How Not To Invest In The Next Luna

How Not To Invest In The Next Luna
Reda Farran, CFA

almost 2 years ago5 mins

  • The first step in assessing a crypto project is evaluating its founders: their background, experience, vision, incentives, and more.

  • Then, assess whether the project has unforkable utility and strong security, and whether it solves a genuine problem and in a better way.

  • Be sure you know where a project’s yield comes from. Yields that are unsustainable or are funded by simply printing new tokens are red flags.

The first step in assessing a crypto project is evaluating its founders: their background, experience, vision, incentives, and more.

Then, assess whether the project has unforkable utility and strong security, and whether it solves a genuine problem and in a better way.

Be sure you know where a project’s yield comes from. Yields that are unsustainable or are funded by simply printing new tokens are red flags.

Luna’s spectacular collapse earlier this month showed that even the most promising crypto projects come with massive risks. It also showed just how important it is to ask the right questions – five of them, to be precise – about any project you’re keen to invest in. So with crypto prices down across the board, let’s go through that checklist one by one…

1. What are the founders’ backgrounds?

Just as you’d assess a company’s management team before investing in its shares, you should assess a crypto project’s founders before investing in its tokens. What’s their previous experience in the crypto space? Do they have transferable experience from Web2 or financial firms? What’s their vision for the project over the next five years? (You can find all of this in the project’s white paper or roadmap). Lastly, do they have skin in the game – that is, are they invested in their own project’s token?

Walk or run away whenever the founders are anonymous. These crypto projects have weaker governance and are more likely to be scams, since there’s zero accountability when something goes wrong. Also watch out for founders who are associated in any way with previous crypto scams or project failures – that’s another red flag.

2. Does the project solve a genuine problem?

A project that doesn’t solve anything will likely end up with few users and its tokens won’t be worth much. So find out: what’s the problem this project is trying to solve and is it a real pain point? Does the project tackle the problem in a better way than existing solutions?

For example, earlier this year we discussed a crypto project called Klima that’s trying to address two genuine problems. First, climate change, by creating a “black hole” for carbon offsets, which represent a tonne of CO2 that has been permanently avoided or removed from the atmosphere. It aims to take those offsets out of the real world, making them scarce and driving up their price. This disincentivizes polluters and incentivizes carbon offset projects like renewable energy, forestation, and so on.

Second, the way carbon offsets are traded. There’s currently no centralized, global market for trading them. Instead, offsets are traded via carbon brokers and middlemen in an illiquid, opaque, fragmented, and inefficient market. Klima’s solution to this problem is its native KLIMA token, each of which represents one tonne of carbon offsets. If the project succeeds, KLIMA tokens can be a better way of trading carbon offsets than the status quo.

Before you invest in any crypto project, clearly describe in a couple of sentences the exact problem it's trying to solve and how it does it better than the status quo. Think of it as a sort of Peter Lynch “crayon test”. As the legendary investor was known to say: never invest in an idea you can't illustrate with a crayon.

3. Does the project have “unforkable utility”?

Most crypto projects are open source, meaning they’re susceptible to competitors copying (or “forking”) their code to build a competing project. That’s why it’s important to assess a project’s defensibility by looking at the usefulness that cannot easily be forked by a rival project.

This quality is called “unforkable utility” – the hard-to-replicate value to a crypto project’s user, or its economic moat. And before investing in any project, assess whether it has it or not. Check out our previous Insight to learn how to do exactly that.

4. Is the project secure?

Hacks in the crypto world happen all the time and can be extremely costly, in some cases losing investors all their money. Be sure to assess a project’s security before investing. Has its code been audited? Has it suffered from any hacks or security issues in the past, regardless of how minor?

Also be sure to assess the security of the particular blockchains you invest in. One way to do that is to look at the number of network participants. See, whether through mining or staking, network participants (also called blockchain validators) help keep the blockchains secure in exchange for some financial incentive like earning crypto. The more users there are, the more secure the network becomes, since it’s harder for hackers to execute a “51% attack”.

5. Where does the project’s yield come from?

If the crypto project offers some yield to investors staking their tokens (sometimes called “staking rewards”), it’s very important to find out where exactly this yield comes from.

A good example is staking rewards that come from a protocol’s revenue – a decentralized exchange’s transaction fees, for example, or a decentralized lending/borrowing protocol’s lending fees. A bad example is yield that’s entirely funded by simply printing new tokens – especially if the promised yield is quite high. If that's the case, the total supply of tokens sharply increases every day as new ones are minted and distributed to stakers. This dilutes the value of each token, lowering its price. So while the total number of tokens you own increases due to staking rewards, the total value of your investment in the token will most likely dip.

Another bad example is yield that’s, quite simply, unsustainable. Take Anchor Protocol, a decentralized lending/borrowing market that offers yields of close to 20% to users who deposit TerraUSD (UST). Part of that yield was funded by the interest Anchor charged borrowers and the staking rewards it earned on tokens that borrowers put up as collateral. The shortfall was funded by a “yield reserve” that kept on diminishing every single day.

The Luna Foundation Guard – a nonprofit that supports the Terra ecosystem, which includes UST and Anchor – stepped in to replenish the reserve back in February, sure, but that didn’t address the root of the problem: the yield Anchor paid out to UST holders was, quite simply, unsustainable. Eventually, the whole ecosystem – UST, Anchor, and Luna – imploded (of course, there were other factors at play too).

Crypto investments might never be without risk, but the good ones can result in a fair amount of reward. Asking the right questions can help you figure out which is which.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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