A Checklist for Evaluating Digital Assets
Last Updated 22 May, 2018
How many times have you read or heard something like this?
“This does not constitute financial advice, and you should do your own research before making any investment decisions.”
Fair enough, but what should you be researching? How do you decide if a coin or token is a scam, half-baked or the real deal? Traditional business fundamentals don’t apply to these assets, so where do you start? Although it’s still not financial advice, this checklist will help you understand what makes one digital asset different from another.
The Cryptocurrency Evaluation Checklist
Fundamentals are generally not open to interpretation, and are very difficult to change. Intangibles are important but not defined by code. Intangibles can change more easily, and they are far more open to interpretation and opinion.
Where does it live?
Digital assets are tracked in the ledger of some blockchain. We won’t get into detail here about what a blockchain is since there plenty of material available on that topic. What we are interested here is which blockchain supports the asset, how that blockchain came to be, and whether or not the asset is defined in the core code of the blockchain or built on top of it.
Original: the blockchain was launched from scratch, and the asset is included in the core code for the blockchain. Note that here we are not strictly talking about original code. Many blockchains draw concepts or sections of code from one another. The key is that the blockchain was started with no history inherited from another blockchain and that the asset we’re evaluating is defined directly in the blockchain code.
Hard Forked: the blockchain was split from some existing blockchain to add or modify features that developers could not agree upon. The asset should still be defined in the code of the blockchain, and it is often given a related name. Examples include Bitcoin Cash (forked from Bitcoin) and Ethereum Classic (forked from Ethereum.) Forks can create some debate about which blockchain is the “original” and which is the “fork” since they both share a common history. Typically the version that keeps the majority of team and network support after the fork is considered the original.
Token: digital assets that do not have their own blockchain but are instead built on top of existing ones are called tokens. We’ll refer to the blockchain they are built on as their “host blockchain.” Tokens are dependent on their host blockchain for transaction processing and history. But, they can have their own rules for creation, supply, and functionality that is defined in smart contracts. Many of the ICOs launched in late 2017 were tokens, and the majority of those were tokens on the Ethereum blockchain.
When considering an investment in tokens, it is important to understand that their success not only depends on the token itself but also on the success of the host blockchain that supports it.
There are other distinctions you may hear with tokens, including “utility tokens” versus “currency tokens”. Those terms suggest the intended use of the token; either as a specialized asset with a specific purpose, or a general-purpose currency. There are also “security tokens” which represent traditional securities (like a stock or bond certificate) on a blockchain. Those distinctions are really about the use case for the asset, which we cover later as one of the Intangibles.
Fundamentals: Capacity Design
How will it grow?
The code of a blockchain includes a design for transaction speed and maximum throughput that must balance performance with network stability and scalability. For tokens, this factor is determined by the host blockchain. The capacity design generally centers on two rules for transaction blocks:
Block Time is a targeted average time for new blocks (and therefore all the transactions in them) to be added to the ledger. Bitcoin’s 10 minute target represents the slow side, versus many newer blockchains that target block times measured in seconds. Note that for most blockchains this speed is a target and will vary from block to block.
Block Size can also be limited based on the number of transactions, the amount of data in the block, or other technical criteria. In Bitcoin, this limit is 1MB of data per block. (The amount of data is related to the number of transactions, but not precisely.) Other blockchains have more complex ways of setting limits such as Ethereum’s dynamic system that considers recent transaction volume as well as settings that mining node operators “vote” on.
It might seem at first read that faster and higher-capacity blocks are better, but the tradeoff is in the potential impact on scalability. For blockchains to work their magic, the nodes need to be able to synchronize with one another fast enough that some don’t fall perpetually behind. Related to that challenge is the risk of a denial of service attack where someone might flood blocks with low-value transactions to overwhelm the network.
Very few blockchains have seen their capacity designs put to the test. The exception is Bitcoin, which saw rising fees and a backlog of transactions in late 2017 to early 2018. Some saw the results of that test as positive since processing priority was rationed by fee amounts. Others saw the raising fees and slower average transaction times as a problem.
That debate about capacity design was at least nominally the driver of the Bitcoin Core versus Bitcoin Cash hard fork. For this analysis we won’t try to sort out which approaches are best. We just want to understand the capacity design for the blockchain and how it may affect future use of a digital asset.
Fundamentals: Initial Supply
Where did it come from?
Digital assets have been launched using one or more of the following initial supply plans:
None: When the asset launched there was no initial supply. All coins or tokens were distributed according to the growth of supply rules built in to the blockchain or contract code. This is the best initial supply scheme in terms of decentralization and scarcity since no organization, group, or individuals received an allocation outside of the “rules” defined by the blockchain code.
Pre-mined: the team that designed the code for the asset begin operating the network privately for some amount of time to accumulate coins or tokens via the growth of supply rules. Typically the rationale for doing this is for the development team to use the assets to fund development and promotion efforts via ICO sales or direct sales on exchanges.
Fixed: the code for the asset explicitly defines an initial supply and the owners of that supply. Rather than launching with an empty ledger that gets filled according to the growth of supply rules, these assets start with balances already in the ledger that are typically allocated to the development team. From an investment perspective, it’s important to recognize that although this method may sound less fair than pre-mining the effect is the same. It means some specific organizations or individuals hold the asset before it is available to the public.
ICO: Initial Coin Offerings are a way to monetize funds generated by pre-mining or from a fixed initial supply. They are often done in stages, starting with large bulk sales and then moving to smaller sales at increasing price points. The risk involved with an ICO-funded asset is that these early buyers are more often speculators rather than investors looking to make use of the asset or waiting for long-term appreciation. They typically have a very low cost basis, and when early ICO buyers decide to take profits it can create downward pressure on prices.
Airdrop: Airdrops are usually intended to drive awareness and interest in a new digital asset. Like ICOs, they typically use assets from pre-mining or a fixed initial supply. The assets are given away based on some scheme. Sometimes they are given in equal ratios to holders of some other digital asset. In other cases, those who want to receive the tokens or coins must request them in some way or take some other action to get an allocation. Airdrops are an interesting new marketing tactic and have been effective, at least in driving initial interest and price action. But, investors should consider the motivation behind large-scale giveaways of an asset that supposedly has some significant value.
Forked Balances: This initial supply strategy generally applies to assets that were created via a hard forked blockchain. When a team decides to modify the code of an existing blockchain in a way that is not backwards compatible, they can opt to still retain the history of that blockchain when they launch the new asset. In doing that, all holders of the original asset at the time of the fork automatically have their equivalent balance in the new forked one.
The stated reason for retaining an existing ledger is usually one of two things:
- The team supporting the fork believe their changes represent the legitimate version of the asset. Ethereum Classic is an example of this. The supporters of that fork felt that new code to “rescue” hacked DAO funds violated the concept of “code as law” and decided to continue maintaining the unaltered ledger.
- The developers want to build support from holders of the source blockchain by effectively giving them an allocation of the new asset they are creating.
In either case of forked balances, the net effect is identical to an airdrop. Holders of the original digital asset are granted identical “free” holdings in the new coin or token.
Fundamentals: Growth of Supply
Will there be more?
Blockchains or smart contracts can define a mechanism for the creation of new tokens or coins over time. Often that new supply goes to the operators of node computers as part of the network incentives we’ll talk about next.
Likewise, the code supporting a digital asset might have limits on how much of the asset will ever be created. Limiting supply creates scarcity which is generally good for asset value. But, additional supply can be a key incentive for maintenance and development of the asset over time. Common rules for growth of supply include:
None: The asset has some fixed initial supply that is the entire supply that will ever be created. Ripple’s XPR token is an example of this. 100 billion XRP were created at the launch of their network with 20 billion going to the team that created the protocol and 80 billion going to Ripple Labs which maintains the network. Many tokens built on Ethereum or other host blockchains have a similar strategy. That means the initial holders have a large influence over pricing as the asset is distributed to the public.
Constant: Some set amount of the asset is created over time, typically when new blocks are added to the blockchain. So the increase in supply is predictable over time, but the total supply is unlimited. Ethereum currently has a constant supply mechanism.
Diminishing: New supply is created over time but the amount of new supply diminishes until some overall limit is met. After that limit, there is never any additional supply. Bitcoin and most coins forked from its blockchain follow this strategy meaning there is some finite limit for how much of the asset will ever be created.
Market Based: Some digital assets, “stablecoins” in particular, seek to maintain a constant value or to keep their value within a certain range. This can be done by varying the supply based on market prices. Although this may sound ideal, the challenge is that there is no proven, code-controlled way to measure and integrate market prices into blockchain logic.
Another approach is to back the digital asset with a reserve of whatever asset it is supposed to remain stable against. Tether and the recently announced Ethereum dollar token from Circle are examples of digital assets backed by actual reserves.
The problem with both of these approaches is that they depend on some organization to define prices and supply or to manage the reserves and make sure they are adequate at any point in time. In other words, both strategies depend on some centralized organization to manage the coin’s value. That goes against the blockchain ideal of a fully decentralized system.
Controlled: It is also possible to build code for a digital asset that enables some person or organization control additional supply over time. This allows for flexibility, but it means that the value of the asset over time can be manipulated by whoever controls the supply. They effectively act as a central bank. For that reason, coins and tokens that allow for controlled supply are more like fiat currencies since their code does not regulate supply and prevent tampering over time.
There are some digital assets which also have a destruction policy defined in their code. Destruction policies generally fall in to similar buckets as growth policies in terms of how they are controlled. Most current destruction policies are designed with the intent of managing market value by reducing supply.
Fundamentals: Network Incentives
Why would you run a node?
Part of the “magic sauce” for blockchains is that they are supported by a broad network of independent computers that store the ledger of transactions and check each other’s work. Any conflicts are decided by majority consensus. Therefore, it is important to have some sort of incentive to inspire individuals and organizations to operate nodes.
Generally that incentive is in the form of new coins which are created according to growth of supply rules. There also must be some rule for how the rewards are distributed among nodes that is fair and prevents gaming or cheating the system. The important types of incentive systems are:
Proof-of-Work (a.k.a. Mining) is the original blockchain incentive system invented as part of the Bitcoin blockchain. Under proof of work, the mining nodes compete with each other to solve a cryptographic puzzle for each new block of transactions. Whichever node finds a valid solution is given the reward for that block and the game starts again for the next block. This design was designed to make nodes “prove” that they were providing computing power to the network. Although it is a random game, over time the law of averages means that each node will get rewards in proportion to how much computing power they provide.
In order to make rewards more consistent, mining computers are often operated in “pools” which share computing power and the associated rewards across a large numbers of systems. A key advantage with proof of work is that it makes for strong security due to the level of competition among nodes. The disadvantage is that mining nodes require expensive hardware and consume large amounts of electricity. Among proof of work systems, there is another important distinction that determines the kind of hardware needed to profitably mine the asset:
ASIC Friendly: These blockchains use cryptographic math that can be completely embedded on a microchip called an Application Specific Integrated Circuit (ASIC). Bitcoin and Dash are examples of ASIC-friendly blockchains.
ASIC mining hardware is far faster and more power efficient per calculation than are personal computers, so the specialized AISC hardware is required to mine these currencies profitably. That makes for a higher barrier to entry for mining nodes since the equipment is expensive and only useful for cryptocurrency mining.
ASIC Resistant: Other proof-of-work blockchains use cryptographic math that require capabilities beyond what can currently be built into an ASIC chip. Ethereum and Monero are examples of ASIC resistant blockchains.
These assets are usually mined using graphics cards (GPUs) which can do the required math quickly. The ability to use general-purpose hardware encourages small mining operations. which in turn helps limit the influence of large operators.
The challenge with ASIC resistance is that over time hardware may be developed that overcomes current limitations. This has already happened with Monero, requiring a software update to re-establish ASIC resistance.
That change worked, but it is safe to assume that hardware development efforts will continue for any digital asset that has significant value. For example, an Ethereum mining product has already been announced. So, ASIC resistance may not be sustainable in the long-run.
Proof-of-Stake reward systems distribute new assets according to the amount held by node operators rather than according to computing power.
In some proof of stake systems, the holdings that will earn rewards must be dedicated to staking rather than held in a wallet that can perform transactions. This is much like the limited withdrawals for some savings accounts or certificates of deposit. Another common feature is to require a minimum balance (sometimes a very large balance) to be staked in order to earn rewards.
In contrast, some proof of stake systems reward most or all holders of the asset so long as they store their funds in a wallet that is constantly connected to the blockchain network.
Examples of proof of stake currencies include PIVX, NEO, and ADA. Interestingly, the Ethereum Foundation is considering a change to proof of stake for Ether in the future. The advantages of proof of stake are that nodes can operate on much simpler hardware, have far-lower power consumption, and reward investment in the asset rather than investment in hardware.
That all sounds great, but there is a debate about the security and sustainability of proof of stake incentive systems. It’s an area of active debate as well as active development efforts.
Hybrid: Some blockchains have a hybrid system of incentives where rewards can be earned via mining or via staking on nodes. Dash is an example of a blockchain with a hybrid reward strategy. Mining nodes create new supply, and staking “master nodes” earn fees for enabling the private sending feature built in to Dash. Hybrid incentive systems combine the advantages and disadvantages of both allocation methods.
Other: There are a few alternative approaches to node operator incentives. Ripple (XRP) and IOTA are examples of digital assets that use other incentive systems. There are other examples, and more are likely to come. Each of these is unique so we won’t go into further detail for this checklist.
But, be aware that digital assets using alternative incentive approaches often sacrifice key blockchain features such as decentralization of control and a systematically-controlled money supply. Whether those tradeoffs are worthwhile is something that time will tell.
For tokens that are built on top of another blockchain, the node operator incentive is effectively whatever mechanism the host blockchain uses. The node operators get their rewards in the native currency of the blockchain, so tokens are dependent on the long-term success of their host blockchain and its incentive mechanism.
Can it keep secrets?
Digital assets can offer different types of privacy features to allow users to protect their identity, balances, and/or transactions.
Bitcoin and many other early digital assets have minimal privacy features. Although it is possible to create a Bitcoin address and operate it without revealing one’s identity, all transactions and balances for all Bitcoin addresses are publicly visible. Any action that reveals the owner of a Bitcoin address (like transferring Bitcoin to or from an exchange that knows the identify of the account holder) means that all the transactions coming into and out of that address can be associated with that person.
Some newer blockchains have added features to increase privacy. In some cases, like Monero and Zcash, those privacy features are a key value proposition. Common privacy features include:
Transaction Masking that obscures the source, destination, and/or amount of transactions between addresses. Dash is an example of a currency that has this feature as an option. Transactions can be sent “in the clear” like Bitcoin or for an extra fee they can sent through a tumbling process to mask the source and destination.
Balance Masking which encrypts balances on the blockchain so they are not publicly visible. Zcash is an example of a coin that offers this option. To see the balance of a Zcash private address you must have the private key.
Address Masking features are designed to hide the relationships between transactions, addresses, and their owners. Monero is an example of a coin that offers address masking via its “stealth address” feature. Senders must generate a single-use address that delivers coins to a permanent address without revealing which address that is.
Tokens could inherit the privacy features of their host blockchain, but not necessarily. Most popular tokens right now are built on blockchains that do not include significant privacy features. However, if privacy-centric cryptocurrencies gain popularity that may change.
Fundamentals: Other Features
What else can it do?
Some digital assets include additional features or limitations based on their intended use. These are not as easily categorized, and it is an area for innovation and differentiation. Some interesting examples of special features are:
Non-Fungibile Assets: Most digital assets are designed to be fungible, meaning one coin or token is exactly the same as another. But, it is possible to create digital assets that are unique from one another. Cryptokitties are an example of a non-fungible digital asset. Each kitty is unique from one another making them a sort of digital collectible. More practical future examples might include things like property titles where each one “looks similar” but proves ownership of some unique physical asset.
Non-Transferable Assets: An interesting example of a non-transferrable token that is in development is the DID token for the Distense project. DID tokens are earned for contributing to Distense projects and represent governance equity in the Distense system. They can be exchanged to and from Ether but they cannot be transferred from one owner to another. This is to preserve the meritocracy of Distense – you can earn equity but you cannot buy it from someone else.
This is far from a comprehensive list, and it is likely that additional unique features will be created for future coins and tokens. These specialized features will be key value drivers for many digital assets meant to serve specific use cases.
Who made it? Who keeps it going?
Although decentralization is an important concept and ideal for digital assets, the reality is that blockchains and smart contracts require a signifiant development and maintenance effort. That means the structure, experience, and strength of the team or community supporting a digital asset is important for success. Key questions include:
Is maintenance and future development managed by an informal community, a formal organization, or both?
Bitcoin is supported by a largely informal community effort. That is good for decentralization of control, but can make significant changes difficult to implement. It also means that the future of the blockchain depends on a supply of willing volunteers to participate in maintenance over time.
In contrast, many ICO-funded projects created foundations or companies to build and maintain the code supporting their digital assets. Formal organizations have the advantage of a more coordinated and focused effort, as well as the very important ability to pay developers. But, it does mean that the organization charged with maintaining the code has tremendous influence over it’s future capabilities and value, in many cases including the money supply.
What is the experience level and skill set of key contributors or leaders of the development effort?
What kinds of work did they do before crypto and what is their track record for delivering functional code? If the asset is designed for some special use case, say a prediction market for Augur’s REP token, are there team members with expertise in that field?
How well funded is the team?
For teams or organizations that raised capital via an ICO or other means, how much money did they raise? How are they using the funds? Once the initial funding runs out, how will development be sustained over time?
Adding complexity to this question is that the development teams of some of the most prominent digital assets have effectively zero funding. So, a large war chest is not necessarily required for success. But, money in the bank never hurts.
How is the community or team connected to the broader cryptocurrency and technology venture spaces?
Having a strong network can be instrumental in getting expert advice and help when needed, and in driving awareness and adoption. Even more critically, strong connections can help with funding. So, for assets where the project may need some help at critical moments the connections of its development team may make all the difference.
Intangibles: Use Cases
What is it for?
Another essential consideration is the intended use or uses for the digital asset. A use case can be general, like conveying payments as with Bitcoin or providing a platform for smart contracts as with Ethereum. Alternately, a use can be highly specific. Examples of specific use cases include the Distense DID token designed to support their contribution-based equity model and the Augur REP token designed to enforce honest reporting on prediction markets.
Within each type of use case, potential investors should consider how unique the concept is. What does this asset bring that would distinguish it from prior solutions or new competitors? For specific use cases, could a general-purpose digital asset support the functionality equally well?
Perhaps the most important question to consider when it comes to use cases is whether or not a blockchain-based solution makes sense at all. Blockchain technology is touted as making legacy processes more efficient, but that efficiency mostly comes in the form of eliminating expensive third parties like bankers and lawyers.
From a technology perspective, blockchains are far less efficient than traditional systems for processing transactions and storing data. Plus, blockchain developers themselves are in short supply and the consensus-based nature of development can further add to time, cost and risk. Unless decentralization, disintermediation, censorship-resistance, or counter-party trust are important, there may not be much of a use case at all.
For tokens that are built on other blockchains, consider what the token does beyond the native currency of its host blockchain. Many ICO tokens were created mostly as a fund-raising mechanism. There is nothing wrong with that per-se, but investors must understand exactly what the token entitles them to in the future. Although the hot debate right now is around whether digital assets are securities, effectively none fit the traditional definitions for stocks (ownership) or bonds (debt).
How do people know?
In general, digital assets build value through the network effect; the more an asset is recognized and used, the greater its value. The nature and strength of the promotion behind a digital asset is important for creating awareness and building support. Promotion usually happens in one or both of two ways:
Organic promotion comes from community discussion related to the project. Assets that do not have a formal organization supporting their development generally rely on organic promotion. Those that do have organizations may also get some of their promotion organically as well.
Directed promotion is carried out by the organization supporting a digital asset and can include funded PR and advertising efforts. Directed promotion tends to be more elegant and coordinated since they are often managed by marketing pros. However, assets that get all their recognition through paid efforts are not as strong as those that manage to get organic community support as well.
Is it ready for prime-time?
The cryptocurrency space is very new and still mostly speculative. There are very few digital assets that are already in real-world use. Over time that should change dramatically, at least for some. For others, a lack of adoption will signal their end.
Since the space is so new, it’s best to think about levels of maturity that are relevant to pre-release and early-adopter stage products. They can be:
- Established with a few proven real-world use cases,
- Ready with all capabilities in production and available for use, ideally with pilots or testing in progress,
- Pre-release where functional code is available for testing but not ready for actual use, or
- Whitepaperware that has a concept and initial design but no functional code yet.
A particular watch-out for investors considering ICO assets; many of them “launched” in the whitepaperware state and many remain there today. This includes many that issued tokens which are just reservations for assets that have not been built yet. An example is the Venezuelan Petro token on the NEM blockchain. The promise is that those tokens will be redeemed for actual Petros once its blockchain is built. If the “real” Petro blockchain is never built, the pre-sale tokens will probably become worthless and there will be no recourse for investors.
Let me Know What You Think!
Do you see a glaring omission or care to debate anything here? Comments and discussions are welcome, and the best way to contribute is by giving me a shout on Twitter.
Template and Examples
This checklist is available as a Google Sheet designed to let you compare two digital assets side-by-side. You can save a copy by picking “Make a Copy” from the Google Sheets “File” menu. Then you’ll be able to edit and store it in your Google Docs. You can also download it as Excel, but you may need to fix the formatting a bit.
Disclaimer and Disclosure:. I am not a financial advisor and this article does not constitute financial, legal, nor personal advice.
Chuck Bair is a Partner with the Lapine Group where he focuses on technology and operations strategy. He has been investing and active in the cryptocurrency and blockchain space since 2014.
Version 1: 22 May, 2018