely, if the 24-hour volume is low, it shows that there is little trading activity and the liquidity is low. This can imply that traders and investors are not showing much interest or participation in the protocol.

Price-to-sales ratio

To determine if a DeFi protocol is overvalued or undervalued, you can use the price-to-sales ratio. This is calculated by dividing the fully diluted market cap of the protocol by its annual revenue. A lower ratio indicates that the protocol may be undervalued, while a higher ratio may indicate that it is overvalued. This is similar to how the price-to-sales ratio is used in traditional financial markets to evaluate a stock.

Unique address count

The metric “unique wallet address count” gauges the number of participants in a specific DeFi protocol, much like “unique users” is used to measure engagement for traditional Web2 applications. When more addresses are present, it may suggest that the protocol is gaining popularity and acceptance. However, it is very important to understand that this metric can be manipulated, so investors should use it in conjunction with other indicators.

Total value locked (TVL)

Total value locked (TVL) refers to the combined amount of funds that are locked into a DeFi protocol by liquidity providers. TVL can be used to gauge the general interest in a specific DeFi protocol or to compare different DeFi protocols to see which one is attracting more value. A high TVL usually indicates a strong and stable protocol.

Market capitalization

Market capitalization, also known as market cap, is the value of a DeFi protocol’s circulating tokens. It is calculated by multiplying the price of a token by the total number of tokens currently in circulation. The market cap provides an overview of the protocol’s size and significance. However, it is of great importance to analyze the market cap in connection with other factors, such as the protocol’s usefulness, acceptance, and competitors.

Network Value to Transaction (NVT)

Many cryptocurrency investors use the Network Value to Transaction (NVT) metric, which is based on market cap and volume. NVT is similar to the price-to-earnings ratio used in traditional finance and helps to compare the fees generated on a protocol to its current value.

Maximum token supply

Always consider the maximum supply of a token while making long-term investment decisions. In case a protocol’s maximum supply is expected to increase significantly in the future, it’s important to confirm that the tokens you purchase will not lose their value.

Inflation rate

When evaluating a DeFi protocol, it’s important to take into account the inflation rate, which is the rate at which new tokens are generated. A lower inflation rate may be better because it suggests that the token supply is managed better, and the token’s value may increase. However, it’s vital to examine the tokenomics and distribution model to make sure that the protocol incentivizes participants while maintaining token scarcity. 

Circulating supply

The term “circulating supply” refers to the number of active tokens in the current crypto ecosystem. Always make sure to note that any future printed tokens are not included in this measurement. Using circulating supply to compare to a project’s current revenue can be a valuable metric.

Evaluating the team

To choose the right DeFi projects, investors should look for use cases that align with their beliefs and carefully assess the teams involved. To do this, they should review the project’s website, whitepaper, leadership team, team members’ previous work, and other relevant documents that showcase their expertise.

When searching for a team to work on a project, it’s important to find individuals with a history of successful projects and expertise in the industry. You should also evaluate how transparent, responsive, and engaged they are with the community on platforms such as Twitter, Telegram, and Discord. If the team is actively involved in open communication channels and provides regular updates on their project development, it indicates a strong commitment to their use case.

Alternatively, if an investor conducts preliminary research and discovers that the project team is unresponsive on social media or lacks transparency, they should approach these projects with caution. Although these factors may not necessarily indicate a scam, they are warning signs that should not be ignored.

Assessing the viability of the project’s technology

To determine if a DeFi project is viable and effective, it’s important to consider the technology behind it, especially the blockchain platform it’s built on. Ethereum is a well-established option for DeFi applications, while other layer-1 blockchains could also good alternatives for scalable DeFi solutions. When investing in DeFi tokens, it’s crucial to consider the pros and cons of the underlying blockchain carefully to make an informed decision..

It’s important to evaluate the smart contracts that fuel DeFi projects. These contracts are self-executing and contain the agreement terms written into code on the blockchain. To safeguard user funds, DeFi projects need to conduct regular smart contract audits to reduce possible vulnerabilities, even though an audit can’t guarantee security. However, checking a project’s audit history of smart contracts can provide some insight into the team’s commitment to protecting users.

DeFi tokens require interoperability to communicate and interact with different platforms and protocols. Interoperability enables easy transfer, trade, and utilization of tokens across various blockchain networks and DApps. Investors should ascertain a DeFi token’s interoperability before investing.

Analyzing the project’s tokenomics

To understand tokenomics, investors should first consider the incentives offered by a project’s token economy. This includes figuring out the token’s role in the ecosystem and its distribution model. It is important to look at factors like the total supply of tokens and how they are allocated to various stakeholders such as team members, advisors, and community members. The distribution model affects the initial token allocation and can impact factors like governance, market manipulation, and decentralization.

It is crucial to take into account the mechanisms used for token issuance such as mining, staking, or other methods. These mechanisms help in generating and distributing new tokens over time. By analyzing these methods, investors can determine if the token is inflationary or deflationary, its scarcity, and the incentives provided to participants.

Analyzing the community and adoption

A project’s potential success can be shown by the strength of its community and its adoption by users. These indicators offer valuable insights into the project’s viability, future growth prospects, and overall market acceptance.

To better understand the community’s sentiment, level of participation, and overall enthusiasm, it’s crucial to engage with them. This helps assess their level of support, engagement, and trust.

As an investor, it is recommended to monitor social media platforms such as Twitter, Reddit, Telegram, or Discord to gather insights about the project’s community. By monitoring discussions, comments, and the level of activity on these platforms, investors can look for signs of positive sentiment, active discussions, and a growing number of followers, which may indicate community trust and excitement about the project.

Conclusion

Understanding and analyzing DeFi projects can be a complex but rewarding venture. By understanding the protocols, the team, the underlying technology, tokenomics, security measures, and the project’s adoption and community, investors can make informed decisions and mitigate potential risks. An analytical approach that factors in all these areas can help separate promising DeFi projects from those that are more likely to underperform or fail. Ultimately, due diligence is key to navigating the DeFi landscape and is an indispensable tool in this dynamic and evolving sector.

FAQs

What is the risk of impermanent loss in DeFi projects?

Impermanent loss is a potential risk in liquidity provision in DeFi, occurring when the price of tokens inside a liquidity pool deviates. It can lead to temporary or permanent loss if the price doesn't return to its original state.

What's the significance of DeFi governance tokens?

DeFi governance tokens grant holders the right to vote on changes to the protocol, creating a decentralized form of decision-making. They empower communities and align the incentives of all stakeholders.

How can smart contract bugs affect DeFi projects?

Smart contract bugs can lead to catastrophic losses in DeFi, as they can be exploited by hackers. They can result in the loss of user funds and significantly erode trust in the project.

How do interest rates function in DeFi lending projects?

Interest rates in DeFi lending projects are usually determined algorithmically, based on supply and demand. Higher demand to borrow assets typically leads to higher interest rates, and vice versa.

What is yield farming in the context of DeFi?

Yield farming involves lending assets through DeFi protocols to earn rewards. It's a way to potentially earn a return on capital, but it comes with various risks, including smart contract bugs and volatile returns.

How do DeFi aggregators work?

DeFi aggregators connect various DeFi protocols, allowing users to optimize their strategies. They streamline the process, enabling users to maximize their yield or minimize their risk across multiple platforms.

What are liquidity pools in DeFi?

Liquidity pools are smart contracts that contain funds for users to trade against. They provide liquidity to DeFi projects, and in return, providers often receive transaction fees or other rewards.

What's the impact of network congestion on DeFi projects?

Network congestion can significantly affect DeFi projects by increasing transaction costs (gas fees) and slowing transaction times. This can make some DeFi operations costly and reduce the overall user experience.

What's the significance of cross-chain interoperability in DeFi?

Cross-chain interoperability allows different blockchains to communicate and interact, opening up possibilities for broader and more diverse DeFi applications. It enhances liquidity, usability, and can unlock more value in the DeFi space.

Disclaimer. The information provided is not trading advice. Cryptopolitan.com holds no liability for any investments made based on the information provided on this page. We strongly recommend independent research and/or consultation with a qualified professional before making any investment decisions.

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Micah Abiodun

Micah is a crypto enthusiast with a strong understanding of the crypto industry and its potential for shaping the future. A result-driven Chemical Engineer (with a specialization in the field of process engineering and piping design), Micah visualizes and articulates the intricate details of blockchain ecosystems. In his free time, he explores various interests, including sports and music.

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