Total Value Locked (TVL) – What Is It And Why It Is Important In Crypto?

The legendary phrase “follow the money” is not just popular in the “All President’s Men” drama, but it is a term commonly used by investors in the crypto space. It is popularly believed that one of the ways to be successful as an investor in the crypto space is to have first-hand knowledge of where the money is moving, even though the market is highly saturated.
It is to this end that such metrics as Total Value Locked (TVL) became an important indicator to monitor actively. This will help you identify which of the protocols in the DeFi space are attracting the confidence and attention of investors.
This guide is written to bring you all the information you need about the total value locked metric, and you can be sure reading will be worth it.
The Full Definition of Total Value Locked (TVL)
One of the popular metrics employed in measuring how big and popular some DeFi protocols are or even the entire decentralized finance (DeFi) market generally is Total Value Locked (TVL). Basically, the term “Total Value Locked (TVL)” is a figure that shows the dollar value of the crypto locked away on the smart contracts of a single application or even on the entire DeFi space.
There are many ways digital assets are locked in the crypto space, some of them are through, liquidity pools, lending protocols, yield, and staking. This metric, however, shows how much capital is in control of those in the DeFi space and it is a very important one for both the investors and the protocols because it has a way of affecting the usability and yields among the end-users of the DeFi application.
Currently, the total value locked of the DeFi space has reached a whopping $169 billion across the globe, with the ETH network having the lion’s share of the figure. As of two years ago, this figure sits at around $400 million. This massive increase shows the interest of big money in space and also the global adoption of space.
Staking, Yield Farming, and Liquidity Pool Explained
Simply because these three factors contribute to the size of the total value locked of a given DeFi protocol, this guide must explain these terminologies to give a better perspective and understanding of the calculation of the TVL.
For everyone that understands how bitcoin is mined and how a BTC transaction is validated on the blockchain, understanding how the proof-of-work (PoW) consensus mechanism works. Just as a refresher, with the PoW consensus mechanism, miners compete to solve a mathematical task, and whoever gets it done first has the right to add the new block to the entire blockchain. But new developments in the crypto space have found fault in the mechanism, especially because of the high energy consumption attributed to the process.
This has led to the development of a new consensus mechanism called the proof-of-stake, where the competition is now about how many tokens a crypto user can stake (or lock away for a particular period of time). The main idea here is that participants lock their tokens away at particular intervals and the protocol assigns the right to validate the block randomly to someone who in turn earns rewards for doing so. Basically, the probability of being selected depends on the amount of crypto you have locked on the protocol.
This means that to be a miner doesn’t necessarily require an investment in purchasing the ASIC Miner hardware but instead a direct investment in the crypto itself. And while staking is done through the native token of the blockchain, some networks employ the two-token system that allows them to reward staking with another token.
So just like there are mining pools where miners in the PoW consensus mechanism pull energy together to stand a chance to mine a block, there are also staking pools that allow crypto users on the network with the Proof-of-Stake (PoS) consensus mechanism to pull their stake together to increase their chances of being the next validator and in turn share the rewards based on each user’s contribution.
While there are huge benefits to staking on different networks that allow it, there are also some risks attached to it, one of them is that the price of the token as at when you staked it might have dropped so much that the rewards you earn cannot cover for the gap when you are un-staking your assets.
However, to round it up, the amount of the total token staked contributes to the size of the total value staked on the protocol.
- Yield Farming
Yield farming is quite close and parallel to stacking. It is another way of getting rewards from a DeFi protocol by just locking the token away. For now, yield farming can be done on the Ethereum network using the ERC-20 tokens, and the rewards are also usually distributed by a type of ERC-20 token.
Users interested in yield farming are often called yield farmers, and they are known to always move their funds from a protocol/smart contract to another in search of a better yield.
While yield farming can be confused with staking, the basic difference is that staking is done to become a validator on the network, but the tokens locked through yield farming are used by the protocol for anything they want (or deemed profitable) especially lending it out to other users.
However, just like staking, yield farming contributes to the size of the total value locked of a given protocol, and as a matter of fact, it is an index considered to contribute more to the total value locked.
- Liquidity Pools
Liquidity pool is another way of locking tokens away on a smart contract, and it also contributes to the size of the total value locked of a DeFi protocol just as staking and yield farming do.
But in the case of liquidity pools, the tokens are locked within a smart contract only to be a source of liquidity for exchanges for trading, swapping, lending and others. And the fees and other money generated by the exchanges become sources of rewards for the liquidity pools.
It has been discovered that most decentralized exchanges (DEX) like Uniswap are relying heavily on liquidity pools as there are no central investors or venture capitalists to invest in them. Users who contribute to liquidity pools are called Liquidity Providers (LP), and they earn rewards in direct proportion to the total amount they provided through the pool.
Think of liquidity pools as a conglomerate of users in the traditional centralized banking system who are running fixed deposit accounts only to provide enough money for the bank to carry out other transactions that will generate profits. The profits are then shared with the users in form of interest.
How to Calculate the Total Value Locked (TVL) and How to Use the Metric
As an illustration, assuming an investor connects their wallet to a DeFi protocol and make a deposit of $1000 worth of crypto to the money pool to validate transactions on the blockchain (the framework of the proof-of-stake consensus mechanism) to receive rewards. And, he also gives out another $1000 worth of crypto for lending on the same DeFi protocol to receive interest. Afterward, he deposits another $1000 worth of crypto in the money pool, but this time around to provide liquidity for those that want to swap the token and to earn a commission for themselves. If this is the only investor on the DeFi smart contract, the hypothetical total value locked of the platform is $3000.
However, before investing in any project in the DeFi space, the TVL metric can help you know if the project is overvalued or undervalued compared to its fundamental value. This can be done by dividing the market cap of the asset by the total value locked. This is similar to the P/B (price-to-book) ratio used in the stock market.
So just as it is with stocks, the higher with P/B ratio, the more you should avoid the stocks as there is little or no fundamental value for the investors to lean on. So just like the market cap of companies can exceed their book value, the market cap of a project can outgrow its total value locked, and the lower the market cap-to-TVL ratio, the better for investors.
So, comparing Aave, Uniswap, and PancakeSwap, the market cap-to-TVL ratio of Aave is 0.29, and that of Uniswap is 2.40 while PancakeSwap is 0.85. Therefore, with these figures, it is better to buy Aave out of the three options.
Another thing is that the market cap-to-TVL ratio can be used to evaluate the current psychology of the investors in the DeFi space. Judging from the overall market cap-to-TVL ratio of the entire space which is 0.70, there seems not to be any danger of extreme euphoria yet, but when the figure is rising to around 3 or 4, it is worthy of attention before investing.
The Importance of Total Value Locked (TVL) in the Crypto Space
The TVL metric shows the value of money locked up by protocols in the decentralized finance (DeFi) space. And this helps investors to measure the overall health of the DeFi space per time. You can see this metric as an indicator to measure the adoption of the DeFi space.
Also, the Total Value Locked metric is one used to compare the market share of protocols in the DeFi space. This allows you to know which of the protocols has an upper hand in the space. There are such tools like DeFi Llama and DeFi Pulse that uncovers the Total Value Locked of several protocols in the DeFi Space, and this makes it easier for investors and every other stakeholder in the space to check which protocol has the largest amount of digital assets locked up in their smart contracts.
All things being equal, protocols with more value locked up in their smart contracts are deemed to be more active and can generate more yield for their participants. And in that manner, those with lower TVL show little or no activity from their participants and automatically lower gains (for those already participating and those interested in joining).
Over time, it has been discovered that it is very tricky to evaluate the performance of a protocol in the DeFi space by its Total Value Locked (TVL) because it looks higher since the entire DeFi space is still young and still evolving. But eventually, market experts postulate that any audited protocols in the ecosystem that have their Total Value Locked starting from $1 billion can be considered a safe option for investment. This shows there has been a huge commitment from its participants over time.
The reason is that the total value locked of a platform is a direct reflection of its integrity. When platforms with lower TVL are offering high yields, investors are advised to stay clear as many of them might just be a scam because no one has trusted them with their assets over time. Hence, the reason for the postulation from the market experts is valid.
The Interpretation of the Total Value Locked Growth
Many analysts and investors measure the DeFi space by the amount of its Total Value Locked, and this means that the higher the TVL, the better the general health of the project is considered.
Interpreting this by logic means that whatever project with high TVL has more demand in the space. And this is owing to many reasons. Some of the reasons can be the strong dev team behind the project, strong user experience generated by the project, and the strong use cases of the project which has attracted more users and in turn, increases the size of the total value locked. And the total locked value is a direct reflection of the value of the project itself.
Also, there is often a correlation between the price of the token and the total value locked of a DeFi protocol. Typically, the price of the asset moves in the direction of the TVL. This means that the higher the TVL goes, the high the price, and vice versa.
The Downsides of the Total Value Locked (TVL) Indicator
To begin with, a larger percentage of the decentralized finance applications (dApps) are built on the ETH blockchain and by implication, over 61% of the total TVL in the DeFi space are tied to the ETH network currently. This means that the growth of decentralized finance applications on the Ethereum space is not necessarily tied to the increase in user engagement and the number of dApps.
As established before, there is a correlation between the size of the Total Value Locked and the price of the native asset on the protocol. This means the increase in the price of Ether (ETH) has a direct reflection on the amount of the total value locked on the main blockchain and not the individual protocol or smart contracts as it is supposed to be.
Additionally, there is an artificial way of boosting the size of the total value locked by just simply counting the same capital twice. This happens when users put in their crypto in the dApp-1 and got their own synthetic tokens in return which they are required to deposit on dApp-2 or another protocol. Both deposits to the two dApps directly contribute to the calculation of the total value locked whereas the only reach capital is the first deposit made to the first dApp.
Another way the total value locked can be a bubble metric is the presence of whales and big investors. Investors with large capital like institutional entities and hedge funds that hold a huge amount of the digital assets, or are even the developer of the project themselves are always capable of faking some transactions with a high value which can consequently boost the total value locked artificially.
Also, while the decentralized finance space (DeFi) is still evolving and its environment is still unregulated, there are high tendencies of having plenty of on-chain activity that focus on short-term gains and speculations. This means that users that decide to lock their crypto-only do so to generate an income passively and they may decide to withdraw it after a while and this can lead to a decrease in the TVL.
Conclusion
The truth is there are many ways to analyze a project in the crypto space before deciding to invest in them, but the Total Value Locked (TVL) is a metric that an investor cannot toy with. As discussed above, this metric and the other derivative metrics from it are considered a measurement of the integrity of the project over the period they have been existing or over a given time.
Also, the metric is used to measure the direction of confidence of other investors in the market, hence, it is a way to measure the sentiment of other investors without peeping on their discussion on social media.
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