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The latest installment in our Beginner’s Guide to DeFi revolves around risk frameworks as they relate to cryptocurrency protocols. It presents a methodical approach to evaluating risk, unraveling the intricacies through an investigation of potential benefits and risks.
Please note that this guide applies to all manner of tokens in the crypto space, including security, currency, and utility tokens.
A critical aspect involves differentiating between risk and uncertainty, focusing on effective mitigation strategies where possible. While risk cannot be completely eradicated, cultivating an awareness of the risk factors at play and assessing mitigation efforts is crucial to finding those diamonds in the rough.
With a full understanding of risks and uncertainties, how can we measure these factors, if possible, and what actions should be taken when comprehending them? This sets the stage for a critical examination of a crypto project, encapsulated in a series of essential questions that unify the entire process within the framework.
What follows is not investment advice but rather a mental model applicable not only to crypto but to other areas in the broader world as well. The framework revolves around expected benefits versus expected costs and the ways we can quantify these concepts. So, without further ado, let’s embark on an insightful journey as we examine the complexities of risk assessment and mitigation in cryptocurrency.
Risk vs. Uncertainty
Although they’re often conflated, risk and uncertainty are two different concepts. Perhaps the easiest way to distinguish risk is that it can be calculated: it involves clear, well-defined probabilities. Risk can be thought of as the probability of potential loss relative to the expected return on a particular investment.
So how does risk differ from uncertainty? Uncertainty pertains to those qualities that elude precise quantification. While we may acknowledge its presence, assigning a concrete number is impossible. This lack of certainty can manifest in different ways, such as the unknown probability of an event occurring or possibly unknown associated costs.
In essence, uncertainty can be thought of as ‘undefined risk’. Consider a scenario where an investment has already been made. What’s the probability of an unforeseen event, such as a meteor striking the company headquarters or the team lead encountering an unfortunate accident? Attempting to attach a number to such events is highly speculative and contingent on too many assumptions.
The actionable insight here lies in discerning between what is calculable and what is not. By identifying and segregating the aspects plagued by uncertainty, one can effectively set them aside for consideration later.
Types of Risk and Uncertainties
We’ve divided risk into systemic and non-systemic.
Systemic (or Market) Risk
Systemic risk, also known as Market Risk, describes risk that is inherent to the entire crypto space rather than an individual protocol or project. To understand systemic/market risk, imagine the macro implications of a severe reduction in the price of Bitcoin. It’s likely to have repercussions on all tokens on the market. For instance, if you hold a stablecoin, its dollar-based valuation may remain unaffected, but it would still likely appreciate relative to Bitcoin. Understanding these mechanisms and their susceptibility to market-wide events is crucial.
One example of systemic/market risk is political risk. The current crypto landscape is rife with regulatory uncertainties. And when a bombshell announcement regarding regulatory compliance is announced by influential jurisdictions, it can have a spillover effect on the entire market.
While it is difficult to predict the outcome of these risks, it’s imperative to consider their potential impact. One way to gain more insight is to draw on the expertise of the community. Individuals with expertise in their own region, such as in regional politics or recent legislation, can offer insights into the potential impact on the value of crypto platforms in those regions. Even though it’s called systemic or market risk, these threats can be difficult to quantify, so for our discussion, they fall under uncertainty.
An example of political risk is the U.S. Office of Foreign Assets Control (OFAC) sanction of Tornado Cash, which not only impacted the platform itself but had spill-over effects on others relying on Tornado Cash’s capabilities for funding, particularly in USDC.
Non-Systemic Risk
In addition to systemic risks, it’s imperative to consider non-systemic risks, which are dangers that apply to specific platforms or protocols. These include:
- Smart Contract Risk: Vulnerabilities or bugs in smart contracts can lead to exploits, hacks, or loss of funds.
- Marketing Risks: Poor marketing strategies can lead to a lack of adoption, decreased token value, or negative sentiment among investors.
- Management Risks: Developers or project founders may engage in fraudulent activities such as rug pulls (sudden withdrawals of liquidity) or exit scams (abandoning the project after raising funds), resulting in investor losses.
- Governance Risks: Weak governance structures or centralized control can result in governance attacks, voting manipulation, or conflicts of interest.
- Economic Exploit Risks: Economic mechanisms within protocols can be exploited by malicious actors to manipulate token prices, drain liquidity pools, or destabilize decentralized finance (DeFi) platforms.
- Regulatory Risks (these can also become systemic, as noted above): Legal and regulatory uncertainties can pose risks to projects, including regulatory crackdowns, compliance issues, or bans on specific tokens or activities in specific jurisdictions.
- Oracle Risks: Decentralized applications (DApps) relying on oracles for external data inputs face risks such as oracle failures, data manipulation, or inaccurate data feeds, leading to incorrect outcomes or financial losses.
- Tokenomics Risks: Poorly designed tokenomics, including excessive token inflation, lack of utility, or unfair token distribution, can erode investor confidence and undermine the long-term sustainability of a project.
The Lindy Effect
Based on survivorship bias, the Lindy Effect states that the longer a smart contract or platform remains unexploited, the greater the likelihood it will remain unexploited in the near future.
However, this doesn’t guarantee immunity from exploitation. Correlating this metric with Total Value Locked (TVL) is crucial. Protocols with low TVL may not be lucrative targets for hackers, as exploitation depends on discoverability and incentive.
Key Considerations for Evaluating Risks
When evaluating risks, key considerations also include the age of the contract, the team’s experience, and any history of contract exploitation on the same or previous platforms.
Notably, a team with a track record of multiple contract exploitations on a single platform raises a big red flag, suggesting a heightened risk of continued exploitation, even if the team has reimbursed affected users.
Contract Upgrade Monitoring
Assessing mechanisms for monitoring contract upgrades is also crucial. Contract upgrades can reset the Lindy Effect, so being informed about them is crucial. For example, if a contract upgrade has a 48-hour window before taking effect, consider temporarily withdrawing funds from the platform to observe the post-upgrade scenario. These risk mitigation actions complement non-monetary strategies.
Although assigning exact numbers might be challenging, the key lies in acknowledging that there exists a probability associated with each action as well as an expected benefit.
Evaluating Opportunities
When evaluating an opportunity, it is essential to realistically assess what is known and quantifiable in terms of risks. While acknowledging the existence of smaller, unquantifiable tail risks, such as regulatory uncertainties or geopolitical conflicts, focus on larger, systemic impacts of these potential threats on the economy and the subsequent implications for any investments or platforms you might be considering.
In essence, we are engaged in a strategic battle against uncertainty, striving to tilt the odds in our favor by conducting a sober assessment of the benefits while mitigating the quantifiable risks. The guiding principle is to ensure that the cost of risk mitigation remains proportionate to the benefits derived from such measures. For instance, when insuring a million-dollar house, the choice of an insurance policy should align with the expected loss of the property. In what time frame will the premiums exceed the payout of the policy, and does this time horizon align with your goals?
Furthermore, it’s crucial to recognize that a token — be it a utility token, governance token, NFT, etc. — represents a bundle of rights, liabilities, and risks. Mentally cataloging this bundle is imperative for comprehending not only what is gained but also the potential risks associated with changes in value. For example, a governance token may provide a voice in a community, offering value beyond financial gain. However, it may also carry risks, such as a slashing risk, where voting in a particular way could lead to a reduction in tokens held.
A multifaceted evaluation should go well beyond pure monetary considerations.
Token Value vs. Token Price
When evaluating opportunities, it’s important not to conflate token price with token value. As just mentioned, tokens can be thought of as a bundle of different rights within a protocol, and these rights form the basis of the token’s value, independent of price. Many factors can influence the token’s price without necessarily affecting its overall value. For instance, an inflationary token designed to distribute property rights among token holders may change the allocation proportions without a direct influence on the price of the token. Therefore, it’s imperative to scrutinize the true nature of the token to understand how it might be diluted over time.
It goes without saying that the ‘number doesn’t always go up,’ particularly in crypto winters. As highlighted earlier, value is not synonymous with token price; rather, value is a more nuanced consideration. This brings us to the core principle of your investigation: identify platforms that generate more value than the resources they consume. Identifying a platform that efficiently creates substantial value could be a positive indicator, especially if it utilizes its resources efficiently. And while true value can be tough to pin down, a platform whose expenditures surpass its revenues is a red flag in need of further scrutiny. Aligning your holding timeframe with the platform’s ability to generate value is crucial.
Bootstrapping a project through a mechanism that encourages support for the token is a common approach for many platforms. However, this method essentially involves exchanging a different valuable asset for the platform’s token or NFT, with the expectation that the platform will utilize that valuable asset efficiently, preserving the value of the medium of exchange. Ideally, the token should contribute to meaningful outcomes, such as the creation of art, robust community infrastructure, and more. In evaluating a project, the focus should be on identifying the value being generated. A lack of discernible value is another red flag and may indicate potential shortcomings or a lack of substance in the project.
Specific Tokenomics-Related Considerations
Can tokens be minted indefinitely? Is there a controlled minting function? Access to information such as burn rates through tools like a Dune dashboard is valuable for assessing a platform’s financial health. Understanding how the supply changes over time affects the proportion of long-term ownership on the platform.
The Team
The team behind the token also deserves scrutiny. Delve into their vesting schedule, particularly if they have immediate unlocks or if their unlocks precede those of other project supporters. Also, identify who has the authority to mint tokens (if possible) and their incentives regarding supply release or reduction. This is crucial in evaluating whether the current token price accurately reflects the expected benefits and risks associated with the platform and can help you avoid pronounced sell-offs when tokens are released to other protocol participants.
Liquidity Concerns
Critical to this evaluation is an examination of the treasury’s status. In the event of a sudden decline in the native token’s value, the platform’s ability to meet financial obligations becomes pivotal. Understand the potential consequences of a fall in value, such as a liquidation cascade, and its impact on market liquidity. Assessing whether the treasury can sustain payments or faces a liquidity crunch is a crucial aspect of risk assessment. Evaluating whether the platform is profitable, approaching profitability, or experiencing escalating losses is integral to this analysis.
Addressing liquidity risk is essential in evaluating the ability to exit a position, particularly concerning unlock schedules. Consider a scenario where you’ve locked your tokens for a year, but a significant portion controlled by VCs unlocks in six months. Assessing whether these stakeholders are incentivized to hold or dump their tokens on the market is important. The impact on pricing and the platform’s ability to convey its valuation to the market before unlocking can affect your exit strategy. Knowledge of these schedules relative to exit possibilities is paramount, as higher exit barriers correspond to increased risk if alternative hedges are not employed.
Yield
When considering yield, an analysis of the source of value paying for the yield is fundamental. Distinguishing whether the yield comes from token minting or actual value creation aids in comprehending the platform’s mechanics. Understanding the source of yield helps to assess whether the token’s current price aligns with its intrinsic value and where the price might stabilize in the long term.
Imagine a project offering a high 115% APY. Why does the market demand such a high APY and what justifies it? Delving into the background can reveal if risks are simply offloaded to token holders to justify the APY, or perhaps it serves as an incentive to hold an inflationary token. Scrutinizing the sustainability of this yield and the potential for the token’s price to decline substantially is crucial. The mantra ‘there’s no such thing as a free lunch’ applies here, urging a thoughtful examination of the market dynamics and one’s assumptions when lured in by high yields.
Deciphering DeFi Risks: What’s Next?
In conclusion, navigating through DeFi risks requires careful consideration and evaluation. Key strategies include understanding the Lindy Effect, assessing token-associated risks, and scrutinizing factors like contract age, team experience, and liquidity concerns. Additionally, distinguishing between token value and price, and evaluating liquidity concerns, yield, and the project’s team are crucial steps.
Roadmaps
The presence of a roadmap is another essential factor to consider when evaluating a project. The absence of a roadmap raises concerns and signals a lack of transparency.
Given that your participation may involve investing time, effort, or resources, a clear understanding of the project’s direction is crucial.
Analytics
Conducting analytics is another valuable approach. Does the project have a Dune dashboard or a self-created dashboard? Analyzing this tool can provide insights into the treasury wallet addresses, resource composition, trends, total platform value, burn rate, and token decentralization. Exploring these aspects can inform you about specific risks associated with the project’s treasury. Consider whether the roadmap aligns with the token trajectory and cash burn, and assess if there are individuals who could potentially impact the project significantly if they decide to exit abruptly.
For a more sophisticated analysis, delve into the platform’s future revenue and loss flows. Discounting these flows to present value (though the calculation is beyond the scope here) allows for a comparison against the cost of investment. While not intended to be specific investment advice, these considerations can guide you in assessing the net benefit relative to the current market value.
Economic Audits
Conducting a simple experiment may shed light on the matter. In the realm of smart contracts, numerous audits are conducted to mitigate technological risks, typically funded by the projects themselves. The results are often made public on their websites, providing potential investors and other stakeholders with insights to build trust in the protocol. The entire process of evaluating risks and economic concerns could be circumvented if economic audits were mainstream. Although occasional semi-related reports may exist, this practice is not prevalent in the crypto space. The availability of such an audit could significantly enhance community confidence in a project.
While several companies are working on establishing insurance markets, it’s unclear if any are currently developing economic audits. The feasibility of such audits may be limited by the inherent uncertainty in the crypto space. Providing a comprehensive audit becomes challenging when clear probabilities or costs cannot be assigned to specific, uncertain threats. While such an audit could outline potential threats, delivering a definitive thumbs-up or thumbs-down would be tough.
Community Engagement and Due Diligence
The community can help you understand the mechanics of a platform, its tokenomics, and its interactions vital in determining the token’s true value relative to its current price.
It’s crucial to engage with the project to find out about its potential. Start by visiting the project page and thoroughly reading the tokenomics section; any reputable project should have one. The absence of this information can be a red flag, indicating a lack of transparency. If the project cannot articulate what they are doing with their tokens, their model, and the token holding structure over time, caution is warranted.
To deepen your involvement, learn about the team and their expertise. Investigate the team’s background, audit history, and any track record with previous platforms. In cases where the team is not doxxed, explore their reputation within the community as a potential risk mitigation strategy. Understanding team incentives and reputation can help identify potential risks, like rug pulls.
Even if you lack the technical expertise to read smart contracts, the community can help. Developers within the community may be able to offer more specific answers regarding any smart contracts. The smart contracts should also be audited by a reputable company, and you should consult the auditing company to verify.
Engage with the community, including core team members, and assess whether the community is enthusiastic and willing to share information about the project. If the community seems guarded, and the team isn’t transparent, it raises another red flag. A reputable project should have accessible representatives who regularly engage with the community through calls or AMA sessions, providing opportunities for in-depth discussions with core members and access to detailed information. In a positive community, there will be transparency and friendliness, serving as green flags.
Applying an Evaluation Framework
Assuming that you’ve identified an opportunity in which the potential benefits appear to outweigh the expected cost of risk mitigation, the next stage is to apply a more in-depth evaluation framework. The first step in this stage is to construct a complete checklist or, ideally, formulate an investment thesis. Begin by brainstorming all of the endeavor’s potential positives and negatives. Now it’s crucial to account for even the smaller tail risks, as outlined above, to include regulatory concerns, geopolitical conflicts, or unlikely events like meteor strikes. While individually these may seem inconsequential, collectively they can result in a substantial impact on the evaluation of a token or platform. As discussed, insurance policy premiums can help in converting uncertainties to clearer risks.
Take marketing as an example of a tail risk. Marketing professionals possess a nuanced understanding of the risks associated with ineffective promotional efforts. Even if a product is exceptional, inadequate marketing can significantly impact the value of the token or platform. Neglecting to thoroughly assess these tail risks creates a vulnerability in your cost-benefit evaluation, potentially leading to adverse consequences if these risks materialize.
While it may be impossible to list all potential uncertainties, the key lies in striving for as comprehensive a list as possible. Complete risk mitigation or hedging against all uncertainties is a lost cause, but understanding as much as possible about these threats is key.
As mentioned above, this exercise gains further efficacy when conducted collaboratively within a community. Building the checklist with others allows for diverse perspectives and experiences to converge, enhancing its comprehensiveness. Additionally, engaging a community in this process may transform items initially perceived as uncertainties into well-defined risks. For instance, an economist may struggle to quantify the risks associated with the loss of community, but someone with experience in community management on platforms like Discord might offer insights into the tangible costs of such a loss. In this way, collaborative efforts enrich the checklist, ensuring a more holistic and insightful evaluation.
Insurance as Mitigation for Unresolved Uncertainty
Even in the face of uncertainty, where the probability of a specific risk is unknown, it is still possible to mitigate it through insurance. For instance, although it may be impossible to know the probability of an event like getting struck by a comet, one can acquire life insurance. This approach transforms a potential uncertainty into a known value by ensuring a payoff to your family in the event of such an occurrence. Many individuals utilize insurance as a tool to convert uncertainty into risk, transferring the burden of that uncertainty to another party — the insuring entity.
However, this transfer introduces a new set of considerations, including the capability of the insurer to meet obligations in the event of significant events such as a comet strike. Despite these concerns, the value lies in converting uncertainties into known costs. While acknowledging the potential knock-on risks and various considerations, the act of listing them allows for potential mitigation strategies or means to convert them into manageable and known expenses.
If you can transfer the uncertainty to a third party for a fee, it eliminates the uncertainty from your calculation, converting it to a risk. The known benefit is the payout if an uncertain event occurs. It’s crucial to note that the aim isn’t to recommend insurance for all uncertainties but to recognize that insurance provides two valuable pieces of information:
1) the premium for a specific risk event.
2) the payout for a policy.
The first point provides insights into how others assess the risk associated with the potential occurrence of events. Several platforms offer a means to explore insurance premiums. You might find that a policy covering contract bugs, economic attacks, oracle failures, and governance attacks costs 2.6% per year. The decision on whether the coverage justifies the cost rests with you, contingent on a thorough reading of the entire insurance policy contract.
The second point signifies that others are willing to bear risks that might be challenging for you to quantify, especially uncertainties. In the mentioned example, this insurance policy would incur a cost of 2.6% per year. If you anticipate a yield of 10%, the insurance policy reduces your expected payoff by approximately a quarter. However, it encompasses all those elements that might be difficult to quantify. It is crucial to assess whether the insurance sufficiently offloads risk, enhancing the likelihood of a positive cumulative average growth rate for your investment. It’s also important to consider if the cost of coverage is justified by the potential benefits or if it could result in an overall loss of funds.
The Kelly Criterion as a Risk Management Strategy
Developed by John L. Kelly Jr. in the field of information theory, the Kelly Criterion has found applications beyond its original domain, particularly in the realm of financial investments and now cryptocurrency. In this context, the Kelly Criterion serves as a valuable tool for managing risk and optimizing capital allocation.
At its core, the Kelly Criterion is designed to help investors determine the optimal size of a series of bets to maximize long-term capital growth while avoiding significant losses. The key principle revolves around finding a balance between capital preservation and capital growth.
In cryptocurrency investments, where market volatility is inherent, the Kelly Criterion can probably best be applied to position sizing. Here’s a simplified explanation of how it works:
- Determining the Edge or Advantage: Before applying the Kelly Criterion, investors need to assess their perceived edge or advantage in a given investment strategy. This could be based on technical analysis, fundamental factors, or some combination of both.
- Calculating Optimal Bet Size: The Kelly Criterion formula provides the fraction of the capital that should be invested in a particular trade or bet. It is expressed as f∗=(bp−q)/b. “F∗” is the optimal fraction of capital to bet, “b” is the decimal odds received on the bet (net odds + 1); “p” is the probability of winning, and “q” is the probability of losing (1−p).
- Implementing Capital Preservation: The result obtained from the Kelly Criterion may suggest a fractional bet size. This reflects the delicate balance between maximizing returns and preventing significant drawdowns. By reserving a portion of the capital, investors are effectively implementing a form of self-insurance against losses.
- Adapting to Sequential Risk: In cryptocurrency investments, where sequential risk is prevalent, the Kelly Criterion helps investors adapt their bet sizes based on changing circumstances. For instance, if faced with a series of losses, the formula would recommend reducing the bet size to protect capital.
- Risk of Ruin Consideration: The Kelly Criterion inherently considers the risk of ruin, helping investors avoid aggressive betting that could lead to substantial losses and potential financial ruin.
- Continuous Monitoring and Adaptation: Cryptocurrency markets are dynamic, and factors influencing trades can change. Regularly reassessing the perceived edge, recalculating optimal bet sizes, and adapting to new information are crucial elements of applying the Kelly Criterion effectively. Reapply the formula often to account for more recent developments.
While the Kelly Criterion is a powerful risk management tool, it’s important to note that its application requires accurate estimation of probabilities and returns, which can be challenging in the unpredictable world of cryptocurrencies. Furthermore, individual risk tolerance and preferences play a role in determining the optimal fraction to be applied from the calculated result.
Still, the Kelly Criterion offers a systematic and disciplined approach to position sizing, aiding investors in optimizing risk and reward in their cryptocurrency portfolios. As with any financial strategy, due diligence, continuous monitoring, and adaptability are essential for successful implementation.
Wrapping It All Up
In summary, our exploration over the past three blog posts has delved into the intricacies of cryptocurrency investments, emphasizing the critical importance of a meticulous and comprehensive approach. From understanding the distinctions between risk and uncertainty to evaluating tokenomics, platform value, and potential risks, investors are equipped with a multifaceted framework to guide their decisions. The consideration of insurance also emerged as a valuable risk mitigation strategy.
While economic audits and advanced risk evaluation tools are still evolving, the overarching theme remains clear: informed decision-making in the cryptocurrency space demands continuous learning, adaptability, and a proactive approach to risk mitigation. As the crypto landscape evolves, staying attuned to emerging trends, refining due diligence processes, and embracing strategic risk management practices will be instrumental in navigating the dynamic world of cryptocurrency investments.
