Importance of Due Diligence
Due diligence is defined as a systematic way to analyze and mitigate risk from a decision. It’s one of the most important steps in evaluating decentralized finance (DeFi) protocols prior to using them.
When using DeFi protocols, users are putting their funds at risk of being rugged (stolen) and therefore, should take proper steps to gauge protocol risks. This post will outline the basic steps you can take to research protocols and evaluate various risks involved in DeFi.
White paper: What is it anyway and why should I read it?
A white paper is a document that describes the technical definitions and theories behind a protocol. A good white paper will outline the basic concepts of the protocol, explain the purpose of the protocol, and provide detailed information on how the protocol operates.
Many white papers also identify an inefficiency in the market and explain how the protocol solves this inefficiency. Reading white papers is an important step to understanding the whole picture of decentralized finance protocols. Without reading the white paper, it is often challenging to understand the motivation behind a protocol and may leave users with an incomplete picture of its goals and objectives.
White papers are NOT documents for shilling governance tokens. If a full protocol white paper focuses on shilling its governance token, that should be approached with caution. There are some cases where a project may write a white paper specifically about their token, this is fine assuming it is not the only paper they have written for the project.
Analysts should also keep an eye on white papers that only briefly describe what a protocol is in theory and do not provide detailed information about how the protocol will work in reality (outside of theory).
Heavily theoretical white papers are not necessarily red flags, as highly complex protocols may have more theoretical papers describing them and providing context, but if a project is not able to explain how their mechanisms work or what the mechanisms are it should be seen as a red flag.
Project Documentation: The Guide to Protocol Usage
Project white papers are a good starting point for learning about a protocol, but project documentation is a vital source of information when conducting due diligence. The project white paper introduces the ideas and mechanisms behind the protocol, while the documentation explains how to use the protocol (provides specific, detailed information about how the protocol works).
Good documentation will contain the following:
- A brief overview of the protocol and what it does;
- Detailed information on how to use the protocol;
- Links to smart contracts and security practices of the protocol;
- A breakdown of project tokenomics (if it has a token);
- Details about protocol fees and revenues.
A project with a white paper and no documentation is likely still in the early stages of development and, in general, will not have a decentralized application (dApp) live yet. If a project has a working dApp and no documentation this should raise some concerns, as it signals the project has not taken the time to properly explain how to use their DeFi application.
Checking the uniqueness of documentation can be a good way to weed out potential scams, bad project teams, and less serious projects. A good project will have thorough documentation written by the project team. One way to check it is by copying and pasting a section of the documentation into google and searching it.
If the documentation is original, then it will be the only generated search result. If you search and get a different project’s documentation in the results as well, it’s possible the team simply copied it from a similar project, which may be a red flag. You can use freely available plagiarism checker tools like Copyscape and Grammarly or their premium versions (paid) to test the authenticity of the project.
The Team Behind the Project
When reading through documentation, there may occasionally be a section about the team behind the project. Knowing who is on the project team is important for verifying its legitimacy. With a doxxed project team, it is easy to do research on each team member to find out what projects they have been associated with in the past and what their reputations are.
Reading through the team members’ social media or LinkedIn accounts can provide good insight into the kind of people on the team and what they believe in. Team members primarily posting about their project’s token and pumping its price is generally not a good sign. A good project team focuses on the product, which should be the protocol itself, not the token.
Navigating around anon teams can be a bit more challenging. You can go through their social media accounts (if they have them) and get a similar read as doxxed team members, but there is no real way to know the person’s history. In general, if the team is focused on the core aspects and development of the protocol rather than pumping their token all over social media they are likely ok.
Tokenomics: Demand and supply of cryptocurrencies
Tokenomics are extremely important for projects that have a governance token. They are the details surrounding the distribution, emissions, and use case of a project’s token. Any project with a token should have a detailed tokenomics breakdown in their documentation.
In general, you should expect to see the following information in the project’s tokenomics:
- Token distribution breakdown;
- Project team token allocation and vesting schedule;
- Community allocation and/or airdrop details;
- Treasury allocation;
- Liquidity Provider incentives (if liquidity mining initiatives are taking place);
- Strategic advisor allocations and vesting schedules;
- Seed round investor allocations and vesting schedules;
- Details about the utility of the token;
- Whether there are coin burns, buybacks, or revenue sharing.
Having this information is key to understanding the protocol’s economic health. Projects that have a significant amount of their token supply allocated to insiders and project team members should be approached with caution, especially when there is no token vesting.
Knowing how to conduct due diligence is a necessary skill to have when getting involved in the decentralized finance space. Below are key points to remember as you begin researching:
- White papers should outline technical definitions and theories behind a protocol, explain how a protocol works and what the purpose of it is.
- Good documentation is key to protocols and it should provide details on how to use a protocol and build with it.
- Researching a project team is important for ensuring the team backing a project has a good reputation and knows what they’re doing.
- Tokenomics should not heavily benefit advisors and project founders over community and retail. Always check token distribution and vesting schedules.
It will take a lot of practice and consistency to build up your due diligence skills,and these are just the first steps!
In future posts we will be taking a more in depth look at smart contract review, analytic tools, and how to do research write-ups. Feel free to hop on the DeFi Pulse Discord server if you ever have questions while researching a protocol, we’re always happy to help!