Yesterday was the Iron.finance Armageddon. I have seen a couple of different theories on the crash including a rug pull by the devs, active DOS attack against Polygon network, or a feedback loop where stablecoin sales caused hyperinflation of the collateral coin which further devalued the stable. Whatever the post-mortems reveal, a lot of people got burned and it’s a good day to brush up on due diligence.
In this first article I‘ll start at the beginning and look at blockchain ecosystems overall, and how I start my research.
To be clear, I’m not a blockchain/DeFi expert, but I do have domain experience in programming and design. You should never substitute someone else’s research or advice for your own judgement.
Third Gen Blockchains
Third generation blockchains are attempting to upstage Ethereum by giving us the same functionality (smart contracts) with improved network mechanics. Every new project has to make a compromise somewhere, and a lot of the more advanced consensus algorithms are math intensive; their flaws are difficult to predict outside of real world conditions. These high risks are also why many newer blockchains are offering high rewards to early adopters.
Layer 2 Scaling Solutions and Sidechains
While third gen chains attempt to replace Ethereum, a slew of other projects are attempting to upgrade it. Sidechains do this with an Ethereum compatible blockchain of their own, while Layer 2 solutions attempt to move processing off of the main chain using rollups or other tricks. The goal here is to make Ethereum faster and cheaper so DeFi can happen in native ETH.
Honorable Mention: The Weird Stuff
The technology underneath cryptocurrency (called Web3) is being used to power new projects which aren’t focused on finance or currency. These are things like UnstoppableDomains, Filecoin, The Graph, Helium, and many others. These projects are seriously cool and deserve your attention, and some of them have governance tokens you can buy or mine, but they aren’t designed to be financial vehicles so I’m going to skip them for now.
So How Do I Judge This Stuff?
Here is the absolute bare minimum research I do before putting any money into a project. The more I invest, the more additional research is warranted.
What is it?
Is this a sidechain, a completely new blockchain, or something else? What parts are decentralized, and what parts are trustless?
Where did the code come from?
Did they fork an existing project, or build from scratch? Was it written by a company, a small team, or an anonymous mystery group?
Who funded the project?
Are VCs listed anywhere? Do you recognize any of them? How do the investors get a return on their money?
What is the consensus algorithm?
Who gets to write to the ledger? Proof of Work? Proof of Stake (direct or delegated)? Proof of Authority? Proof of Burn? Something more exotic? If there is a whitepaper or a lot of talk about DAGs, you should check Google for criticism of the algo.
What do CoinMarketCap and Coingecko say?
Are a lot of people using this project? What is the market cap and 24hr trading volume? How volatile is the native token’s price? Are there a lot of markets and CEXs that support the coin?
Is there market analysis available?
Does IntoTheBlock have data? Can you see how much is owned by whales or investors? If you divide the market cap by the percent held by whales, how much power do they have to manipulate the market?
Who does the mining, and how are they rewarded?
The harder it is to be a miner, the more centralized that power will be. Does it take special or expensive hardware? Are the mining rewards from gas fees or new coins? Is the native coin inflationary or deflationary? What is the hashrate (if applicable) and how often are new blocks mined?
How would an attacker break the system?
PoW is susceptible to 51% attacks on the hashrate. PoA networks have the same vulnerabilities as traditional online banks. In a PoS/DAG chain, who gets to pick the next block-writer and could that be compromised?
What wallets are compatible?
Can you use MetaMask? Is the wallet software open source? Are independent developers making wallets? Can you use a hardware wallet with it?
What does a typical transaction look like?
Are gas costs high, low, or variable? How fast do blocks get written? Are there a lot of complaints about network congestion?
Where can you see transactions and smart contract code?
Is there a block explorer like etherscan or polygonscan? Are contracts written in Solidity or Vyper, or something else? Can you see contract source code or is it compiled/opaque?
What does social media have to say?
Too much hate or too many fanatics? Does it seem like FOMO/FUD to manipulate the market? Is there a forum, Discord, Telegram, etc, and how much activity is there? Are developers actively talking with the community? Are there a lot of complaints or warnings on Twitter and Reddit? Any history of a crash, rug pull, or hack?
How do you get money in and out?
To enter or exit the ecosystem, will you be going through a wrapped token, or a bridge? If that bridge goes down are you stuck? Can you buy into the platform directly from a CEX like Kraken or Coinbase? Is there a fee to get in or out?
The list above isn’t exhaustive and you should do as much due diligence as you need to in order to feel comfortable before you risk anything. Even when you feel confident, it’s a good idea to run some small test transactions.
Once you’re in, the research doesn’t end. Keep following news about the project and connect with the community. If anything smells off, trust your instincts. The whole point of this research is to spot dangers early.
This is the first article in a series. Please share the tools and websites you use to do your research in the comments below. If you found this essay helpful, please give it a clap.