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10 Point Checklist for Auditing Cryptoasset Investments

 

Ever bought a cryptoasset making magic beans look like a sound investment? I have, so to institute some discipline in my altcoin investing process. I’ve developed an audit to help me avoid duplicating past mistakes.

Many things can derail promising cryptoasset projects. Minimizing the risk of going to 0 is more important than trying to maximize your return. Why? Good crypto projects are infinite games* and an infinite game cannot continue if there are fatal flaws in its design.

*Infinite games include any authentic interaction, from touching to culture, that changes rules, plays with boundaries and exists solely for the purpose of continuing the game – James Carse

While areas overlap the ordering is intentional. This is intended for use as a framework to identify sound cryptoasset investments, purchased on secondary markets like exchanges, when you have a low chance of directly impacting the project.

In which case cryptoeconomics is the most important factor to consider with the rest continuing in declining order of importance.

Now things do get a bit more muddled in the middle. If you were to argue decentralization is more important than scalability I think there is some validity to that perspective and you can reorient the checklist to suit your preferences.

The objective is to systematically identify fatal flaws as early as possible in your research. Allowing you to discard projects unlikely to succeed as investments quickly and move onto your next cryptoasset project research efficiently.

Follow the links for further details on auditing the items in the checklist.

Cryptoeconomics

  1.  Project requires token to work
    • Defensible tokenization
    • Incentivizes user adoption, certain behaviors (or deters bad), needs own token to work
      • Ex: Requires: ETH, Does not require: KIK
  2. Properly aligns incentives across stakeholders
    • PoW, PoS, Decentralized Oracles, Token created registries
  3. Mechanism to maintain scarcity
    • Issuance won’t drive down the existing value of current coins
    • Reasonable inflation rate
  4. Mechanism to generate value
    • Governance, Volume (Transactional Activity), Anonymity
  5. Mechanism to generate network effects
    • Each new user increases value of network exponentially
      • Value provided exceeds cost of joining – prompts new user growth
    • Payments, Accessibility (foundation of usage), Expand investor base (new exchange listings)
    • Partnerships
      1. Pair up to provide for end users (Dapps)
      2. Integration with other projects increases size of user base

Investability

  1. Disciplined well-structured capital allocation process
    • How are funds deployed to increase project value, grow ecosystem, and provide resources for development
    • Incentives for outside contributions Ex: bounties

Bottom Line – Does spending deliver value?

2. Proven natural demand (adoption increasing over time)

Activity of addresses more important than volume of addresses

3. Mechanism to capture value

    • What does project offer to incentivize users to keep using it (not defect to alternatives)
    • Direct relationship with end users ala Facebook
      • User experience provided – ease of use (often overlooked in crypto)

Bottom Line – A Better user experience translates to more value capture

4. Brand

    • Don’t dismiss projects with great branding
      • Even if you don’t want to invest well-funded alternatives can impact your investments increasing their risk

Superior branding can outperform superior teams/products if they generate higher network effects

  1. Defensibility
    • Elusive – competitors sure to follow
      • More defensible – Projects with steeper learning curves, higher cumulative experience, obscurity, pre-commitment from bigger project

Distribution

1. Insider skin in game

If others get more favorable terms incentives may not align

2. Optimized for long term usage of product

3. Equitable token sale

  • Pre-ICO vesting schedule (LIFO)
  • Need to know if whales exist

4. Broad distribution – distribution directly affects Network Effect (could limit people obtaining token)

  • Allocation to investors (Pre product >80%, post > 50%)
  • Pre-mine: plan in place to prevent flood of tokens to the market

5. Limited supply

Team Evaluation

  1. Track Record of historical achievements
  2. Distinctive combination of skills
    • Team – engineers, start-up experience, marketers, leaders
  3. Unique qualifications for tackling the problem
    • Experience with the problem they are trying to solve
    • Strong community means more talent around project
  4. Experience building distributed systems
    • Low supply of people = big advantage
  5. Transparent and consistent ethical behavior
    • Consistent communication, active social media profiles, frequent updates on project

Project

  1. Live and has existing users
    • Active users = less likely to be a scam
  2. Well written quality white paper
    • Concise and low on hype
  3. Demonstrated understanding of the landscape (competitors and substitutes)
    • Know your opponent
  4. Unique value proposition
    • Privacy coins with different methods of anonymizing users
  5. Open source
    • Project transparency – intentions more discernable

Scalability

  1. Leads can hire and develop
    • Diverse team, project leads hire for skills they lack
  2. Defined Roadmap
    • Path to market, milestones (evaluate track record of hitting milestones)
  3. Outside developer interest in contributing
    • Expanded ecosystem
    • Strengthens core offering, open source
    • Evaluation of outside developers (coingecko, onchainfx)
  4. Sustainable burn rate
    • Market cap, team size, funds raised
  5. Geographically distributed
    • Global ambitions = Larger potential user base

Securability

  1.  High Volume of Nodes
    • More Owners = loss of importance if one goes down, reduced risk of collusion, response to malicious intent
      • Cost of node for entry barrier (low cost = more owners),
      • Technical requirements for entry barrier
  2. Widespread distribution of miners/stakers
    • More Locations = less jurisdiction risk if legal issues arise

 (CryptoID for node information)

3. Systematic approach for dealing with bugs

    • Easy reporting method
    • Quick and non-defensive response
    • Mechanism to halt activity
    • Bounties
    • Updates run side by side until they agree

4. Untiered rewards

    • Masternodes – could receive disproportionate amount v. standard mining or staking
      • Large number of coins as collateral (cost barrier for many*)
      • Technical barriers*

*This could consolidate number of entities capable of setting up a masternode

5. Easily stored securely

    • Usable wallet solutions
      • Defines ability to interact with project

(Blockgeeks.com wallet guide)

Decentralization

  1. Widespread Developer contributions
    1. None over 20% (not realistic for small projects)
    2. Higher share = increased key man risk
  2. Roadmap for Decentralized Government
    • Increased centralization expected in beginning – is there a roadmap to decentralization?
      • Example, Augur kill switch
        1. Forces earned influence once decentralized
        2. If abandoned, project can move forward with others
  3. Lack of concentrated holders (via wallets)
    • None over 5% (unrealistic for smaller projects)
      • Drill into details of concentrated ownership (Exchange, company, pre-mine)
    • For newer projects trend toward less concentrated ownership is ideal
    • Old projects with continued concentrated ownership is a red flag

(CryptoID for wallet information)

  1. Would function normally without creators
    • Increased decentralization and robustness against failure
    • Can project move forward if founder is no longer active participant?
  2. Global
    • Diversify legal and regulatory exposure
    • Increases potential access to additional resources and users

Engagement

*Depth > Breadth (ex. are comments insightful)

*Not how many, how much (ex. active commenting)

*Deeply Engaged > Large User Base

Quality discussion (should be project focused not price based)

*Look for a niche community of early adopters with strong belief

1.Developer adoption of protocol

a. Stars – interest in tracking

b. Watchers – receive notification of activity

c. Commits – revision to codebase, code added (higher activity = more interest)

Often summarized by Coingecko developer score

2.  Active commenting on Reddit: Active discussion = active community > numerous cheerleaders

3. Ongoing discussions on social media / messaging apps: Daily engagement important

Weed out paid activity and followers, etc…  Surge during hype cycles can inflate numbers

4.  Positive Twitter sentiment*: Mentions > Follows (>10,000 per month) (Scaled based on size)

*Postive mentions outweigh negative ones

5.  Uptrend in Google Trends: Visibility of project, ability to maintain attention

Risk Management

  1. Code Audit
    • Review code base for vulnerabilities
  2. Anti-Fragile – gets stronger when stressed
    • Speed and complexity are enemies – projects doing complicated things rapidly typically compromise on security
  3. Low funding risk
    • FIAT – not other coins Ex: ERC-20 tokens holding project treasury in Ethereum
  4. Attack Risk
    • Attack Cost Per Day / Market Cap > 0.01%
  5. Regulatory
    • More decentralized = less risk
      1. Founder posturing – anti-regulation for marketing = more scrutiny
      2. Functionality – alternative to regulated option (DEX) = more scrutiny
      3. Technology – ex. privacy coins -> Active communication on use cases outside of illegal functions
      4. Language – tone of public talk about regulation Ex: (ZEC v. XMR)

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Steve Miller

Founder at Crypto Jungle
Steve is a CFA® Charterholder and founder of Crypto Jungle. A site devoted to helping people hack through the weeds to find the Crypto gems.

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