How Investors Can Improve Crypto Due Diligence

Asking tougher questions up front can help prevent surprises later on

How Investors Can Improve Crypto Due Diligence


With the damage from unethical actors, hacks, and other breaches totaling billions of dollars during 2022, there is obviously some volatility in the marketplace. Investor confidence is shaken, regulators continue to take a harder look at crypto, and calls for banning crypto have come back to the forefront. Setting aside the fact that banning crypto is virtually impossible, except in autocratic nations with little room for dissenting opinions, this misses the wider point. During the 'dotcom' bubble of the late 1990s and early 2000s there were numerous failures, meltdowns, and collapses. The AOL-Time Warner merger is referenced time and again as the pinnacle of market mania, and an especially high profile example of capital misallocation. Despite the damages, market fallout, and uncertainty that followed the bubble bursting, the digital economy has proven to be invaluable. Every aspect of the modern economy, and the tens of millions of jobs directly connected to and dependent on those foundations, (via fiber optic cables and other infrastructure) that were deployed during these bubble years continue to serve as economic engines. Despite the strong start to 2023, there are still many open items and questions that need to be addressed before cryptoassets can continue to move into the mainstream financial marketplace. In the aftermath of FTX, whose management team and structure allegedly managed to deceive some of the largest venture capital firms in the world, the importance of due diligence in the crypto space has moved prominently to the front burner. Let's take a look at a few of items that investors, large and small, need to keep in mind when assessing the viability of future crypto or token projects. What are the fundamentals? An obvious question, but that one that certainly needs to be asked in the wreckage of the many speculative projects that failed in 2022. Rapid rises in prices, celebrity endorsements, flashy promotional campaigns, and other related activities attract attention and capital, but need to have strong foundations to be sustainable. Obviously not every crypto investor is going to be an expert in programming languages, or the specifics of how certain tokens operate, but there needs to be an understandable use case between the issuer, the token, and the prices of said tokens.

A crypto project might claim to be a governance token or a stabilizing mechanism for related projects but it has volatile trading ranges. This could not be supported by the fundamentals. Any potential investor should carefully examine the basics, given the extent of frauds and scams that occurred in the sector over the 2021-2023 period. How does the supply be managed? Supply and demand are important in any industry, but they are even more so for crypto-based projects. It is not only important to know how the token's supply will be managed, but it can also influence the price. This information can provide valuable insights into how the project is managed. Due to recent revelations about 1) how enterprise tokens were held and traded at FTX and 2) the more recent questions about the reserve assets - including the commingling these assets with customer funds – at Binance, it is important to scrutinize how the token supply management is managed. The trust and confidence in the investing market is influenced partly by the results achieved by an organization but also by how transparently the tokens or equity are managed. The investment community is looking for results. However, these results must be easily understood and repeatable over time. Potential investors (and regulators alike) will be able to gain a better understanding about the process and how it is managed. This includes the company culture.

Are the operations transparent? Transparency and trust are key issues. The more opaque or confusing operations, financial statements, and other communications, the higher the red flags. Although trade secrets and business practices that are proprietary to crypto can be used to conceal results, they should not be used as a smokescreen to hide them. There are many factors that must be clearly stated and presented to withstand scrutiny for a crypto project. The following are some of these.

First, what is the project's underlying profitability? While this does not mean that every token launch must immediately make a profit, most startups don't. However, there should be a plan that will provide financial returns. Is the token or coin offering tied to an existing company or just created for capital raising? To put it another way, does the token provide any value for investors other than possible price appreciation. This can be easier to manipulate than a direct connection with an existing business. Finally, is the token issuer able to provide financial records and ownership information as well as other institutional data? Accessing these data sources is good business practice and can help to identify bad actors early in the process.

Due diligence is not a topic that often makes the headlines. It usually comes up after investors have been hurt or fail. Investors of all types need to be diligent in order to grow and mature in 2023.