The spectacular Moon collapse earlier this month taught us that even investing in the most promising cryptocurrencies comes with big risks. He also taught us how important it is to ask ourselves the right questions (five questions to be exact) about any investment in cryptocurrencies that we are going to make. So, with cryptocurrency prices down across the board, let's look at the lessons learned with the return of Terra.
1. What are the backgrounds of the founders?
Just as we would evaluate the management team of a company before investing in its shares, to make an investment in cryptocurrencies we have to evaluate the founders before investing in their tokens:
- What is your previous experience in the cryptocurrency ecosystem?
- Do they have experience in Web2 or financial firms?
- What is your vision for the project in the next five years?
- Do they have a stake in the project, i.e. are they invested in their own project token?
It is important to always stay away from anonymous founders. Investing in cryptocurrencies where the founders are anonymous have weaker governance and are more likely to be scams as there is no accountability when something goes wrong. We should also be wary of founders who are somehow associated with previous crypto scams or project failures; That's another red flag. It is very useful to consult the Whitepaper or the project roadmap to find out this information.
Moment in which Do Kwon finds out that UST loses parity with the dollar.
2. Does the project solve a real problem?⚙️
Projects that don't solve a problem will likely end up with few users and their tokens not worth much. We consider that the minimum requirements to be met when investing in cryptocurrencies would be at least the following:
- What is the problem this project is trying to solve?
- Is it a real pain point?
- Does the project address the problem in a better way than existing solutions?
For example, we can make an investment in cryptocurrencies such as Climate which attempts to address two real problems:
- Climate change, by creating a “black hole” for carbon offsets, which represent one ton of CO2 that has been avoided or permanently removed from the atmosphere. Their goal is to take those trade-offs out of the real world, making them scarce and increasing their price. This disincentivizes polluters and incentivizes carbon offset projects such as renewable energy, forestry, etc.
- The way carbon offsets are marketed. Currently there is no centralized global market to market them. Instead, offsets are traded through carbon brokers and intermediaries in an illiquid, opaque, fragmented and inefficient market.
Klima project statistics. Source: Klima
Klima's solution to this problem is its native token KLIMA, each of which represents a ton of carbon offsets. If the project is successful, KLIMA tokens may be a better way to exchange carbon offsets and make an investment in cryptocurrencies. Before making an investment in cryptocurrency, we have to clearly describe the exact problem you are trying to solve and how you do it better than others. Think of it as a kind of Peter Lynch “pencil test.” As the legendary investor said:
3. Can't the project be forked?
Most cryptocurrency projects are open source, meaning they are susceptible to competitors copying (or “forking”) their code to create a competing project. That is why it is important to evaluate the defense of a project by looking at the utility that cannot be easily forked by a rival project. This quality is called "unmissable utility«: the value of the difficulty of replicating a cryptocurrency project, better known as a hard fork. And before making an investment in cryptocurrencies, we must measure their real value. Check out our Insight above to learn how to do exactly that.
Explanation of a hard fork. Source: Medium
4. Is the project safe?
Hacks in the cryptocurrency ecosystem happen all the time and can be extremely expensive, in some cases investors lose all their money. We must make sure to evaluate the security of a project before investing:
- Has your code been audited?
- Have you experienced hacks or security issues in the past, no matter how minor?
We should also be sure to evaluate the security of the particular blockchains in which we make a cryptocurrency investment. One way to do this is to look at the number of network participants. Whether through mining or staking, network participants (also called block validators) help keep blockchains secure in exchange for some incentive such as earning tokens. The more users there are, the more secure the network becomes, as it is more difficult for hackers to execute a “51% attack.”
Explanation of a 51% attack. Source: Axia Global Trading
5. Where does the profitability of the project come from?
If the asset in question offers some return to investors who lock up their tokens (sometimes called “staking rewards”), it is very important to discover how exactly this return is generated. A good example is staking rewards that come from a protocol's revenue: transaction fees from a decentralized exchange, for example, or lending fees from a decentralized lending/lending protocol. A bad example is returns that are funded entirely by simply printing new tokens, especially if the promised returns are quite high. If that is the case, the total supply of tokens rises sharply every day as new ones are created and distributed to investors. This dilutes the value of each token, lowering its price. So while the total amount of tokens we hold goes up due to staking rewards, the total value of our investment will most likely go down.
Time of the beginning of the collapse of UST.
Another bad example is returns that are… simply unsustainable. Take for example Anchor Protocol, a decentralized lending protocol that offered returns close to 20% to users who deposited TerraUSD (UST). Part of this profitability was funded by the interest that Anchor charged borrowers and the staking rewards it earned on the tokens that borrowers put up as collateral. The deficit was financed by a “profitability reserve” that continued to decline every day.
Anchor protocol collapse. Source: Defillama
Luna Foundation Guard, a nonprofit that supports the Terra ecosystem, which includes UST and Anchor, stepped in to replenish the reserve in February, sure, but that didn't address the root of the problem: the return Anchor paid to holders. UST was unsustainable. Eventually, the entire ecosystem (UST, Anchor, and Luna) collapsed (of course, there were other factors at play as well). Investing in cryptocurrencies may never be risk-free, but the good ones can result in a fair amount of profits. Asking the right questions can help us discover which ones have true potential.