How to Analyze DeFi Projects
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How to Analyze DeFi Projects

How to Analyze DeFi Projects

Na-publish Jun 1, 2023Na-update Nov 24, 2023


  • Before diving into the analysis process, it's essential to understand the fundamental aspects of DeFi projects.

  • Investors should identify the projects that fulfill the use cases they believe in and evaluate the team behind them. 

  • The technology that underpins a DeFi project is also a crucial factor in determining its viability and effectiveness. 

  • The strength of a project's community and its adoption by users are also significant indicators of its potential success.

What Are DeFi Protocols Used For?

The explosive growth of decentralized finance (DeFi) has revolutionized the financial landscape, offering a variety of innovative products and services. As a result, individuals now have unprecedented access to financial services and products without the need for intermediaries like banks or traditional financial institutions. 

DeFi has democratized finance, allowing anyone with an Internet connection to participate in activities, such as lending, borrowing, trading, and earning interest on their digital assets. However, with numerous projects entering the market, it's crucial to understand how to analyze DeFi projects effectively. This means investors should conduct thorough due diligence into a project before acquiring its tokens.

Understanding DeFi Fundamentals

Before diving into the analysis process, it's essential to comprehend the fundamental aspects of DeFi projects. DeFi refers to financial applications built on blockchain networks that aim to provide open, permissionless, and trustless alternatives to traditional financial services. These projects typically offer features such as lending and borrowing, decentralized exchanges, and yield farming.

Given the open, permissionless nature of this technology, there is a wide range of individuals and teams building a variety of applications covering a numerous use cases, such as giving users unprecedented control over their personal data and complete ownership of their digital assets. New entrants to the world of DeFi should approach these projects with caution and skepticism.

Why Is DeFi Due Diligence Important?

Conducting due diligence in DeFi is essential due to the unique characteristics and risks associated with this rapidly evolving sector. DeFi investment often involves risks, such as potential rug pulls, hacks, and the loss of a portion or all of the investor’s capital. Thoroughly assessing the project's fundamentals, team, technology, and security measures allows investors to make informed decisions and possibly avoid potential scams or poorly executed projects.

By conducting due diligence, investors can make informed decisions, mitigate risks, and identify investment opportunities that align with their investment objectives and risk tolerance. It helps establish a foundation of knowledge and understanding necessary to navigate the complex and dynamic DeFi landscape.

This requires individuals looking to get involved with the DeFi space to approach new projects while keeping the following factors in mind.

There are several popular metrics that can provide valuable insights into the performance and potential of DeFi projects. These include the token’s 24-hour volume, inflation rate, price and market capitalization.

Total value locked (TVL)

Total value locked, or TVL, is an aggregate amount of funds locked into a DeFi protocol. You can think of TVL as the total amount of funds deposited by liquidity providers to one protocol. For example, Uniswap’s TVL is over $4 billion as of February 2023. That means users have deposited over $4 billion into Uniswap. You can look at the TVL to assess the overall interest in a particular DeFi protocol, or use it comparatively to see which DeFi protocol is “locking” in more value than others. Being able to attract a large TVL is usually a sign of robustness.  

Market capitalization

Market capitalization, or market cap, calculates the total value of a DeFi protocol's circulating supply of tokens. It is obtained by multiplying the current price of a token by the number of tokens in circulation. Market capitalization offers an overall assessment of the protocol's size and prominence. However, it’s essential to consider market cap in relation to other factors, such as the protocol's utility, adoption, and competition.

24-hour volume

The 24-hour volume measures the total value of trades executed within a specific DeFi protocol over a 24h time span. A high 24h volume indicates active trading and better liquidity, suggesting a vibrant ecosystem and market interest. A low 24h volume, on the other hand, signals low buying and selling of the protocol's tokens, indicating lower liquidity. A low 24-hour volume can have several implications, including a lack of interest or participation from traders and investors.

Inflation rate

Another important metric to consider is the inflation rate. Inflation rate refers to the rate at which new tokens are created within a DeFi protocol. A lower inflation rate can be favorable, as it indicates a more controlled token supply and potentially higher value over time. However, it's crucial to assess the overall tokenomics and distribution model to ensure that the protocol strikes a balance between incentivizing participants and maintaining token scarcity. This topic will be explored further in this article.

Price-to-sales ratio

Price-to-sales ratio is used to determine whether a DeFi protocol is undervalued or overvalued. To calculate the price-to sales ratio, divide the fully diluted market cap of a DeFi protocol by its annual revenue. The lower the ratio, the more undervalued the protocol may be, and vice versa. This works similarly to how the price-to-sales ratio is used in traditional financial markets to see if a stock is undervalued or overvalued.  

Unique address count

The unique wallet address count is a metric that measures the number of participants in a particular DeFi protocol. It’s a measure similar to unique users for traditional Web2 apps that calibrate user engagement. An increasing number of addresses could be a good indicator of growing popularity and adoption. It’s important to note that this metric can be manipulated and investors should use this metric in combination with other indicators. 

Evaluating the DeFi Project Team

Investors should identify DeFi projects that fulfill the use cases they believe in and evaluate the teams behind them. This can be done by examining the project's official website, whitepaper, leadership team, team member’s past work experience, and other documentation relevant to  the team members and their expertise. 

Look for experienced developers, advisors, and industry experts with a track record of successful projects. Assess the team's transparency, responsiveness, and engagement with the community on platforms such as Twitter, Reddit, Telegram, and Discord. Active involvement in open communication channels and regular updates on project development are positive signs that the team behind a project is committed to the use case they’re attempting to tackle.

On the other hand, an investor’s initial research could reveal that the team behind a project is unresponsive on social media or there is little transparency about the team. While these factors aren’t necessarily indications of a scam, they are red flags and investors should be cautious about getting involved with these projects.

Assessing DeFi Technology

The technology that underpins a DeFi project is a crucial factor in determining its viability and effectiveness. One of the key aspects to consider is the blockchain platform on which the project is built. 

Ethereum, for instance, is a popular choice, offering a robust and established infrastructure for DeFi applications. Other layer 1 blockchains have emerged as promising alternatives for scalable DeFi applications too. Investors looking to acquire DeFi tokens should weigh the pros and cons of the underlying blockchain to make an informed decision.

Another critical aspect is the evaluation of the smart contracts that power the DeFi project. Smart contracts are self-executing contracts on the blockchain with the terms of the agreement directly written into code. It’s essential for DeFi projects to regularly audit their smart contracts to mitigate potential vulnerabilities and protect user funds, even though an audit doesn’t necessarily guarantee security. Nevertheless, reviewing a project’s smart contract audit history can shed some light on the team’s efforts to safeguard users.

Interoperability is another crucial aspect of DeFi tokens that ensures seamless communication and interaction between different platforms and protocols. It allows tokens to be easily transferred, traded, and utilized across multiple decentralized applications (DApps) and blockchain networks. Investors should check how interoperable a DeFi token is before deciding to invest.

Analyzing the Tokenomics of DeFi Projects

Tokenomics refers to a project's token economy and the incentives it offers. Investors should begin by understanding the token's purpose within the ecosystem and its distribution model. 

This involves examining factors such as the total supply of tokens available and how they are allocated to different parties. These parties can include team members, community members, advisors, or other stakeholders. The distribution model helps determine the initial distribution of tokens and can impact factors like decentralization, governance of the project, and the potential for market manipulation.

Token issuance mechanisms are also important to consider. These mechanisms can include mining, staking, or other methods by which new tokens are created and distributed over time. Evaluating these mechanisms can help investors understand if the token is inflationary or deflationary, its scarcity, and the incentives provided to participants.

Assessing the project's revenue streams is also crucial. Understanding how the project generates income and sustains its operations provides insights into the potential value and sustainability of the token. This could include revenue generated from transaction fees, platform usage, or other sources.

Reviewing Security Measures

Given the occurrence of security breaches in the DeFi space, it’s crucial to assess a project's security measures. Look for regular audits conducted by reputable third-party firms, which is usually a good sign that the project is proactively identifying potential vulnerabilities to ensure smart contracts security. 

Bug bounty programs are another indicator that a project takes security seriously. In a bug bounty program, the organization sets out specific criteria, guidelines, and rewards for individuals who find and responsibly disclose valid security vulnerabilities. These programs often have a defined scope, which specifies the systems, platforms, or software that are eligible for bug hunting.

When a bug hunter discovers a vulnerability, they may submit a detailed report to the organization outlining the issue, its impact, and steps to reproduce it. The organization then verifies the reported vulnerability and, if valid, rewards the bug hunter with a bounty or a predetermined monetary reward.

Willingness to partake in this process to identify vulnerabilities may indicate a project’s commitment to keeping abreast of potential weaknesses and taking proactive steps to mitigate them.

Analyzing DeFi Communities and Adoption

The strength of a project's community and its adoption by users are essential indicators of its potential success. These indicators provide valuable insights into the project's viability, future growth prospects, and overall market acceptance.

Engaging with the project's community is essential to gain a deeper understanding of their sentiment, active participation, and overall enthusiasm. This interaction allows you to assess the level of support, engagement, and trust within the community.

Social media platforms like Twitter, Reddit, Telegram, or Discord provide a wealth of information about the project's community. Investors should monitor discussions, comments, and the level of activity on these platforms, looking for signs of positive sentiment, active discussions, and a growing number of followers. Positive sentiment indicates community trust and enthusiasm for the project.

Closing Thoughts

Analyzing a DeFi project is a critical process to make informed investment decisions in the rapidly expanding decentralized finance space. By considering factors such as the project team, technology, tokenomics, security, and community engagement, investors can gain a comprehensive understanding of the project's potential.

Even so, it’s critical to never invest more than you can afford to lose. While the above factors are crucial to making informed decisions, this list isn’t exhaustive and investors should practice caution and approach DeFi projects with skepticism.

Further Reading: 

What Is Real Yield in DeFi?

Four Ways to DYOR on DeFi Yield Farms

How AI Will Influence DeFi: Promises and Delusions

What Are Flash Loans in DeFi?

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