Measuring and Managing the Risks Involved in your Investments
sexypotato, April 2022
Article 3 in a 3 Article Series to help you Do Your Own Research (DYOR)
In the previous article I’ve mentioned briefly some risks that to a greater or lesser extent can threaten, erode or erase your investment. In this one, I’m going to talk about them and a few others that I find relevant. But quite frankly, risks on any investment are countless and covering them all would be a titanic job for me, so I’ll just focus on those that are common in crypto and judge the most important.
To summarize, in general there are four group of risks that we need to be aware of:
- Business Risks
- Economic Risks
- Market Risks
- Scam Risks
Let’s explore each of them.
1. Business Risks.
Some risks are related to the strict performance of the project, the product or service, and the team:
• No adoption at scale or no adoption at all: Most projects have a hard time getting their products or services being used by people or companies. If nobody or just a few uses your product, what’s the point of building it in the first place? Those who fail are doomed to die. Adoption is key for us investors to get a positive ROI on our investment.
• Recurrent delays to deliver a product: Does this sound familiar? Delays are understandable, especially in crypto, but when they become a common thing, it’s worrisome. This could be a sign that the team cannot deliver and gives more room to other participants to come and share the pie.
• Not able to compete: Crypto is highly competitive. There are dozens of projects popping up almost daily so being able to compete is a fundamental thing. If the team is not able to adapt its products based on new ideas or demands, there’s also no future for investors.
• Not sustainable long term: I’ve seen a lot of cool projects which are not sustainable long term. A product is a living animal that needs to be fed with new features, which can only be done with a budget or incentives for contributors. So a product with no income will not be a product in the future, it will certainly get obsolete and left behind.
• Lack of funding: This one has similar implications as the previous one. Scarce resources bind the hands of those building the product, which limits the scope and threatens sustainability long term.
• Lack of marketing: Either due to lack of funding, incomes or promotion skills, a poor and unambitious marketing program reduces the potential user base and gives more room to the competition to increase their market share.
• Lack of engagement and passion from team members: Well, if those working for the project are not committed to the cause, just GTFO my friend. These people are the most valuable asset of a crypto project, they should be happily working for it. If they are not, they can leave at any time to find a better job. Keep in mind that in the end we are investing in people.
• Lack of support from the community: A strong community provides support and rich feedback in regards to new features to be included and things to change or make better. If there’s no engagement from it, or if the community barely exists, it’s probably a sign that things are not being done well or there’s simply no interest in the product being built.
• Fights among team members and community members: Heated discussions are fine as long as all parties are respectful and polite to each other, heck we are humans with passion and blood in our veins. What’s really concerning is to see founders or team members being often aggressive with community members and close-minded when criticized. That’s a sign of immaturity, authoritarianism and lack of professionalism. Under these circumstances, most of the time the ship ends up being crushed by the rocks and sinks to the depths of oblivion.
• Fights among team members: Similarly, often unproductive fights among members of the team especially in the biggest offices have the same result as before.
• Regulatory issues: Either by not having a legal framework or having issued a non-compliant token, any project in such condition is at high risk of being prosecuted by regulators. This is a fact and you as an investor need to be aware of the possible consequences for your investment.
2. Economic Risks.
A few other risks are related to bad treasury management, poor token design or to an unfair token distribution among stakeholders:
• Hacks to the treasury: If you have been long enough into crypto you already know this risk is a juicy one. Treasuries of crypto projects are honeypots to hackers. If proper security measures are not taken and properly maintained, smart contracts can be exploited and funds can be stolen, killing the whole thing. The importance of having the smart contracts audited, and especially by a reputable company, cannot be overstated!
• Highly inflationary supply: A high inflation rate with no burning can ignite a spiral of selling pressure and eventually take the price down to 0. I’ve seen this many times and the outcome is very hard to reverse. Inflation is good as long as it’s controlled and in accordance with the natural growth of the business.
• No incentives to holders and validators: A token with no incentives to be held is naturally a death token. Compensation in any kind like staking or liquidity mining rewards, airdrop rights and fees for validators (if applicable and relevant) are always a good thing to keep a healthy token economy.
• High concentration of tokens in the team: This may cause team members to lose focus and get distracted by so much money in their pockets when prices go up, and potentially be tempted to dump their holding. A healthy balance between hard work and good rewards must be obtained to keep things going. Besides, members come and go and when they leave they may become big stakeholders that could sell at any time if they don’t support the project anymore.
• High concentration of tokens in short term investors: With similar effects, if a big portion of the tokens are held by short term investors, you as a tiny one can be dumped by them at any time and suffer big losses. Some Venture Capitalists or deep pocket investors aka whales have a long term investing horizon, but some others are just sharks looking to maximize their profits, so it’s important to know and check them in advance as much as you can.
• Small number of holders: The narrower the base of holders, the more volatile the price becomes as their selling has a higher impact. Besides, a wider base provides stronger support and speeds up the adoption of the products.
3. Market Risks.
Unfortunately, even if everything else looks good, there are some other risks that are related to market behavior:
• Lack of trading gates: One big challenge for projects has always been to get listed on a CEX. This was a big problem for holders as they were trapped and only able to sell OTC. Fortunately, nowadays DEXs allow pretty much all tokens to get listed, as long as liquidity is provided.
• Lack of liquidity: Being able to trade doesn’t mean it’s easy to sell. Enough liquidity in a secondary market is very important and needed, to prevent having a big impact on the price and losing your gains or capital.
• Front running and sandwich attacks: When you execute an order to buy (or sell) a token, while this order is pending you can be front-runned, meaning somebody (human or bot) takes advantage of it, removes liquidity to buy (or sell) before you do and then uses your liquidity to cover the position. In the end, you get a worse price than the one you’d have and the counterparty makes a riskless profit.
• Snipping bots: This is something similar to front running. In some cases, your orders can be targeted by sniper bots who track all transactions from the mempool and may want to take advantage of them, for example by issuing a similar transaction with higher gas fee, which will be executed before yours, removing what could have been your liquidity and selling to you at a higher price. This happens mostly with big transactions, and in new token listing where initial liquidity is taken by a bot and immediately sold higher to retail investors.
• Price manipulation: Pretty much every token is in one way or another highly manipulated either by wash trading, spoofing, pumping & dumping, releasing fake news, or using insider information. And the less liquid a token is, the easier it becomes to manipulate it.
• Token delisting: There are times when CEXs can delist a token for lack of interest from their customers or for not being compliant with new regulations, in the end it’s their business to decide. This may cause liquidity shocks to holders.
• Hacks to exchanges, bridges and decentralized wallets: Although security measures have been improved a lot in the last years, history tells us that exchanges, bridges and wallets can be hacked, which puts customers’ holdings at risk of being stolen.
4. Scam Risks.
And of course, there are always risks that are just related to scams:
• Money grabs: This happens more often than you think, especially in the NFT sector. But in general terms, a money grab occurs when funds are raised but there’s no product being built or it’s never delivered. It also happens when it’s just a copycat with simple twists. There’s no vision and ambition from the team to innovate, just a will to take the money and disappear or slowly fade away with it.
• Rug pulls: This has become the king of scams in DEFI. A rug pull consists of ‘suddenly’ abandoning the development of the project and removing (and selling) the liquidity from the DEX’s pool. This leaves token holders with a useless and illiquid token.
• Ponzi schemes: At this point we all know what a ponzi is, and this is where the Cambrian explosion actually happened. People have used their imagination in the most creative ways to design innovative mechanisms to cheat and steal funds from other people, which is really sad to see.
In the next article I will provide some tips that any trader must keep in mind to become a master. I hope you’ve enjoyed this one. If you did, please share it!
Sköll!