What Is TVL?
A Step-by-Step Guide to a Key Metric in DeFi
By: Rahul Nambiampurath • Loading...DeFi Explainers
Total value locked (TVL) is one of the key indicators to help us understand the value of a smart contract protocol. Smart contracts recreate traditional finance by codifying contractual logic and automating it.
While smart contracts enable the development of decentralized finance (DeFi), it’s TVL that measures the amount of crypto funds bound by these programs. As a result, TVL is the primary indicator showing the public’s interest in a certain protocol, commonly known as decentralized application (dApp).
How Is TVL Calculated?
Let’s take one of the largest decentralized exchanges as an example: Uniswap. This dApp pioneered the development of Automated Market Makers (AMMs) so that users can exchange tokens without having to use intermediaries. For example, anyone can deposit funds into Uniswap’s liquidity pools representing paired tokens
Token pairs such as wBTC/ETH lock up users’ funds, making them into liquidity providers (LPs). When other traders want to exchange a token, either wBTC or ETH, they would tap into that pool to withdraw its liquidity. Each liquidity pool has its own TVL, showing how much crypto funds people deposited, denominated in USD.
In turn, LPs receive a cut from this token swap. When all of these liquidity pools are combined we can see Uniswap’s total liquidity. Then we can combine all the liquidity pools from other chains outside Ethereum: Arbitrum, Polygon, Optimism, and Celo. Combining the value of all locked tokens in all pools, expressed in USD, Uniswap would have $5.18B total value locked (TVL) as of October 2022.
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The same calculation process can be applied to lending dApps like Aave or Curve as well because they use the same principle of smart contracts pooling liquidity.
Nonetheless, TVL doesn’t account for yields and outstanding loans that LPs’ deposits earn. Instead, TVL only mirrors the value of smart contract deposits. If we move away from dApps to the entire blockchain network, such as Ethereum, it will account for all dApp TVLs. As of October 2022, Ethereum has $31.43B TVL.
Why Is TVL Important?
Total value locked measures the value of deposits and people’s interest in a certain dApp or blockchain network. Similarly, when people deposit more funds into one bank than the other, it indicates that one bank is more popular.
On the lower dApp level, TVL shows the protocol’s health. If it holds more funds, it has deeper liquidity that can efficiently serve more customers. Because users themselves are liquidity providers in decentralized finance, this is critical for robust markets. Otherwise, the lack of liquidity causes significant token swap delays.
Moreover, if there is too much demand that can’t be supplied, it causes token price movements, resulting in failed transactions. This is why you will see slippage tolerance percentages in liquidity pools for each token pair.
If the token price goes above 0.3%, the token-swap transaction fails. Lower TVL on a dApp or a blockchain means there is less stability from money circulation. This could then translate to lower rewards and the overall health of the protocol.
Is TVL Trustworthy?
What if a dApp has a greater market capitalization than its TVL? In that case, this would indicate that the protocol is overvalued. By the same token, if we divide the protocol’s market cap by its TVL, and the ratio is lower than one, it is undervalued.
With that said, this market cap/TVL ratio is dynamic, as we can see from Uniswap’s example.
After all, the market cap value depends on the price of the native token multiplied by its total circulating supply. For Uniswap protocol, this is a UNI governance and utility token. Its value is typically influenced by social media hype, exchange listing, new protocol upgrades, etc.
With Uniswap’s TVL higher than its mcap, it is slightly undervalued. Typically, any platform with less than $1B TVL should be taken with a risk-on mindset.
Alongside mcap/TVL ratio, another factor that can skew TVL as a value indicator is whale activity. These high-net individuals, or institutions, can temporarily bloat a protocol’s TVL with a single deposit. Likewise, they can pop the TVL balloon with a single withdrawal.
For this reason, it is useful to note the protocol/blockchain’s overall user number. One of the best resources for that kind of information is Dune analytics. In the case of Uniswap, this statistic would fall under the community dashboard.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.
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