DeFi Due Diligence. Shall we?

Continuously work-in-progress

I was always a curious mind. But the mindset of ‘getting to the bottom of things’ is something that I developed during my electrical engineering studies at uni. I had joined a group of young people who were coming from all parts of Turkey to study at Bogazici University, one of the most prestigious schools in the country. It was a group that I was so impressed by the sheer intellect of on the very first day of school.

And we had the best professors, who taught us what it takes to truly learn. There was no short cut. You had to make the effort, a lot of it. Not just to pass the exams, but to deeply understand all those new concepts that none of us had heard of before.

It is the same thing for me now. I have been studying the DeFi market since the middle of 2020 (yes, Covid-induced with a bit more time at hand). I am not going to lie that I was in crypto space since 2016 (seems to be the common entry point for most!). I wasn’t. But I have been in financial services for a long time and I invest in ‘transformation of financial services’ at D4 Ventures. And DeFi is that transformation.

As someone who has to ‘get to the bottom of things’, I have been building a framework for due diligence of DeFi projects.

Here is a short summary of a work-in-progress version.

Planning to share more of it as it develops and expands.

General Due Diligence Framework

• Whitepaper

  • Is there a whitepaper for the project?

  • Is it a properly written document?

  • Is it copied from another whitepaper elsewhere? (i.e. authenticity check)

• Tokenomics

  • What is the total vs. circulating supply?

  • What is the allocation of supply? (i.e. team, early community, investors, etc.)

  • What is the cliff and vesting period?

  • What is the governance framework? (e.g. goals, mechanics, etc.)

• Business Model / Product Offering

  • What is the business model? (i.e. p2p lending pools, market making, swap / trading, etc.)

  • What is the product offering? (e.g. are the returns reasonable in comparison to other DeFi projects?)

  • What blockchain is the project based on?

  • Does it support multi-chain? What is the status vis-à-vis interoperability

  • What is the story / progress to date?

• Team

  • Does the team have any previous DeFi / Crypto experience?

  • Does the team have any financial services experience (incl. traditional finance)?

  • Are there developers in the team? What is their experience?

• Community

  • Is there a community account? (e.g. Telegram, Discord, Twitter, etc.)

  • What is the engagement level among members?

  • Is the development team transparent in their communication?

• Security

  • What is the security protocol? Has there been any hacks / attempts?

  • Is it possible to review the smart contract source code?

  • Has there been any audit?

DeFi Properties

In addition to the general DD framework above (which is to be expanded), there are ten main properties to assess a DeFi project. Have listed them below with a short description for each and sample questions to ask.

I actually prepared this in a table format with a column at the end for a score to be assigned for each property. It would be something like this:

1. Composability: The ability to connect components with each other and build a complex multi-component financial system

   • How easy is it to connect components?

   • Could other DeFi protocols connect to this protocol and vice versa?

2. Flexibility: The ability to be easily modified

   • How much flexibility is embedded in the smart contract?

   • What is the process to add one new asset to the protocol?

3. Decentralisation: Facilitation of services without a trusted intermediary

   • Is the system truly decentralized?

   • Is there still need for an intermediary, albeit decentralized?

4. Accessibility: The ability for anyone and everyone to use the protocol

   • Is it a permissioned private platform?

5. Innovativeness: Open-source code that allows for innovations

   • Is the core technology open-source?

   • Is it publicly available to view online?

   • Are users / non-users able to propose improvements?

6. Interoperability: Functional and technical ability to operate across blockchains or on the same blockchain for different services

   • How frictionless is it to operate across different blockchains?

   • Are there any time delay / cost issues?

7. Borderlessness: Being truly global without any links to a particular fiat currency in any specific location

   • Is there any limitation for access in any part of the world?

   • Is there any limitation for AML / KYC?

8. Transparency: Observability of the smart contract or the financial data on it

   • Is it possible to review the smart contract?

   • Is it possible to review the transaction data?

   • What is the ‘block explorer’ that we can use?

9. Automation of Business Processes: Autonomous operation of the smart contract between two counterparties without a need for a third party

   • Is an external authority still needed?

   • Who is responsible for the correct functioning of the smart contract?

   • Is there need for any additional measures?

10. Finality: Validation of the transaction by all network nodes

    • Would security and immutability come at the expense of higher settlement and liquidity risk?

Select Sources for DeFi Due Diligence

https://www.ingwb.com/binaries/content/assets/insights/themes/distributed-ledger-technology/defi_white_paper_v2.0.pdf

https://thedefiant.io/red-flag-alert-a-framework-for-vetting-crypto-projects/