A framework for measuring crypto risk
Summary: How can we better spot risky crypto projects, before they fail? Subscribe here and follow me to get more mental tips and tricks.
The crypto investment industry needs a framework for measuring risk.
By “risk” I don’t mean whether a crypto investment is volatile; I mean if he could collapse entirely.
For example, most would say Bitcoin and Ethereum are less risky than a crypto startup. Most would say that Tether and USDC (backed by dollars) are less risky than Dai (backed by crypto).
The question for you: What are the risk factors that make you stay away from a crypto investment?
Is it an anonymous founder? A summary business model? Forked code?
Here are my warning flags – I’d love to hear yours.
Build a Crypto Risk Model
What we have in mind is something like our Blockchain Investor Scorecard, which was published in 2018, and has stood the test of time. This is the dashboard we use for all of our crypto ratings, and it really works.
While the scorecard has some questions that measure risk (like Team Health, above), it really measures the strength of the underlying crypto “company”.
It measures the potential reward. But how to measure the potential risk?
Could we have seen this coming? Obviously, most did not. But could we better spot the Jenga towers before they come down?
I believe we can. Here are some questions we might ask of any crypto investment: the first steps towards a rigorous risk measurement framework.
Is the team anonymous?
Anonymous teams are less accountable.
Does the team have a significant track record in crypto (“10,000 hours”)?
Experienced teams are less risky than novices.
Does information asymmetry exist?
Does the team have information that you don’t or is it all on-chain?
Does the team demonstrate scrupulous honesty and integrity?
Are there any red flags, yellow flags or potential conflicts of interest?
Does the leader(s) promote themselves on Twitter?
Large Twitter presences may signal that they care primarily about themselves.
Are investors buying the token expecting the price to rise?
Forget any pretense of “decentralization”: does it smell like security?
Is the company headquartered in a jurisdiction without clear crypto regulations?
Small, crypto-friendly countries are better than big, unfriendly countries (US, China, etc.)
Does the company lead a specific crypto niche (stablecoins, lending, etc.)?
Category leaders are more likely to be targeted by regulators, especially in the US
Is the company well capitalized?
Do they have enough operating cash and is it liquid (e.g. stablecoins)?
Can you easily explain the business model of the company?
Do you understand how they make money and can you describe it to others?
Is there an element of “increasing returns”?
Do they promise investors, implicitly or explicitly, that this number will increase?
Does the company regularly warn of risks?
Are they in the habit of pointing out potential downsides?
Have other credible investors raised red flags?
Have you researched other viewpoints and considered their concerns?
Smart contract risk
Have their smart contracts been audited by a reputable company?
Are the results publicly available?
Is there a public forum or repository for reporting bugs or issues?
Can you easily find it on their website or on Github?
Has the company been responsive to reported issues?
Are they used to reacting decisively, or is it radio silence?
Did the company survive the stress tests?
Has it withstood one or more market declines, hacks or other crises?
Does it rely on inter-chain bridges?
Historically, bridges between blockchains have been honeypots for hackers.
How many active users does the project have?
There is a certain security in the number. More users in general = more responsibility.
How many followers do they have on social media (Twitter and/or Reddit)?
The court of public opinion can contribute to public accountability.
Is the project listed on major crypto exchanges?
Big companies want to protect their investors, which provides additional security.
What is the expected return?
What is the standard deviation?
What is the Sharpe ratio?
These can be compared between crypto projects for benchmarking purposes.
Perhaps the most important question is your own integrity. Just as criminals are likely to associate with other criminals, shady investors are likely to be attracted to shady investments.
I’d put that in a separate category, but since most people think they’re pretty good – even when their behavior isn’t – I’m not sure how reliable this will be. If nothing else, it’s a reminder that our own karma also plays a role.
The Blockchain Risk Dashboard
Our plan is to put these questions in a new dashboard – call it Blockchain Risk Dashboard – which we can use with our Blockchain Investor Scorecard.
Since risk and reward go hand in hand, we hope these two tools will give our community of crypto investors even more confidence in our top picks.
Are there any elements you would add? Remove? To change? Let me knowand I’ll share the best comments in next week’s article.
Go ahead, send me a message. There is no risk.