How to do Due Diligence on an ICO

ICO stands for Initial Coin Offering. "The birth of a currency" would be an accurate way to describe it as well. And let's not skip the "Initial Con Offering" version too, which does a good job of explaining 95% of them.

There seem to be about 1400 cryptocurrencies around today. People buy the newly invented coins as they pop up, because they see their friends getting rich from last month's newly invented coins. How long this can be sustained is the million dollar question; for those who call the top win big, and bagholders lose their savings.

So let's do our best to understand them, by taking these systems apart to see what they are made of.

The anatomy of a cryptocurrency

With every cryptocurrency,

There is software that defines the protocol of the currency.

There are developers that write the software.

There is a ledger (a.k.a database) which has list of all transactions.

There are transactions that get verified when people submit them.

There are coins that get generated and issued over time.



The catch is, there are many different ways in which these 5 items can be implemented. And they generate wildly varying scenarios when things play out over a long-term period of time.

Let's describe how each component can vary.

1. How trustworthy is the codebase?

...or "are the software authors decentralized?"

The codebase is an extremely important aspect, since the security, scalability, fairness, maintainability and longevity of the project are heavily dependent on the code itself. A trustworthy codebase often starts out as a community-built highly detailed protocol specification and gets continuous feedback and contribution from the worldwide open source community. Once it reaches a stable version, it usually ends up having multiple codebases developed in tandem that are all compatible with the protocol spec. For example, Bitcoin has many different implementations (bitcoin core, btcd, bitcoind, many others) and Lightning Network has several implementations (lnd, c-lightning, eclair, ...). The competition and cross-auditing between the projects provides extremely high levels of stability & security.

When a codebase is designed & maintained solely by a corporation or private entity, it fully lacks the advantages of a worldwide, decentralized open source protocol that comes to life as multiple compliant projects at once. These projects often lack any backing or contribution outside of the funding of the private corporation (such as Ripple).

2. How old is the project?

...or "has the project had enough time to reveal and fix its weaknesses?"

A shiny marketing page is often enough to convince the laymen of the imminent hockey-stick success of a new cryptocurrency, however in reality, the technical design, implementation, and adoption is ultimately what determines the success (or lack thereof).

Brand new projects usually come with the downside of not having their quirks, security holes & scalability limitations discovered yet. Since experts in the field can't possibly have the time to carefully audit every new ICO (out of the thousands that come out), the projects first have to compete for the attention of said experts, and over-time, gain a following of senior developers that contribute, and eventually prove themselves worthy as a project. This is not easy. But it is the only path to the longevity of a cryptocurrency.

Cryptocurrencies (and their protocols) also change over time, as the system is improved and upgraded by the developers. Although it may seem that a fast-moving team might be the best way forward, similar to start-ups, with cryptocurrencies there is huge value to a project that stays stable and does not experience too many drastic changes along the way. Longevity, stability, lack of controversies -- these all contribute to the chances of future success.

3. Who has copies of the database?

...or "is the ledger decentralized?"

When it comes to a bank, we all know that they hold full authority over their databases that hold account & transaction information. They aren't transparent to anyone outside the institution, which is what cryptocurrencies attempt to fix. The first promise of cryptocurrencies that resonate with people is that they make the transaction ledger public and distributed, for anyone to see and verify at will.

However, many private entities have been using the word "decentralized" to talk about their internal systems -- and not in terms of public transparency. For example, NetCents ($NC) has no plans to make their transaction ledger public for their NCCO currency, but continue to use the word "decentralized" as a marketing technique to generate buzz in an active market. In these situations, the private entity still holds private control over the transaction processing mechanism, and users of such systems ultimately put full trust in the central authority to execute transactions lawfully and fairly, since the ledger cannot be independently verified by a third party.

4. Who does the transaction verifications?

...or "is transaction verification decentralized?"

Having the ledger transparent is one thing, and actually processing a transaction is another. Some cryptocurrencies choose to have a public ledger, however hold authority over confirming transactions that are being added to the ledger (such as IOTA). Once again, there is a significant level of trust that must be placed in the central authority, as there is a reliance on their continuing benevolence as they maintain the network.

The more "trust" is needed to be placed in an authority, the harder it gets for the network to survive long-term, because every corporation (a.k.a. central authority) experiences change (or bankruptcy, or closing down, etc) due to the departure of a management team or similar circumstances. With fundamental changes in the central organization, success of the network would be in jeopardy. Hence the longevity of such projects have far less guarantee than a community-maintained open-source project with no centralization for transaction verification.

5. Who is in charge of issuing new currency?

...or "is currency issuance decentralized?"

Okay so let's say we have a cryptocurrency where both the ledger, and the transaction verification capabilities are decentralized. Everything sounds good -- but what remains? The currency supply has to come from somewhere.

Fair currency issuance is one of the biggest problems to solve in any economic system. Gold is probably the easiest decentralized currency issuance system to understand, because everyone understands that issuing new gold requires digging it up, which is a costly endeavour. And anyone who wants to mine gold can do so, which makes it a fair method of issuance.

This is why "mining", which is a way of artificially creating scarcity, is such a popular method of issuing new currency. Beyond the benefits mining provides for the integrity of the system as a whole (proof-of-work is by far the hardest system to "hack"), mining also has an additional benefit of providing fully democratic means of issuing currency.

Many cryptocurrencies, in an attempt to be fast and energy-efficient, opt for the so-called "pre-mined" coins, where a central authority holds control over the currency supply, and can issue out new currency at will (at ZERO cost), and sell it directly to buyers.

There are some grey-area coins, such as RaiBlocks (a.k.a. NANO) where management holds full control of the currency supply, but they choose not to sell directly to buyers. Instead they created "faucet" systems where users were rewarded with coins for solving Captcha problems online (so that they cannot be automated, and human interaction is required). Although this is marginally more fair than a sell-directly-to-customer method, it still requires trust in the management team, and could still be prone to malpractice.

Currency issuance, and its fairness, is the item that I personally feel is the least talked about in mainstream media. However it might just be the most important...





Wrapping it up

Using the 5 points we just described, it's very easy to reveal the true nature of a cryptocurrency project.

Cryptocurrency checklist comparison

For a digital currency to truly be called a "cryptocurrency", it needs to satisfy all of these points. Otherwise it's merely a digital token -- more similar to poker chips, or in-game currency for online games, than it is to physical gold. They may have value, however the value is only retained for the duration of the private institutions' existence and operation.

In fact, here is the checklist from the formal definition for a "cryptocurrency" from Wikipedia:

The system does not require a central authority, distributed achieve consensus on its state.



The system keeps an overview of cryptocurrency units and their ownership.



The system defines whether new cryptocurrency units can be created. If new cryptocurrency units can be created, the system defines the circumstances of their origin and how to determine the ownership of these new units.



Ownership of cryptocurrency units can be proved exclusively cryptographically.



The system allows transactions to be performed in which ownership of the cryptographic units is changed. A transaction statement can only be issued by an entity proving the current ownership of these units.



If two different instructions for changing the ownership of the same cryptographic units are simultaneously entered, the system performs at most one of them.

Source: https://en.wikipedia.org/wiki/Cryptocurrency

Be careful out there -- while it may be easy to make money on altcoins simply by becoming an early adopter, don't forget that HODL'ing is ultimately ultimately a bet on the continued adoption and the undying support of the open source development community. Any project that relies on a central management team and their goodwill, is much more likely to discontinue than a community-maintained, decentralized project. Once you are looking at timelines that are decades long, instead of months, the outcome of altcoins may look very different.



The question I like to ask myself before I HODL is: "how likely is this currency to still be in circulation 20 years from now?".





My bet is on Bitcoin. DYODD and best of luck.











