Decentralized finance (DeFi) has gained tremendous popularity, revolutionizing our very notion of lending and borrowing. Since 2020, DeFi in particular has offered innovative and thrilling alternatives to traditional financial systems. It lures in users by offering them better returns and more custody over their funds. Navigating the DeFi landscape, especially with small-cap tokens, requires a clear understanding of both the opportunities and the risks involved. With GreedyChain.com, we give you the whole picture. Our deep expertise empowers you to be one step ahead of competition in Web3.

DeFi TVL Surpasses $116 Billion

DeFi is exploding on all fronts! This growth can be seen in its total value locked (TVL)—which is the total value of assets deposited into DeFi protocols. As of this writing, DeFi Pulse shows the total value locked—the amount of money in these services—in cryptocurrency at about $40 billion. It has peaked at $116 billion. This massive jump reflects an expanding trust and engagement in the world of decentralized financial services. AAVE and MakerDAO are among the leading decentralized applications. Today, they each have $4.9 billion and $7.9 billion respectively tethered in crypto. These platforms allow users to lend and borrow cryptocurrencies without the need for intermediaries, using blockchain-based smart contracts to automate the process.

Overview of Total Value Locked (TVL) in DeFi

For users and developers alike, TVL is a key metric that reflects the health and activity of the DeFi ecosystem. It provides the combined worth of assets locked in different DeFi protocols. This has been particularly true for decentralized lending platforms, decentralized exchanges (DEXs), and other so-called DeFi financial applications. A higher TVL generally indicates greater confidence and participation in DeFi, while a lower TVL may signal a decline in activity or concerns about the security and stability of the protocols.

There are many things that can contribute or detract from TVL. These are the prices of the underlying cryptocurrencies, the interest rates on lending platforms, and general bullish or bearish sentiment in the crypto market. Keeping an eye on TVL trends over time can offer important clues about the development and organic progression of the DeFi space.

Factors Contributing to the Increase in Lending Activity

Decentralized Finance lending, through protocols like Aave, Compound, and others, have grown in the past two years to approximately 4 million users, per Dune Analytics. Several factors have contributed to this increase in lending activity:

  • High APY: DeFi lending platforms often offer significantly higher annual percentage yields (APY) compared to traditional savings accounts or fixed-income investments. This has attracted users looking to earn passive income on their cryptocurrency holdings.
  • Accessibility: DeFi lending platforms are generally accessible to anyone with an internet connection and a cryptocurrency wallet, removing barriers to entry associated with traditional financial institutions.
  • Innovation: DeFi protocols are constantly innovating, introducing new features and functionalities that enhance the user experience and attract more participants.
  • Transparency: DeFi transactions are recorded on a public blockchain, providing greater transparency and auditability compared to traditional financial systems.

The vast majority of DeFi ecosystems are deployed onto Ethereum. Beyond being the second-largest cryptocurrency by market capitalization, this platform is a leader in decentralized applications. Users will be able to select their desired money market to provide liquidity. They can do this while earning interest pegged to today’s APY, all made possible through blockchain-based smart contracts.

Small-Cap Lending: Opportunities and Risks

While established DeFi platforms primarily deal with large-cap cryptocurrencies like Ethereum (ETH) and Bitcoin (BTC), some platforms are now exploring the inclusion of small-cap tokens. This creates exciting new possibilities for investors and at the same time enormous risk.

In DeFi, users must lock collateral in cryptocurrency as collateral to take out a loan. This collateral needs to be in the form of other tokens valued at much higher than the loan, often 1.5 to 3 times its value. Flash loan attacks happen when an individual takes a massive flash loan of one token. They then exchange it for another token to artificially pump and dump the prices of both tokens.

  • High APY: Small-cap tokens often offer higher APY on lending platforms due to their greater volatility and risk.
  • Early Adoption: Investing in small-cap tokens through DeFi lending can provide early exposure to promising projects with high growth potential.
  • Diversification: Lending small-cap tokens can diversify a DeFi portfolio and potentially increase overall returns.

Investing in DeFi lending platforms that leverage small-cap tokens poses significant risks even with rigorous due diligence and strong risk management practices. Beyond that, it’s very important to look at the fundamentals of the project, the team behind the project and community support. Here's a checklist of factors to evaluate before investing:

  • Volatility: Small-cap tokens are highly volatile, and their prices can fluctuate dramatically in short periods, leading to potential losses for lenders and borrowers.
  • Liquidity: Small-cap tokens often have limited liquidity, making it difficult to buy or sell large amounts without significantly impacting the price.
  • Security Vulnerabilities: DeFi platforms that support small-cap tokens may be more vulnerable to hacks and exploits due to less rigorous security audits and testing.

AAVE provides a more money-market based approach that allows lenders and borrowers to pick which token they want to trade in. The Compound protocol itself underpins over a dozen cryptocurrencies, including DAI and ATokens.

Navigating the Risks: Due Diligence and Risk Management

Implementing risk management strategies is essential for protecting your investments in small-cap DeFi lending:

  1. Project Fundamentals: Understand the project's goals, technology, and use case. Is it solving a real problem, and does it have a competitive advantage?
  2. Team: Research the team behind the project. Do they have experience in blockchain, finance, or relevant industries? Are they transparent and communicative?
  3. Community: Assess the project's community support. Is there active engagement on social media and forums? Are there strong developers and contributors?
  4. Tokenomics: Analyze the token's supply, distribution, and utility. Is it designed to incentivize long-term holding and participation in the ecosystem?
  5. Security Audits: Check if the DeFi platform and the small-cap token have undergone security audits by reputable firms. Review the audit reports to identify any potential vulnerabilities.
  6. Liquidity: Evaluate the liquidity of the small-cap token on various exchanges and DeFi platforms. Ensure that there is sufficient trading volume to avoid slippage when buying or selling.
  7. Smart Contract Risks: Understand the risks associated with smart contracts, such as bugs, exploits, and governance issues. Consider using platforms with insurance or bug bounty programs to mitigate these risks.

The market capitalization of a cryptocurrency is considered one of the most important factors while estimating the position of a coin within the market. In today’s rapidly evolving market, investors are faced with choices of investing in crypto large-cap projects or low-cap alternative crypto options.

Risk Management Strategies

Liquidity pools act as the backbone of DeFi, allowing for trading and lending to happen in a decentralized manner. A DeFi liquidity pool typically locks two cryptocurrencies into a smart contract. These liquidity pools provide the tokens necessary to execute trades directly on decentralized exchanges (DEXs), using liquidity pools instead of order books.

  • Diversification: Diversification is key in DeFi investing, as it reduces exposure to the impact of poor performance from one coin and increases the chances of capturing upside as successful projects grow. Allocate your capital across multiple projects to reduce the impact of any single project's failure.
  • Position Sizing: Avoid investing a large portion of your portfolio in small-cap tokens. Start with small positions and gradually increase your exposure as you gain confidence in the project.
  • Stop-Loss Orders: Use stop-loss orders to limit potential losses in case of a sudden price drop. Set stop-loss levels based on your risk tolerance and the volatility of the token.
  • Take Profits: Set profit targets and take profits when the token reaches your desired price level. This helps you lock in gains and avoid the risk of losing them due to market corrections.
  • Regular Monitoring: Monitor your investments regularly and stay informed about the latest news and developments in the DeFi space. Be prepared to adjust your positions as needed based on market conditions.

DeFi lending allows for fast swaps and borrowing. Transactions take seconds or minutes instead of months and years.

Understanding Liquidity Pools

Though small-cap DeFi lending offers thrilling prospects, it poses crushing hazards. Highly attractive APY coupled with early access to the next promising DeFi project can be a dangerous combination. You should always exercise extreme caution in making these investments. With careful due diligence and risk management, investors can better weather the stormy small-cap DeFi lending landscape. Checking out what’s at play with liquidity pools will make a big advance to their investment perspective. Keeping educated and learning will be the keys to your success in this fast-paced and ever-changing landscape of DeFi.

How Liquidity Pools Work:

  1. Liquidity Providers (LPs): Users who provide liquidity to the pool are called liquidity providers. They deposit an equal value of two tokens into the pool, such as ETH and a small-cap token.
  2. Automated Market Maker (AMM): The pool uses an automated market maker (AMM) algorithm to determine the price of the tokens based on the ratio of the tokens in the pool.
  3. Trading: Traders can swap tokens directly with the pool, with the price automatically adjusted based on the swap size and the pool's composition.
  4. Fees: Liquidity providers earn fees from the trading activity in the pool, which are distributed proportionally to their share of the pool.

DeFi lending allows for quick swaps and borrowing, with exchanges taking place in seconds or minutes, rather than months or years.

Conclusion

Small-cap DeFi lending presents both exciting opportunities and significant risks. The potential for high APY and early exposure to promising projects can be attractive, but it's essential to approach these investments with caution. By conducting thorough due diligence, implementing robust risk management strategies, and understanding the mechanics of liquidity pools, investors can navigate the small-cap DeFi lending landscape more effectively. Remember, staying informed and continuously learning are crucial for success in the ever-evolving world of decentralized finance.