Beginner’s Guide to DeFi Risk Management Part 3

Roadmaps, Analytics, and Economic Audits

TL;DR:
The conclusion of our guide to DeFi risk management emphasizes the importance of considering a project's roadmap and conducting analytics. Community engagement and due diligence, including team expertise and reputation, are crucial. Economic audits are rare but could enhance confidence. Applying the Kelly Criterion aids in optimizing capital allocation for risk management. Overall, continuous learning, adaptability, and strategic risk mitigation are key in cryptocurrency investment.

In the preceding sections of this Beginner's Guide to DeFi Risk Management, we've dissected risk management in the context of cryptocurrency investments, from distinguishing between risk and uncertainty to evaluating tokenomics and platform value.

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The information provided in this blog post is for informational purposes only and should not be taken as any form of investment or legal advice or any form of recommendation or endorsement of a project. We make no representations or warranties of any kind, whether express or implied, regarding any projects mentioned on this website. In no event shall we be liable for any claim, damages, or any other form of liability, whether in action or in tort, arising from or in connection with any project mentioned on this website. Conduct your own research and due diligence when engaging with any crypto project or service.

In this final installment, we take the long view, exploring tools like roadmaps, economic audits, and the Kelly Criterion while emphasizing the significance of community engagement and strategic risk management practices.

Please note that this guide applies to all manner of tokens in the crypto space, including security, currency, and utility tokens.

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.

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This article was first published on Medium and is based on the seventh edition of the Shimmer DeFi Education Sessions, presented on 27 October 2022 by Gruad. The summary, organization, and additional detail in the article are by DigitalSoul.x.

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. For example, if the net present value of a token, according to calculations, is $10 while the current token price is $5, it signifies a favorable margin of error. 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.