Total Value Locked (TVL) and Why It Matters in Defi
How Defi Platforms Work
DeFi protocols refer to blockchain-based platforms that enable users to lend, borrow, trade, and store cryptocurrencies and other digital assets without intermediaries such as banks or exchanges. These protocols are self-enforcing and run on a distributed network of computer programs called smart contracts.
When a user deposits assets into a DeFi protocol, the assets are often locked into a smart contract until a certain condition is met, such as loan repayment or contract expiration. When the total value of these assets in the protocol is added up, we arrive at the TVL of that protocol.
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What is Total Value Locked (TVL)?
Total Value Locked (TVL) is a crucial indicator used in the decentralized finance (DeFi) ecosystem to measure the total value of assets locked in a specific protocol or platform. It indicates the entire quantity of available capital in a certain DeFi ecosystem at a given time. For example, if a user deposits $1,000 worth of Ethereum into a lending protocol, and another user borrows $500 worth of Ethereum using that deposit as collateral, the TVL of the lending protocol would be $1,500.
TVL is a metric that enables investors to evaluate the likelihood of a DeFi protocol’s success by measuring its popularity. If the TVL is high, this indicates that the project is in high demand and that consumers are willing to invest significant capital in it. This might be interpreted as a vote of confidence in the protocol, and it could encourage additional users and investors to get involved with the project.
A higher TVL also signifies that a significant amount of cash is locked in DeFi protocols, indicating that protocol participants will receive more benefits and profits. A lower TVL shows less available capital, resulting in lesser returns. Typically, when the TVL of a DeFi platform increases, liquidity, popularity, and usability also increase.
The Growth of TVL on Defi Platforms
The rise of DeFi and the increasing popularity of cryptocurrencies are two key factors responsible for TVL’s meteoric rise in recent years. After hitting $1B in November 2020, Aave’s TVL for the DeFi protocol climbed to over $6B by February 2021. Similarly, Uniswap, a decentralized exchange, saw its TVL expand from one billion at the start of 2020 to about $10.3 Billion by the end of the year.
Currently, the most significant protocols in terms of their TVL are LIDO, which has surpassed MakerDAO as the largest liquid derivatives staking platform. DefiLama reports that the current TVL for MakerDAO is $8.11 billion, which is significantly lower than the TVL for LIDO, which is approximately $9.4 billion. AAVE and Curve are two other highly regarded techniques.
However, it’s important to note that TVL can be a volatile metric, as market conditions and investor sentiment heavily influence it. A sudden drop in TVL could indicate that users are losing confidence in the protocol, while a surge in TVL may be a sign of a temporary market frenzy. This is why investors combine TVL alongside other metrics when making investment decisions, such as the underlying technology, the team behind the project, and the potential risks and rewards.
It is essential to remember that TVL can be a highly unpredictable statistic because market conditions and investor sentiment can significantly impact its value. A sharp decrease in TVL could indicate that users are losing confidence in the protocol, while a surge in TVL may be a sign of a temporary market frenzy. Hence, investors use TVL with other measures when making investment decisions. These criteria include the technology the project is based on, the team working on the project, and the potential risks and benefits.
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How is TVL Calculated?
TVL is calculated by summing up the total value of all the assets locked in a DeFi protocol. These assets can be cryptocurrencies, stablecoins, or any other asset the protocol accepts. TVL can be calculated in real-time and is a useful metric to track the growth of a DeFi protocol.
It is calculated by multiplying the total number of tokens locked in a protocol by their market value. For example, if a DeFi protocol has 100,000 tokens locked in it, and each token is worth $10, then the TVL of the protocol would be $1,000,000. TVL is a dynamic metric that changes as the value of the locked assets fluctuates.
TVL Analytical Tools
The market share of DeFi protocols can be easily identified through analytics platforms like DefiLama, which provides data on the amount of crypto assets locked in their respective smart contracts.
The Ethereum DeFi network includes over 500 protocols. It has a TVL of approximately $25.55 Billion, compared with BNB Smart Chain, which is the second-highest TVL at $4.9 Billion in value, Tron with $4.5 Billion, and Arbitrium with $1.52 Billion. The total TVL in Defi as of the time of writing stands at $ 38.87 billion.
Limitations of TVL
Market volatility is one of the main variants that can highly affect the value of locked assets, starting with the price of ETH, whose platform is where most assets sit. The considerable increase in the price value of ETH inevitably affected the TVL of DeFi from 2020. This means the total value locked can increase without any new users or capital entering DeFi.
Furthermore, because of the nature of DeFi services, money can easily move around and be counted multiple times, thus miscalculating the protocol’s liquidity capacity. As with every indicator, TVL only estimates the market condition. Because of its flaws and approximation, it should not be the sole indicator determining an investor’s strategy.
See also: Layer 2 Blockchain Explained
Why is TVL an Important Metric for DeFi Projects and Investors?
TVL is an important metric for DeFi projects and investors for several reasons:
- A measure of Success: TVL is a measure of a protocol’s success. The greater the TVL, the greater the protocol’s ability to attract investors and provide liquidity. In turn, this attracts new users to the platform, generating a circle of growth.
- Risk Assessment: TVL is an essential indicator for assessing the risk associated with investing in a DeFi protocol. A high TVL suggests that a significant number of investors utilize the protocol and that it has a high level of liquidity. This means that investors can readily exchange their assets, lowering the risk of loss resulting from illiquidity.
- Marketing: TVL is a valuable measure for DeFi projects to sell their platform. A high TVL is a sign that the protocol is well-liked by investors and has a solid standing in the industry. This can potentially bring in additional investors, aiding the protocol’s expansion.
- An Indicator of Liquidity: Liquidity is crucial to DeFi protocols that offer lending and borrowing services. TVL is an essential metric for measuring the liquidity of a DeFi protocol. A protocol with a high TVL signals sufficient liquidity to facilitate lending and borrowing services. This is particularly important for protocols that support stablecoins, as these tokens require high liquidity to maintain their peg to the U.S. dollar.
- An Indicator of Growth and Adoption: TVL is a crucial statistic for assessing the expansion and adoption of DeFi protocols. A protocol with a high TVL signifies that it offers its users significant services because it draws in a sizable user base. This may draw even more people, starting a cycle of growth and adoption that reinforces itself. Low TVL protocols may find it challenging to attract new users, making growth difficult.
- TLV as a risk Indicator: Finally, TVL can predict risk in DeFi. Protocols having a high TVL may be more vulnerable to hacks and exploits since they are a greater target for attackers. Furthermore, protocols with a high TVL may be more vulnerable to systemic hazards, such as a sudden reduction in the value of assets locked within the protocol. This can lead to a liquidity crisis and, ultimately, the protocol’s demise.
- Comparison: TVL is an excellent tool for assessing the performance of various DeFi protocols. For example, if two lending protocols offer comparable features and interest rates, the one with a higher TVL is often regarded as more successful and trusted by users. A high TVL shows that more users are prepared to deposit their assets into the system, implying that they believe the protocol is dependable and secure.
TVL is significant because it can provide information about the popularity and success of a DeFi protocol. A high TVL shows that a protocol is attracting a substantial number of users and that those users trust the protocol enough to entrust their assets to it. This is particularly significant for protocols that offer lending and borrowing services, as a high TVL indicates that the protocol has sufficient liquidity to facilitate these services.
See also: Layer 1 Blockchain Explained
How TLV determines DeFi market trends
In the DeFi ecosystem, TVL is an important statistic that be can used to determine market trends. A rise in TVL suggests that many users are entering the DeFi space, which could increase demand for DeFi services. This can drive up the prices of tokens associated with these protocols, leading to a bullish trend in the market.
Similarly, a decline in TVL can signal a bearish trend in the DeFi industry as fewer users are entering the market. TLV is also essential for determining DeFi market trends. If TVL increases or drops, it can reflect a shift in the popularity of particular DeFi protocols or the demand for certain DeFi services, such as lending or trading. Changes in TVL might also signal market patterns in the broader cryptocurrency market, such as an increase or decrease in cryptocurrency demand.
Factors Driving the Increase in TVL
There are several factors driving the increase in TVL, some of them include:
- The Rise of DeFi: As was previously said, DeFi offers its users decentralized financial services that, in terms of accessibility, transparency, and cost-effectiveness, outperform conventional financial services. Using DeFi protocols, users can lend, borrow, and trade assets directly with one another, eliminating the need for intermediaries and leading to lower transaction costs and increased accessibility. Users’ increased use of DeFi has also increased TVL. This is because more users are depositing assets into DeFi protocols to use these services.
- Incentives: DeFi protocols’ incentives have also led to the expansion of TVL. Several DeFi protocols reward users who contribute liquidity to the protocol with tokens. These incentives have increased TVL by attracting more users to DeFi protocols. For instance, yield farming is a DeFi concept in which users deposit their assets into liquidity pools to receive incentives. These rewards may be more tokens, lower transaction fees, or other incentives. Yield farming has become a popular method for users to generate passive income from their assets, which has led to a substantial increase in TVL.
- Institutional Adoption: Finally, institutional adoption of cryptocurrencies and DeFi has also played a role in driving the growth of TVL. As more institutions invest in cryptocurrencies and explore DeFi opportunities, the amount of capital flowing into the ecosystem has increased, leading to higher TVL.
Conclusion
DeFi protocols have garnered great interest in the crypto industry due to their decentralized nature, enabling investors a new level of financial independence. TVL is a critical statistic for measuring the success and popularity of DeFi protocols.
It is an important indicator for DeFi initiatives and investors. It is a measure of the success of a DeFi protocol, an indicator of the risk of investing, and a great marketing tool for protocols. Even as the DeFi industry develops and diversifies, TVL will remain vital for sizing up protocol efficacy for investors and end users.
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