The next 100 million crypto investors.

Health, Wealth, and Happiness

September 16, 2022

“To be a successful investor, you don't need to take excessive risks and be involved in all sorts of financial instruments. You need to understand your risk appetite and understand a few asset classes well. Stay within your boundaries, and your wealth will grow at a decent pace.”

― Naved Abdali

In today's issue: Risk and reward go hand in hand.

We've done good work measuring potential rewards with our Investor Scorecards based on our peer-reviewed research (see below for our latest).

But how do we measure crypto risk? How do we protect investors from the next crypto collapse, bankruptcy, or rug pull?

Here's where we need your help. Read on and speak up.

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Must Read

Today’s most important story for crypto investors.

Reports on Digital Assets (U.S. Treasury): Back in March, the Biden administration signed an executive order for Ensuring Responsible Development of Digital Assets, a.k.a., "Let's figure out our stance on crypto."

Today, the U.S. Treasury released three reports in response, which contain nothing too controversial, but continue to move the ball forward on regulation.

The Future of Money and Payments outlines the changes to payments technologies and recommends continuing to explore a central bank digital currency if the public wants one.

Implications for Consumers, Investors, and Businesses suggests better education and protections for consumers and continued regulatory oversight (such as it is).

Action Plan to Address Illicit Financing Risks in Digital Assets is perhaps the most detailed of the three reports, with specific proposals for catching bad guys.

Investor takeaway: The bigger story is not what's in these reports, but that the reports are being written at all. Each word released by the government adds to crypto's legitimacy as a new investment class. In the big picture, it's progress.

A Framework for Measuring Crypto Risk

by John Hargrave

The crypto investing industry needs a framework for measuring risk.

By “risk,” I don’t mean whether a crypto investment is volatile; I mean whether it could collapse entirely.

For example, most would say bitcoin and Ethereum are less risky than a crypto startup. Most would say Tether and USDC (backed by dollars) are less risky than Dai (backed by crypto).

The question for you is, "What are the risk factors that make you stay away from a crypto investment?" Is it an anonymous founder? A sketchy business model? Forked code?

Just reply back to this email with your response. We’ll read them all!

Building a Crypto Risk Model

What we have in mind is something like our Blockchain Investor Scorecard, which was published back in 2018 and has stood the test of time. It’s the scorecard we use for all our crypto ratings, and it really works.

Every question gets a rating from 1 to 5. Then, you average them up.

While the scorecard has some questions that measure risk (like the team integrity one above), it really measures the strength of the underlying crypto “company.”

It measures potential reward, but how can we measure potential risk?

Specifically, I’m thinking of the crypto companies that have collapsed this year. You know who they are (that last link is a particularly great read).

Could we have seen this coming? Obviously, most didn’t, but could we get better at spotting Jenga towers before they collapse?

I believe we can. Here are a few questions we might ask of any crypto investment, the first steps toward a rigorous framework of measuring risk.

Team Risk

Is the team anonymous?

Anonymous teams are less accountable.

Does the team have a meaningful track record in crypto (“10,000 hours”)? Experienced teams are less risky than novices.

Is there information asymmetry?

Does the team have information you don't, or is everything on-chain?

Does the team demonstrate scrupulous honesty and integrity?

Are there red flags, yellow flags, or potential conflicts of interest?

Are the leader(s) self-promoters on Twitter?

Large Twitter presences can signal they’re primarily looking out for themselves.

Regulatory Risk

Are investors buying the token hoping the price will go up?

Forget any claims of “decentralization." Does it smell like a security?

Is the company headquartered in a jurisdiction without clear crypto regulation?

Small, crypto-friendly countries are better than large, unfriendly ones (U.S., China, etc.)

Does the company lead a specific niche of crypto (stablecoins, lending, etc.)?

Category leaders are more likely to be targeted by regulators, especially in the U.S.

Financial Risk

Is the company well-capitalized?

Do they have enough operating cash on hand and is it liquid (e.g., stablecoins)?

Can you easily explain the company’s business model?

Do you understand how they make money? Can you describe it to others?

Is there an element of “continually increasing returns?"

Do they promise investors, either implicitly or explicitly, that numbers will go up?

Does the company warn regularly about risks?

Do they make it a practice of pointing out potential downsides?

Have other credible investors raised warning flags?

Have you searched for alternate points of view and investigated their concerns?

Smart Contract Risk

Have their smart contracts been audited by a reputable firm?

Are the results publicly available?

Is there a public forum or repository for reporting bugs or issues?

Can you easily find it from their website or Github?

Has the company demonstrated responsiveness to reported issues?

Do they have a track record of responding decisively, or is there radio silence?

Has the company survived stress tests?

Has it held up during one or more market downturns, hacks, or other crises?

Does it rely on cross-chain bridges?

Historically, bridges between blockchains are honeypots for hackers.

Traction Risk

How many active users does the project have?

There’s some safety in numbers. More users generally = more responsibility.

How many followers do they have on social media (Twitter and/or Reddit)?

The court of public opinion can help with public accountability.

Is the project listed on major crypto exchanges?

Big companies want to protect their investors and provide further safety.

Financial Metrics

What is the expected return?

What is the standard deviation?

What is the Sharpe Ratio?

These can be compared across crypto projects for benchmarking.

Behavioral Risk

Perhaps the most important question is your own integrity. Just as criminals are likely to hang out with other criminals, shady investors are likely to be attracted to shady investments.

This could be a category of its own, but since most people think they're pretty good (even when their behavior isn't), it's unclear how reliable it will be. If nothing else, it's a reminder that our own karma plays a part as well.

The Blockchain Risk Scorecard

Our plan is to put these questions into a new scorecard (call it the Blockchain Risk Scorecard) that we can use alongside our Blockchain Investor Scorecard.

Since risk and reward go hand in hand, our hope is that these two tools will give our crypto investing community even stronger confidence in our top picks.

Are there any items you’d add, remove, or change? Respond to this email and I’ll share the best feedback in next week’s column.

Go ahead and email us. There's no risk!

Health, wealth, and happiness,

John Hargrave

Publisher

Bitcoin Market Journal

ICYMI