Crypto for Advisors: Understanding Crypto

It was another big week in the US, with the launch of exchange-traded funds for Ethereum, making the second-largest cryptocurrency by market cap accessible to investors through a traditional offering.

Have you ever thought about how to evaluate cryptocurrency projects and what criteria to consider? In today’s issue, Matthew Burgoynepartner at law firm Osler Hoskin & Harcourt LLP, provides a guide for investment advisors to evaluate crypto projects.

In Ask an Expert, David Ben KayPresident of Function X, answers questions advisors can consider when evaluating investments.

–SM

As this week’s exclusive sponsors Crypto for Advisors newsletter, we would like to congratulate Grayscale for launch of their new Ethereum ETFThe ticker is simply ETH – we see what you did there!

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How to Evaluate Cryptocurrency Projects: A Guide for Investment Advisors

As the cryptocurrency and blockchain industry continues to gain momentum, investment advisors are undoubtedly facing an increasing number of questions from clients about specific crypto assets and the projects behind them. Evaluating these projects requires a thorough understanding of several crucial factors to ensure informed investment decisions. The following sections highlight areas that advisors should consider when assessing the nature and legitimacy of any cryptocurrency project and corresponding crypto asset:

Due diligence of the project founder

Research the background of project founders, including their professional history, past projects, and industry reputation. Look for verifiable expertise and be alert for potential fraud. Red flags include newly created social media profiles and anonymous teams.

Review and critical analysis of tokenomics

Tokenomics refers to the economic model of the token, including its supply, distribution, and utility within the project. The main aspects to analyze are:

• Supply and distribution: Understand the total token supply and how it is distributed among stakeholders. Pay attention to the distribution between founders, team members, advisors, and investors. A well-balanced distribution minimizes the risk of market manipulation.

• Utility: Evaluate the practical use of the token within the project. Tokens should have a clear purpose, such as facilitating transactions, accessing services, or encouraging participation. Projects with vague or unnecessary use of the token should be approached with caution.

• Inflation and deflation mechanisms: Evaluate whether the project has mechanisms to control the token supply, such as token burning (reducing supply). Understanding these mechanisms helps assess the long-term stability of value.

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Business Plan Evaluation

A realistic and solid business plan is essential to the viability of any token project. In the crypto industry, a business plan is typically presented in a white paper, which is a foundational document that outlines the project’s vision, the nature and use of blockchain technology, and the implementation strategy. Key elements to review include:

• Token requirement: Determine why a token is essential to the project. The token should solve a specific problem or improve the functionality of the project, not just serve as a fundraising tool.

• Market need and competition: Analyze the market demand for the project solution and identify its competitors. As is the case in the world of traditional finance (“TradFi”), a unique value proposition and a well-defined market niche are indicators of potential success.

• Revenue model: It is essential to understand how the project plans to generate revenue. Look for sustainable and scalable revenue streams that are realistically achievable under the given market conditions.

Risk factors

Identifying potential risks is essential when evaluating token projects. Common risk factors include:

• Technical risks: Assess the likelihood of technical failures or vulnerabilities; multiple blockchain and software code audits conducted by reputable third parties are positive signs and reduce the likelihood of hacking incidents, which can result in significant losses for consumers.

• Liquidity risks: The liquidity of some tokens may be heavily concentrated on a few crypto asset trading platforms or liquidity pools. When a significant portion of the tokens are held on only a few of these platforms, buying or selling them efficiently may become difficult, especially during periods of high trading volume.

• Risks related to competitors: Many tokens face significant competition from other blockchain platforms that offer similar or improved features. When analyzing a cryptocurrency project, consider whether high gas/transaction fees or network congestion are associated with the blockchain. There may be competing projects and tokens that offer lower transaction costs and faster processing times, which could turn software developers and users away from the project under review.

Regulatory considerations

Assess whether the token issuance triggers any regulatory requirements, such as anti-money laundering (AML) laws or securities laws; many new projects trigger one or both areas of law, while some older, well-established projects that are sufficiently decentralized do not trigger these laws. It is essential to check whether the project founders have obtained legal advice and whether sales are restricted in major markets such as the US and UK. Such restrictions could indicate an attempt to circumvent securities regulators in those countries, suggesting that the token sale may involve the sale of securities or derivatives.

Conclusion

Evaluating token projects requires a holistic approach, taking into account the credibility of the founders, the token’s business model, the quality and viability of the business plan, potential risks, and regulatory compliance. By carefully analyzing these factors, investment advisors can provide informed advice to their clients, helping them navigate the complex and evolving cryptoasset landscape.

– Matthew Burgoyne, Partner, Osler Hoskin & Harcourt LLP

Ask an expert

Q: What are the key things to consider when reviewing cryptocurrency projects from a legal perspective?

A: From a legal perspective, three key areas I look at when evaluating a cryptocurrency project are: compliance, governance, and security. Does the team include dedicated and knowledgeable people responsible for these areas? While it is natural and expected that the team will have technical and marketing expertise, I would also like to see people with strong legal and financial backgrounds to ensure that the company has been set up in compliance with local laws to be able to operate as it sees fit and that it is aware of international laws and standards that could impact the execution of its proposed business plan. I would prefer to see these people in key management and decision-making positions, although if the company is at a very early stage, the company’s advisors should at least include lawyers and accountants or people with strong legal and financial management backgrounds. If the company intends to issue a token or has already done so, I would also expect to see a legal opinion from the relevant jurisdictions to ensure compliance with local laws and regulations.

Q: How can advisors help their clients make investment decisions based on this information?

A: Legal compliance and governance are factors that factor into any investor’s assessment of risk in a proposed project. They are by no means the only factors, but simply part of the calculation in determining whether or not to invest. Particularly in the cryptocurrency sector, many legal issues remain in gray areas – and therefore potentially riskier. This will depend on the investor’s risk tolerance and judgment as to whether the potential returns of a project outweigh the potential risks.

Q: What is a good example of a project from a legal point of view?

A: Projects that are past the start-up stage and have a proven track record of compliance and good governance practices will be easier to monitor. The required licenses, registrations and filings will already be in place, as well as guidelines for internal practices and operations that are usually in written form. This is in contrast to early-stage startups. In these cases, more emphasis will be placed on individual team members and their experience and track record in other projects, as well as on the white paper that envisions the regulatory framework in which the project will operate and how governance issues will be handled internally.

While these comments are quite general and can be applied to any project, they are particularly important in the field of cryptocurrencies where, from a legal point of view, many things are still in flux. Lawyers have the task of gathering as much objective information as possible to present the potential investor with an assessment that allows them to make an informed decision.

– David Ben Kay, President, Function X

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