Chapter 9

Qualitative Analysis—Risk

“Zitcoin . . . shmitcoin . . . litcoin . . . Bitcoin. . . . There are so many different cryptocurrencies to choose from, and all of them seem worthless.”

If you couldn’t tell, these words came from someone who was less than enthused by cryptocurrency.

Shockingly, those words came from my father.

To be honest, his comment hurt. Here I was, someone passionate about an investment that was innovative and transformative. How could he be so bold as to throw everything under the bus?

Having reflected on this encounter with my father, I realized I was interacting with someone who had made both a wise and fair point.

Anyone with decent software skills can spin up their own cryptocurrency. Exchanges are happy to add these new coins to their platform—they earn money from people trading. A small exchange has no strong incentive to “quality check” projects. Because of this simple fact, investors are in danger. At your fingertips you have the ability to invest in dead projects that have long been abandoned by software developers. Simultaneously, this vice also opens the door to opportunity. You have the ability to invest in quality projects in their infancy.

This is where qualitative analysis is vital. What questions and facts need to be examined about a cryptocurrency to determine if it is undervalued, overvalued, or even worthless?

Qualitative Relationships

Anyone who has ever been in a relationship knows about the concept of “red flags.” Those small quirks or habits that masquerade deeper behavioral issues that won’t become apparent until the person has been committed to. Investing often involves committing capital. Our goal with qualitative analysis is to uncover the red flags of an asset before you invest, not after. The more thorough your qualitative analysis, the more effective you will be at uncovering a quality investment.

Qualitative analysis is subjective analysis centered on non-quantifiable information that helps generate valuable conclusions. In the blockchain space, there are hundreds of different projects to be sifted through. How do we find the nuggets of truth? Do we care about personnel? The marketing plan? The skill of the coders contributing to a project? Does that tweet really make a difference?

Your qualitative analysis is what differentiates why you believe one project is more valuable than another. It is the gradient by which you rate a project in comparison to competitors. While quantitative analysis is based on concrete numbers, qualitative analysis is everything that is not numerical. Qualitative analysis builds a narrative that informs our decision to invest in a project.

Qualitative analysis hinges upon two ideas: risks and opportunities. Blockchain protocols are software. When you invest in a cryptocurrency, you must understand the fundamental risks of software development. In addition to understanding the individual risk the software project carries, you must also understand the use cases that are enabled by the particular blockchain. These use cases are the opportunities. Valuable use cases are the catalyst for more and more people to use a particular blockchain. This is known as adoption, the driving force of cash flows and transactions on a blockchain. Risks are examined before adoption (which is examined quantitatively in the blockchain sphere) because the objectivity of your investigation may be tainted if you start with the opportunities.

“Throughout my financial career, I have continually witnessed examples of other people that I have known being ruined by a failure to respect risk. If you don’t take a hard look at risk, it will take you.”

—Larry Hite

Risks

The beauty of software development is that the challenges and risks of yesterday are still valid today. Due diligence is urgently in order before you invest in a cryptocurrency—not after. This was the most common error during the 2017 cryptocurrency bubble. New investors would invest in a cryptocurrency without understanding how the underlying blockchain protocol worked, who the programmers were, and what the timeline of the project was. Only in hindsight would these new investors “discover” bits of information that fit their narrative they would then use to defend their investment decision.

Confirmation bias took center stage, yet again.

In the blockchain space, this “buy and then justify” mentality manifests itself as tribalism. Visit any online crypto community and you will see vicious attacks against different blockchain protocols. Naturally, this is in tandem with a blind defense of the cryptocurrency said tribalistic investor has invested in.

Anthony Sassano, a longtime investor and podcast host in the blockchain space had this to say:

“Cryptocurrency naturally lends itself to tribalism. There is a strong incentive to be loyal to certain projects; that incentive is, mostly, monetary. People who have invested money into something will obviously have a strong inclination to ensure its success. Of course, money isn’t the only incentive people have. Strongly-held beliefs and ideologies play a huge part in cryptocurrency just as it does in real life. Some people don’t even care about money, but they still want to see a certain project fail because they believe that it deserves to.”

To simplify this further, people will defend what they have invested in because they are also emotionally invested. Be humble enough to understand that your qualitative narrative could be wrong (or at least pieces of it). If you fail to accept this, then you are no longer an objective investor. Such religiosity about your own narrative is fraught with financial risk.

What are the risks of software development? Starting in the early 1980s, a variety of in-depth studies from software engineering research tackled this question. At the International MultiConference of Engineers and Computer Scientists in 2011, Tharwon Arnuphaptrairong published a paper titled “Top Ten Lists Of Software Project Risks: Evidence From The Literature Surveys.” This brilliant research paper took an amalgamation of other research papers and boiled this heap of data down into a subset of risks that are commonly found in industry. Here are the four primary risk categories:

•User

•Requirements

•Project Complexity

•Team

User

An empty parking lot at a restaurant is typically a sign of a dying or dead business. Blockchain protocols are no different. The primary risk of any blockchain resides with the user.

Imagine a road with a toll booth. In order to use the road, you have to trade in dollars for a different currency. How much you are willing to pay for the other currency in order to use the road is based on how much you value the ability to use the road.

A cryptocurrency with no users or transactions implies no one values the ability to drive on the road. Zero transactions reveal that no one cares about changing, updating, interacting, or sustaining the underlying blockchain ledger. Therefore, the cryptocurrency is useless.

If we want to invest in the most valuable blockchain “road,” we must ask ourselves what factors make a blockchain less valued by users? Often, it has to do with the drivers on the road themselves. With blockchain software development, the drivers on the road are simultaneously investors. This means the drivers’ visions for the what, when, and how of the road can conflict with the construction team (software development team) and fellow drivers.

The following are the most common user conflicts during software development or “road construction”:

•Users resistance to change

•Conflict between users

•Users with negative attitudes toward the project

•Users not committed to the project

•Lack of cooperation from the user

You currently use a toll road that brings you from A to B. You hear about a different toll road that does the same thing, but with a different design and rules. Is it worth transitioning over?

Users’ resistance to change is founded upon the following question: “Is the problem solved with this blockchain worth it for me to migrate from a current (usually centralized) solution?” Finding the answer to this question should be the first qualitative step of any cryptocurrency qualitative investigation. A blockchain that is not solving a problem worth solving is bound to fail in the long wrong. Why switch toll roads as a driver if I am perfectly content with the toll road I currently use?

Imagine you invested in the toll road at the earliest stages of construction. You ask the construction team (software developers of the blockchain protocol) about how things are coming along. You get no response. Upon further investigation, you realize the construction crew is ignoring any and all interactions about the road. Worse, you are unable to communicate with your fellow drivers and investors because, in this fictional world, there is nowhere to meetup.

Traditionally, a specific forum exists (separate from social media) where users can ask questions and discuss the project in depth with fellow users. If this forum does not exist, then you should not invest. This implies a lack of a dedicated channel for developers, users, and builders to communicate with each other about the details of the project.

If the forum does exist and users are asking developers the hard questions and getting quality responses, you have found a set of developers that are addressing the central risk of a project—the quality of communication with users about the software development and the features enabled by the blockchain being built. Users should be kept up to date on how the project works, why certain features are being put into place, how those features impact them, and how the users can help the project grow.

The reasons users would not be committed, why they wouldn’t cooperate with testing, and why there may be conflict between users (with a negative sentiment about the project) can typically be traced back to the quality of communication. Therefore, you must investigate this dynamic, as communication is profoundly wrapped up in user risk.

“Let the builders build and the community manager communicate” is a common phraseology and excuse used by a variety of teams building out a blockchain. In my humble opinion, this creates direct friction with users because of the fact that users in the blockchain space are categorically expecting a quality of communication that falls in line with what a traditional stock investor would receive. Because of the lack of regulatory communication required for any blockchain development project (and therefore cryptocurrency), there are an untold number of scenarios in which investors have put in millions of dollars, only to receive zero communication from the developers.

In the traditional stock world, this is unheard of. Investment policy statements, board calls, quarterly news releases, and investor conferences are the norm. Contrast this to crypto, where communication appears to be an afterthought. This is why user risk is the primary qualitative risk. Expectations are high because users are monetarily invested in the project and expect a certain amount of confluence on a regular basis.

Your qualitative analysis should grade user risk on a scale of zero to one hundred. One hundred would imply the best blockchain development project in the entire crypto space as it pertains to user relationships and communication. In other words, user sentiment is exceedingly positive and sustained. Zero would be the exact inverse. It would be recommended to record this entry in your investment journal—justify the value assigned and what factors it was built upon. This methodology will be repeated for all five software project risks.

Requirements

With software development, requirements are the benchmark by which progress is measured. These requirements created by blockchain software developers are the features required in order for the blockchain protocol to satisfy the goals of what said blockchain exists to solve and create. An excellent blockchain protocol will have developers that understand proper requirement creation and completion. A blockchain project that does not manage requirements in a consistent manner raises a red flag. The following are requirements risks:

•System requirements not adequately identified

•Unclear system requirements

•Incorrect system requirements

•Continually changing requirements

All projects should have a timeline of software development benchmarks and releases. This should include past releases as well as future releases.

If there is no timeline and only cryptic statements about when and how the blockchain project will be developed, then you have encountered a monumental deal-breaker. If you cannot find the history of the requirements that have been developed to date and where the project is headed with precise goals, dates, and objectives, then the underlying crypto asset is carrying a significant amount of requirements risk.

A project that has no listed requirements or evidence of software development are what we call “vaporware.” That is to say, the blockchain of the project does not exist in any meaningful form, and so the cryptocurrency of said blockchain will never be of any significance.

Continually changing requirements are what I call “The Runaway Train.” This risk is the most complicated of the four requirement risks because it can be dressed up and disguised as progress. Set a deadline, miss the deadline, and then move the deadline with a promise of “soon.” Rinse and repeat. While “The Runaway Train’’ isn’t terribly hard to spot, it’s hard to identify a project as such without sticking around long enough to see if this is true.

GitHub is a platform that hosts software projects—useful tools are available to track a project’s progress. Any changes to the codebase are recorded and visible for all to see. This is where checking GitHub repositories for a blockchain project becomes a helpful qualitative hint about how a project is progressing.

Search “Official (insert blockchain you are investigating) GitHub repository.” Check the open-sourced repositories and look at the progress in recent history. A Runaway Train will not have any new commits, edits, or comments in recent history. If edits exist, they will be extremely minute changes that are not actually moving the project forward, creating a mirage of forward momentum.

Examining requirement risk allows you to peer into the progress a blockchain development team is making. Great progress will increase the value of the underlying cryptocurrency and give you hard evidence of the actionable steps and plans that are being made.

Project Complexity

Project complexity risk is centered around the degree to which the innovation of the given project is unprecedented and groundbreaking. With blockchain, all projects suffer from project complexity risk. As an asset class, the technology is immature, and the innovation groundbreaking. Not all blockchains are created equal, nor is the significance of the research to enable certain features and use cases. The following are project complexity risks:

•Project involves the use of new technology

•High level of technical complexity

•Project involves the use of technology that has not been used prior to the project

•Immature technology

Typically, projects that incur a high degree of project complexity risk don’t meet deadlines and are typically holders of vaporware. More importantly, the marketing surrounding the blockchain will give off the “vibe” of a research project. A strong clue is that the focus of the software development/marketing is centered on research instead of the adoption of the platform by users and developers. Usually these blockchain research projects do not have a usable platform or even a portion of a “toll road” to be used!

Entirely avoid the cryptocurrencies of these blockchains until there is an actual working product.

RChain was founded during the ICO mania in 2016. RChain was a blockchain project that promised to use “rho-calculus” to solve Ethereum’s scaling problems, allowing more people to drive on the “toll road.” Rho-calculus was apparently cutting edge, but a short amount of qualitative research would have revealed it was an entirely theoretical field of mathematics that was largely unexplored.

RChain, after its ICO, a digital fundraising/stock distribution process enabled by blockchain, proceeded to burn through $65 million in runway in less than a year, buying assets such as housing for its employees. As you can probably guess, RChain is now largely insolvent. A simple qualitative investigation would have pointed to a terrifying amount of project complexity risk—an entirely new type of mathematics was required in order for the project to succeed.

Rchain’s narrative was entirely centered on its ongoing research—research that is not complete is just that.

Incomplete.

Team

“You know, as most entrepreneurs do, that a company is only as good as its people. The hard part is actually building the team that will embody your company culture and propel you forward.”

—Kathryn Minshew, The Muse

A blockchain’s value is built upon the skill of the individuals building the protocol in parallel to the project’s ability to convey what problem is being solved and why. If I give thirty wrenches to thirty birds, they will only manage to stare at my car, or even worse, manage to defecate on it. Give a mechanic one wrench and you have a whole different story.

The following are team risks:

•Inexperienced team members

•Team members lacking specialized skill required for the project

•Unstable organizational environment

•Level of decision friction caused by quantity of developers

•Business structure of the team

The quality of the developers is everything. Your qualitative analysis needs to ask the following question: “Are the developers and non-developers competent/skilled/experienced enough to push the project forward to complete the goal requirements?”

The quantity of software engineers does not always directly equate to cost-effective project progress. The average amount of capital generated by ICOs was $11.2 million as tracked by in 2019 to 2020. This number has decreased since the peak ICO hype. Previously, this number was closer to $25 million—leaving business management with over-enthusiasm for what was possible and a pressure to perform. Gut reactions were often to hire a large number of software engineers. While new ICO funding appears to be slowing down, the remnants of many large and mismanaged ICOs still prowl around.

Due caution is always in order. The greater the number of developers, the longer it takes for minute protocol changes to be proposed and effectively implemented into a decentralized blockchain protocol because of administrative bloat. This is a risk that large-scale projects suffer from regularly.

Within this equation is the fact that a skill labor shortage exists within blockchain development.

“In the current market, finding and retaining blockchain talent is one of the most challenging things for any blockchain company. . . . We recognize that there is a talent deficit across the blockchain industry. . . . The number of blockchain companies arriving compared to the relatively low number of those with skills or experience in blockchain is clear to see.”

—Gaurang Torvekar, CEO and cofounder of Indorse, a decentralized social network for professionals

The more high-caliber talent gathered around any given blockchain, the higher the probability the project is valuable and will go the distance. Developers are the lifeblood of a project. Competitive advantages in the blockchain space are from creating properties attached to a blockchain that are valued by users globally. This creative process and innovation are only made possible by software engineering talent.

“Companies want to have a first-mover and competitive advantage through blockchain technology, and it is much better for them to be trailblazers than play catch up”

—Gabriele Giancola, CEO of qiibee, a blockchain-powered loyalty ecosystem

Qualitatively, investigating a blockchain project’s employees is important. How skilled are they? How long have they been in the crypto domain? What are their qualifications? This investigation starts with the project’s website—followed up by in-depth LinkedIn searches.

Predatorial blockchain projects that are not aiming for long-term sustainability and return for the original investors will not have workers who are qualified or public facing. Workers who are here for the long term are typically blogging, tweeting, and—dare I say—loving this space on a semiregular basis. This is not to say every project needs its developers shouting from a social media platform. Rather, they should have a degree of past material created by them that points to the fact they are passionate about blockchain technology.

If a critical business entity within a blockchain project is not willing to stake its reputation in a publicly facing manner in any capacity, then the cryptocurrency of the blockchain being investigated doesn’t deserve your investment trust. This reinforces what we know to be true: communication is healthy.

Leadership turnover creates a risk of an unstable organizational environment. If the original creator of a project abandons a ship without an explanation, then you may have observed a train run amok. Blockchain brings a unique conglomeration of philosophy, technology, creativity, and vision when a unique blockchain is “created” in the form of a white paper—the original outline for what the blockchain exists to solve.

When a captain flees their own proverbial blockchain ship, users will follow suit. Technology innovates at an exceedingly faster pace than traditional products. If a leader sells all their cryptocurrency of the blockchain that they created, you need to immediately re-assess your position. This sell-off is equivalent to someone selling off all their shares (ownership) of a stock. If an individual who has the greatest amount of information about a project bails, something is going on that you cannot ignore.

The final team risk is business structure: “Is the project marketing more than it is building?”

A blockchain’s value proposition is weaker long term with blockchain companies that are investing more in making the product appear valuable as opposed to making the product valuable. Check for employee titles on the project’s website to get an idea of the overall composition of total marketers, business personnel, and software engineers.

“Competition is fierce in the Blockchain space, for every legitimate project that exists, you will find at least ten others that claim to offer it in the future, creating more competition in your niche market. . . As a co-founder of a project, I’ve seen many projects make empty promises and that have had huge followings, quickly revealed as exit scams. If you are promoting [or investing] in any blockchain project, make sure you do your due diligence and are promoting something real.”

—Sebastien DiMichele, cofounder of Syscoin

Industry Risk

Industry risks are risks specific to an industry. Often, the most significant industry risks are out of a company’s direct control. When you drive on the road, you can’t control the other drivers, although you can do your best to anticipate them.

In cryptocurrency, the following categories that are specific to blockchain as an industry are the heaviest hitters:

•Business Risk

•Exchange Rate Risk

Business risk within an industry risk context consists of factors controllable and uncontrollable by a company. Examples are bankruptcy of clients or suppliers, brand fatigue, loss of assets, consumer preferences, competitors’ actions, or bankruptcy of the blockchain development company itself.

In the blockchain space, bankruptcy is a real risk. Over 50 percent of ICO projects have already shut down because of insolvency, making the underlying cryptocurrency worthless. A survey by from late 2017, in tandem with Fortune, found nearly 150 crypto projects failed before fundraising was complete, and over 276 failed after the ICO funds were raised.

Exchange rate risk is a subtle phenomenon, but one that market movers pay close attention to.

First, what is market liquidity? It is the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value. In other words, it is the degree to which you can buy and sell an asset for the price you believe the asset is valued at.

Next, let’s describe how trading and exchanging any asset works, while gaining an understanding of the importance of liquidity.

Meet our brilliant investors: Adam, Bob, Cat, Dog, and Eagle. Adam posts a potential sale of his Bitcoin for . Picture this as sticky notes being posted on a whiteboard with a ladder separating posted sticky note prices from cheapest to most expensive.

Bob posts a potential purchase of a Bitcoin at ninety cents. Cat decides she wants to purchase Bitcoin right this moment. Cat would like it for as cheap as possible, preferably for ninety cents. Unfortunately, this market is extremely illiquid. If Cat is going to purchase Bitcoin on this exchange right this instant, she will be performing a market order, and will have to purchase the Bitcoin for one dollar from Adam instead of her desired ninety cents. This discrepancy between what she wanted to purchase the Bitcoin for and what is available for purchase on the market is called slippage.

Dog posts two Bitcoin for sale at $1.10. Eagle posts three Bitcoin for sale at $1.20. Adam decided he wants to purchase five Bitcoin. If he performs a market purchase order, he will first purchase Dog’s Bitcoin, and then Eagle’s. Unfortunately, because no orders are on the books between Dog and Eagle, Adam will end up losing a potentially significant sum of money because of slippage.

Professional investors understand the analogy above is incomplete because published bid/ask spreads are available for all to see. Needless to say, exchange rate risk is the risk incurred because an order is executed at the worst-than-expected price because of discrepancies between bids (offer price to sell) and asks (offer price to buy at).

Cryptocurrencies with low volume and market cap have a higher exchange rate risk because of lack of liquidity. A big player who wants to exit a huge position will struggle to do so without losing a significant amount of money because of low liquidity. This is similar to Adam losing money because of the gaps between Dog and Eagle’s posted sell prices.

Cryptocurrencies with bad liquidity are dangerous, as the cost to exit a position is expensive. Investors want liquidity on entry and exit. Very few cryptocurrencies have credible liquidity to have low exchange rate risk. From an institutional investor perspective, this is one of the many reasons cryptocurrency is regarded as being such a risky prospect. Before you invest in a cryptocurrency, investigate the level of liquidity in the market for that token and how that will impact investors’ ability to enter and exit. Typically, the greater the volume, the greater the liquidity and the less exchange rate risk.

As the development of blockchain technology progresses, cryptocurrency as an asset class will become more mature and take on entirely new sets of risk. After you have rated all five of the primary blockchain risks (User, Requirements, Project Complexity, Team, Industry Risk) on a scale of zero to one hundred, you will have a risk profile scorecard. In any investment, return is examined in relation to the risk that was taken in order to achieve the return. Return is generated from cash flows of a company (in this case, transactions to modify the blockchain ledger) that are ultimately redirected to the user in the form of a dividend or a more valuable asset pricing. Your risk profiles should be continually updated to reflect the state of your investments, causing you to make changes to your positions as new information modifies your risk profiles.

We have fully taken the time to examine the risks. Yet in order to understand if the project is a good investment, we must gain a thorough understanding of the narrative and opportunities of a cryptocurrency as an investment. This portion of qualitative analysis is what we will tackle next.

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