Introduction

From its genesis to its boom in 2020, DeFi has gone through exponential growth. An indicator is therefore needed to measure DeFi protocols. With an increasing number of new projects being created one after another, the application of DeFi is becoming more and more diverse. But currently, there are no universal metrics that apply to all DeFi protocols.

To solve this problem, a dedicated indicator that measures the popularity and value of a project is adopted to analyze DeFi: Total Value Locked.

What is Total Value Locked (TVL)?

Total Value Locked (TVL), an indicator of the total amount of liquid assets, is a key indicator used in DeFi. The TVL of a protocol refers to the total value of all collateral in an application, which is typically used to assess the value of assets stored on multiple DeFi protocols or on a single one. These assets are usually stored in USD or other fiat currencies.

Generally, these assets include returns and interest generated from services such as liquidity pools, lending, and staking, which are provided through smart contracts. If an investor wants a DeFi protocol that offers the highest rewards, the TVL will show the total value secured on DeFi staking protocols and total assets deposited by liquidity providers.

Since the DeFi Summer two years ago, DeFi has developed into a big industry that is diverse, prosperous, and interoperable. DeFi applications include trading, lending, staking, stablecoins, bridges, derivatives, insurance, etc. Besides, with the emergence of new protocols, DeFi has become increasingly larger and more diverse, driving the TVL to grow continuously. TVL is usually utilized by investors to measure whether the entire DeFi ecosystem or a single DeFi protocol has the potential to produce profits.

According to the estimation by DeFiLlama and Coingecko, there are over 140 chains and 3,000 protocols in DeFi, with an accumulative TVL of about $56 billion. In addition, there are over 400 DeFi coins sharing a total market cap of over $44 billion.

DeFi total TVL by CoinGecko

The application of TVL in DeFi

Trading

The most common types of trading in DeFi are swapping, staking, mining, etc. TVL can be used here to evaluate the transaction fee of a DeFi protocol to decide whether to invest in the protocol.

The stability of the value of TVL is an important measure of DeFi protocols. If the value of TVL only changes slightly, the DeFi project is believed to be operating in an effective, stable way, hence is less likely to face funds shortage and able to attract more investments and participants, thereby driving up the trading volume of the protocol and returning the trading fee to stakers as rewards.

Lending

For DeFi lending protocols, the asset volume and fund liquidity of the project serve as key factors to measure if it is a good investment. By analyzing the TVL, we get to know the maximum assets that DeFi can support. In addition, the fund withdrawal of the protocol should also be considered. High liquidity and sufficient funds make the protocol safer and less likely to incur a run. Then investors can lend their funds to such protocols to gain more profits.

How to measure DeFi by TVL

Total Value Locked (TVL)

Simply put, higher TVL implies the better performance of the DeFi protocol. This refers to measuring the total liquid assets of the DeFi project purely by looking at TVL. Higher TVL typically means more capital locked on the protocol, which indicates high potential and competitiveness.

Among the 10 protocols shown in the figure below, MakerDAO has the highest TVL, followed by Lido and Curve. That is to say, MakerDAO is favored by most investors and has received a large amount of investment; in contrast, Instadapp, which ranks 10th, is less favored and thus receives less investment.

By DeFi Liama

​​Market Cap (​​Mcap) / Total Value Locked (TVL)

A smaller Mcap/TVL ratio indicates the higher potential of the project. Market cap refers to the total value of a coin, which is calculated by multiplying the coin’s current market price by its total supply. A smaller ratio means that more capital is invested, indicating the coin is undervalued and has sound future growth potential.

As DeFi protocols are based on public chains, the total value of a coin in circulation on the public chain could also be considered to compare with other chains, thereby evaluating market expectations. For example, Ethereum, ranking at the top by the number of DeFi projects it hosts, charges a certain amount of its native token ETH as the transaction fee. This contributes to the prosperity of the Ethereum ecosystem and the huge growth of its market cap. This is the same for other public chains such as Solana and Uniswap. Therefore, the Mcap/TVL ratio can be used to analyze the market expectations of different chains.

In addition to being used as a metric for comparing different public chains, this ratio is also an indication of the relationship between Mcap and TVL. A lower ratio typically indicates more investments and higher future growth potential. That is why some investors prefer to use the ratio of Ethereum as a standard metric to compare with other public chains. By contrast, a higher ratio means fewer investments and insufficient value locked. The market may be overheated and over-hyped, leaving high risks. The fall of coin prices may lead to large capital outflows.

As shown in the figure below, the Mcap/TVL ratio of Lido, Uniswap, and PancakeSwap are all higher than that of MakerDAO, which is 0.07901, indicating an overvalued market expectation; on the contrary, JustLend and Instadapp, which have a lower ratio than that of MakerDAO, are considered to be undervalued currently and have more room to grow.

By DeFi Liama

Trading Volume (VOL) / Total Value locked (TVL)

A higher VOL/TVL ratio indicates higher returns of capital, which means that trading volume on a DeFi protocol can be used to evaluate asset utilization on the protocol. This is because the trading volumes can be determined by transaction fees paid in the native token of the chain. This ratio also indicates the relationship between trading volume and TVL to compare the capital utilization rate between different DeFi protocols, and further analyze the capital liquidity and fee income of the protocol.

A higher ratio indicates healthy funds usage, high liquidity, low risks, and stable fee income. In contrast, a lower ratio implies underutilized funds, lower liquidity, as well as unstable fee income.

Controversies about TVL

How to measure the actual TVL of diversified protocols

DeFi has been continuing to innovate all the way, with increasingly diversified protocols being created. It is more challenging to value a chain as more projects pop up.

To address this problem, data providers like Coin Metrics are needed to track data to be measured continuously. They synthesize TVLs of each protocol and commit to maintaining and updating the records. However, it would be difficult to value a new protocol that has no historical data to refer to. In addition, data providers should also keep abreast of updated versions of protocols and smart contracts. For example, Uniswap is now supported by the 3rd version and each version adopts different methods to track the collateral. To address this problem, the TVL of Uniswap calculates the sum of TVLs of all versions. Hence, the data provider needs to value the TVL of each version one by one.

Both the number of protocols and the versions will affect the valuation of the total amount of assets of a public chain, and a double-counting problem may occur.

Actual TVL is unknown

Most DeFi protocols do not stipulate the specific type of collateral. The diversity of collateral types has made the valuation more complex. What’s more, it might be difficult to find an appropriate valuation method applicable to some types of collaterals.

As is shown in the figure above, the figure on the vertical axis is the rough statistics of the collateral types of Uniswap v1/v2/v3, Sushiswap, Curve, Aave v2, Compound, and Makeri. Their assets can be traded on multiple chains or centralized exchanges, making it more difficult to collect data and make an accurate estimation.

The multiplier effect of locking in repeated staking

In DeFi protocols, investors can re-stake by creating derivatives of the asset, which causes the problem of repeated staking. In short, the lending service provided by DeFi protocols allows investors to stake assets in it and lend out other different assets. In this way, assets used as collateral in one protocol can be staked in another. The double-counting increases the multiplier value in an invisible way, but the actual asset is less than the TVL on record. Therefore, it is necessary to ensure that the assets locked in this protocol are not used in other protocols, so as to avoid double counting.

How to make an accurate valuation of floating coin price

TVL is an indicator of the total amount of liquid assets on a DeFi protocol. Formula: TVL = number of coins x current price of coins.

Based on the market price of coins, assuming that the number of coins remains unchanged, the TVL will also show huge differences when the coin price fluctuates greatly. Then the accuracy of TVL may be affected by constant changes in coin prices.

In addition, as mentioned above, more and more DeFi protocols now support multiple coin assets or other types of collateral. Therefore, the valuation of TVL should consider the fluctuations in the prices of multiple coins or collaterals.

Conclusion

DeFi has now entered a cold winter after the DeFi Summer. However, due to a growing number of new DeFi applications, all the way from 1.0 to 2.0 to 3.0, the DeFi market at present is still in its infancy. Therefore, an indicator is needed to measure the capital flows of DeFi protocols. TVL is used to measure capital liquidity and is hence created.

Although TVL is the most commonly used indicator in DeFi, the measurement of a single protocol or the entire TVL will be affected by multiple factors, including collateral types, platforms, versions of the application, double-counting, value fluctuations, etc. Therefore, the fund size of a DeFi protocol cannot be measured only by the TVL estimates.

In the future, in addition to including more collateral types, lending finance, etc., DeFi needs to have a more accurate measurement method given the prosperity of this industry. A single standardized indicator may not be applicable to all DeFi protocols. Therefore, we should never measure a DeFi protocol by simply relying on TVL on the protocol. More diversified indicators should be considered when measuring a DeFi protocol.