Last week was a crazy one. Not because a house of cards fell down, they’ve been falling down since humans are humans, but because of the exposure and drama around it. Fueled by misinformation, the story is getting crazier by the minute.

Many people argue about DeFi being alright, but for anyone who’s been around financial markets in general is easy to see there’s lots of shady things “verified by code”. In the end, everything is a narrative, codified or not, and narratives are easy to manipulate.

I wanted to give my grain of salt in the matter writing something more practical: a field guide to help anyone figure out whether a project, token, or financial offer will be able to deliver its promise.

Disclaimer: these are just my opinions based on my personal experience. They’re also not made for short-term speculation nor day trading, which are, in my opinion, a waste of time. Challenge everything you want, as you should do with everything in life, debate is welcomed.

How to use this?

Easy! Just ask the main questions:

What is it?
How will I profit from it?
Who is offering it and why?

Answering these questions should be pretty straightforward, if your counterpart is an honest node. Look for transparency, auditable code, simplicity, regulations, etc. and you will avoid most failures.

If you’re short on time, skip to section 3. You shouldn’t need more.

But if you do have time, try answering the deeper questions on this guide, like what is value?

Intro: why trust me?

The whole point of this guide is you should ask questions before giving your money to something, be it a person, project, or Turing-complete artifacts crafted by nerds.

Trust by default is my setting for human relationships, distrust by default is my setting for financial relationships (aka giving my money in exchange for some financial asset). I’ve made many mistakes (coughs in sOHM’s), but my view comes from working in the financial industry and its borderlands for over a decade.

I worked at a trade desk, co founded a lending startup, and now co founding a crypto startup. I’ve seen the best and the worst of the industry, and I believe I’ve only scratched the surface. Yes, I think it’s all the same industry. Traditional, fintech, and crypto; more or less technology; more or less regulated; more or less intertwined. Everything for the pursuit of optimally allocating resources in society, with a broad spectrum of what optimal is.

Quick note on value and intrinsic value: something is as valuable as people think it is. Value is an agreement, not something intrinsic.

Final quick note: I guess we can all agree we live in a world where money is supposed to grow. If I lend you money, you should pay interest. For alternative takes on this, read my notes about it.

1. What is it?

First question we should ask is “what are we looking at”. It could be a token, a derivative, an ETF, a stock, etc. There are many financial agreements out there, in many flavors. Does it give you rights to something? The option to perform an action in the future? Does it give you ownership over something? Are you lending assets to someone else? If you can’t easily answer these questions, maybe you should stay away.

Some examples:

Company Shares: They give you some ownership over the company. You’re a partner, an entrepreneur! If the company earns profits, you get a proportional share! If the company dies, you get nothing. A business professor might say share prices are the discounted value of future profits, but we all know it’s all about the narrative.
Treasury Bonds: The treasury of some country borrows money from someone, commits itself to pay a fixed interest to the creditor. You are not a partner, you are the bank. Usually, you have preference over the assets in case of liquidation, but more often than not, other people have a higher preference, so in case the debtor can’t repay, you get scraps.
Ether: Digital money. Cool. This gives your no rights, it’s just money. A programmable, censorship resistant, decentralized store of value, measure of accounts, and exchange medium.
ENS tokens: A right to participate in the governance of the ENS DAO, or delegate those rights. Can also act as money, to a lesser extent (everything can act as money if we’re honest).
stETH or similar: My rights to claim a portion of the staked Ether in a validation pool. The underlying asset is the Ether in the pool, this token just represents my ownership of some of those tokens, making it a liquid position (I can get out if there’s someone willing to buy it from me).
Put option: A contract that allows you sell an asset at a certain date in the future to someone, fixing some of the terms of the transactions beforehand (price, date, etc).
For more examples, visit Investopedia

2. Can I earn money out of it? Should I? What is it paying? Does it makes sense?

Cool, you have a rough idea of the thing you want to invest in or you are holding. Now, will I earn some money out of if? 🤑 Most of the time, profits will fall into either of these categories:

2.1. Price go up:

The main driver of economic greed. We all have a friend that was early to some investment. “If only I had invested back then, when they wouldn’t stop talking about it”. Chances are you’re suffering from survivor bias, they might have lost money with other bets, but that’s not the point.

One of the “easiest” ways to get rich is betting on the right asset which price balloons! You just need to be lucky or really diversify your portfolio. But, is it sustainable? Does it make sense for the price to go up?

Putting the “everything must go up” current narrative aside and agreeing something is valuable because people agree it’s valuable, how can we really know the price will go up? Is the company’s future so bright that shares will inevitably sore? Is the crypto currency so powerful that it will dominate how we transact or store value in the future? Is the interest the government is paying too good to pass on?

Answers to these questions are complicated and in my view no amount of technical analysis or gut feeling are gonna be enough. It’s better to diversify. I remember during my advanced finance class in university, someone asked the professor if the differential equations we were using to calculate the future price of a bond or an option had had any impact on markets. “Surely, having such predictive capabilities must’ve moved the prices." To which the professor answered “No, these tools are just trying to model how humans behave."

Truth is markets are more similar to Keyne’s idea about common knowledge and how the crowd tries to guess what the crowd is thinking. He gave an example of a news paper contest to pick the prettiest girl (they were other times). The winner would be picked among the ones who voted for the most popular candidate. Most people vote for their favorite candidate, assuming others would think like them. Some people would vote for the candidate that they thought most people would vote for. Other people would vote for the candidate they thought some people would think most people would vote for. Another group would vote for the candidate they though other people would think some people would think most people would vote for. Most people would agree I should stop this recursive stupidity, because I’ve made my point.

Most of the time you have higher chances of winning at the casino than investing in the right asset that will moon, but there are some red flags you should pay attention to avoid disasters. For some, refer to point 3 of this guide.

With derivatives (futures, options, etc) you’re playing a similar game some people were playing in the example above or you’re looking to protect yourself from the irrationalities of humanity by fixing a future price. Either way, profits or losses come from prices going up or down.

Nice! You’re someone’s partner! You feel like an entrepreneur or at least a venture capitalist, you’re taking risks, and they’re sharing the rewards with you! Or maybe it all went south, doesn’t matter, you knew it was one of the options, right? Right?

Here you’re basically earning the same proportional rewards as your partners. Be them other shareholders, business owners, other protocol validators, or liquidity providers on a dex, if business goes kaput, everyone is on the same page.

Not much to say here, just make sure you know the risks involved and that your partners are taking the same proportional risks as you, otherwise you’re being conned. For example, ask where the profits come from. Sales? Fees? Other people’s investments? Read the fine print or understand the underlying contract, make sure the partnership is equal.

2.3 Yield:

The final path to profits: Yields! In the traditional world, this would mean you’re playing bank by lending money or assets to someone else. In the crypto world, it’s a little more complicated (and shady, but “verified by code”. Ha).

Essentially, yields come from someone or something paying a variable or fixed fee or interest as long as they hold or use your money or assets. The fundamental assumption behind this contract is that you are not equal partners and that you could be doing something else with the money during the same time. In other words, money must always grow. Saving accounts at banks are the most basic instrument in this category: you are lending money to the bank, so they can lend it to someone else and earn a spread between the interest they charge and the one they pay you. Aave protocol works in a similar but decentralized way, you lend your crypto to the contract and the contract lends money to someone else, yield comes from interests paid by that someone.

The most important question with yields is “why is my counterpart paying for this?” Are you lending money to someone so they can buy machinery or use it as working capital? Nice, chances are you are helping a small business to grow, like investors do through Cumplo or similar marketplaces. If the business fails, you can be repaid from the leftover assets (it can take a while); if it succeeds, they won’t have problems paying the interests.

Maybe someone wants to nudge you into doing something. In some countries, leaving your money in a saving account yields negative interest to encourage you to invest it in something else or spend it. But maybe inflation in your country is too high, so rates are higher to encourage people to leave it in a saving account. Similarly, a crypto company or protocol might offer a yield so you don’t get rid of your tokens (the more selling pressure, the lower the price). In this case, they’re paying you to keep the tokens in the hopes of making it more scarce. Is this sustainable? Will they run out of money or will the asset go down in price while you were holding?

Bottom line for this question is to understand why our counterpart is willing to pay me to lend them something. What they are trying to achieve. With a small business it’s pretty straightforward, they don’t want partners and they need working or investment capital. Governments usually change rates to control inflation or are generally transparent about their intentions. Or they could be leveraging their positions to earn more profits from point 2.2, taking even more risks. Be weary of counterparts with too much leverage (see point 3).

There are projects and people who intentionally obscure their intentions. If the promise of yield seems too good to be truth, if the rewards will only make the underlying asset less valuable, or if you can’t be sure of the final result, be weary.

The second most important question you should ask is “what are they paying me with?" Is the yield being paid in the same currency or token you’re investing? Or is it something else? Is it a generally accepted currency, like dollars, euros, or ETH? Can I use these rewards to buy or do something else? Is part of that reward free of charge? If it’s free, why would anyone give you something they say it’s valuable, for free?!

There’s a fundamental law of physics: matter is not destroyed nor created, only transformed. The same can be said about money. If someone is rewarding you for borrowing your money, they are paying out of their pockets, they are making someone else pay, or they think the asset they’re paying you with is worthless or will be in the short-term.

3. Who is my counterpart? Why are these people selling rights, ownership, or borrowing money from me or someone else? Why are they giving me these tokens for free?

Finally, try to figure out who these people are, what their intentions are. It’s difficult, but there are some red flags worthy of noticing:

Leverage: if your counterpart is leveraged, you might want to be careful. Banks are regulated so they don’t over leverage and, in case of a bank run, people don’t lose their money. Leverage is always riskier, and thus the rewards are higher. Also, be weary of anyone who offers you leverage to earn more, it’s seldom worth it in the consumer space. Make sure you know what you are doing or at least be prepared for a worst case scenario.
Giveaways or airdrops: Unless the token has a clear purpose, like governance, think hard before going into something like this. Why would anyone in their right minds give you something for free if they think they’re valuable? If you can’t tell if they’re crazy or not, find out their intentions, or analyze the underlying contract (coded or not), stay away.
Insane yields or rates: These are meant to attract people and most of the time are not sustainable. If there’s no clear source of revenue paying for the yield, it’s only air. Chances are your assets will be less valuable or the project will implode.
“A YouTuber recommended this investment”: Why do you think they recommended it? Are they being paid? Are they trying to pump the price?
Good intentions don’t justify risk taking
As stated above, someone has to pay for the yield, figure out who is. Ideally this is not you (unless you want to donate your money).
Reputation: at the end of the day, our reputations are all we have. Are our counterparts reputable? Are there sketchy things surrounding them that don’t align with your values? Make sure you understand the implications.
What’s in it for them? While working at an investment bank we would warn customers about impending risks or companies going bust. They would tells us to check our information, because [INSERT NAME OF WALL ST BANK] had recommended the opposite: to buy! It turned out that bank had a big position in the asset, so they’d dump it to their own customers and avoid losses… To the customers they can always say “You knew the risks involved”.

TL;DR

Question everything! Stay away from red flags

That’s it. If you ask these questions and try to find answers, you will be able to stay away from most scams. It’s not bulletproof, there are no certainties in life, but help it will.

In the end, we are all free to do whatever we want to do. My only advice is to think before acting, question your counterpart’s intentions, try to see the forest instead of the tree(s).

Do you agree with this pseudo-guide? Any other red flags you have noticed?