In 2017, I began a series of articles that followed my observations of the cryptocurrency market. It turned into a small ebook that is available on Amazon, which had modest sales.
After the bear market of 2018/19, and the rise of a new bull market which seems to be focused on #DeFi, I wanted to revise my book to help protect newcomers to the space. I've spoken to friends who were burned in 2017 because they bought in at the peak of the market madness, and I see it likely to play out again. 2020 has been a wild year, and there seems to be an acceleration of people YOLO'ing their money into moonshot investments that is sure to end in disaster.
The First Mistake: Misunderstanding Risk
When I wrote in 2017, I titled the first mistake as misunderstanding market cap. This was the major valuation tool used by traders then, which is the result of (current price) X (total tokens). This mistake is still made today, but it's part of a larger problem: misunderstanding risk vs reward.
The most ideal speculations minimize risk, while offering the possibility of outsized rewards.
Part of understanding the risk of a particular token is its market cap, but it's a mistake to think market cap is everything.
Let's walk through a major fad right now and identify the risks involved.
Yield Farming
Twitter's fintech crowd is currently going nuts about yield farming, a process which involves lending tokens and earning yield not only in the standard APR offered (1-10% usually), but a second "governance" token that allows holders to speculate on the lending platform itself.
These governance tokens give holders a vote, and have often jumped in value greatly since Compound.Finance introduced the concept a couple months ago. Their token, $COMP, was paid to lenders and borrowers alike, meaning one could borrow a token at 5% and still earn 100% or more in $COMP.
The massive success of this has created a gold rush in imitators, from $BAL, to $YFI, to $YAM. It is absolutely manic, with speculators willing to rush in early to any token promising 1000% and more yields on lending.
There are a number of other tokens that are riffs on these; I won't name them because they're popping up constantly, and most are hustles and scams with a few clever memes pushing 24 hour pump and dumps.
Insiders-those who live and breathe crypto-have been able to "farm" these tokens and earn a ton of money. The crypto Chads know which teams are legit, and which are not.
Major whales have the added benefit of earning enough tokens that they can influence future voting.
Consider: a VC fund with millions of dollars can pick up many millions in yield, as well as a significant portion of the governance tokens...similar to a leveraged stock buyout, but free. They pay in risk exposure, but otherwise, it is an incredibly quick multiplication of holdings!
If I wanted to take control of Compound.Finance, or another successful platform, and I got paid to do it, I would absolutely jump on that opportunity. These pools have hundreds of millions of dollars in crypto currency being staked.
If $COMP or $YFI lose their value by 80-90%, a lot of speculators end up holding the bag. (Let's be honest; we've gotten used to it)
But if we're a major VC who has gotten most of those tokens with the purpose of controlling the protocol, a major drop in price is insignificant-with 30, 40, or 50% of the voting power, the VCs can move the platform in any direction they want.
Counting the Risks
In the above discussion, there are X risks I can count:
- Ethereum has a major failing with a corresponding price shock
- The smart contract holding a large amount of DeFi funds has a major bug and tokens are lost/locked
- The smart contract holding a large amount of DeFi funds has a minor bug and some tokens are lost/locked
- New laws written that outlaw or heavily tax using DeFi
- Governance decisions make tokens less desirable (VCs enrich themselves at the expense of the public good)
- Oracles (price feeds) are manipulated resulting in loss of capital by the unprepared
There are more risks, but this is a good start. Many of the above risks represent actual real life problems that happened. $SNX holders found their debt rising significantly this winter as someone learned to manipulate the price oracles on $MKR. Ether and BTC dropped hard in March, as explained in this post from Coinbase, resulting in many Vaults being undercollateralized and open to liquidation.
YOLO
Yes, you say, I know the risks, but I will get in, and get out, and make a small HUGE fortune in the meantime.
If you absolutely must speculate, set aside a small amount of money-an amount you'd be comfortable losing at the casino. It is fun to put a small bet into a moonshot, but don't risk your future. Losing a small amount of money can be educational; losing your entire investment portfolio because of an error or a hack can be a disaster.
Understand the risks. Take only the best opportunities. If you are new to crypto altogether, DON'T YOLO into a hot crypto because somebody gave you a tip. There will be plenty of opportunities. Take your time to learn about the space-you may have other skills that can earn you crypto. Read my book (it's a few years old but the concepts are evergreen) and let me know what you think in the comments.
Remember, ask lots of questions.
Good luck!
-Jeff