Total Value Locked (TVL) is one of the key indicators that helps us understand the value of a smart contract protocol. Smart contracts restore traditional finance by codifying and automating contract logic.
While smart contracts enable the development of decentralized finance (DeFi), it is TVL that measures the amount of cryptocurrencies locked up by these programs. Therefore, TVL is the most important indicator of public interest in a particular protocol, commonly referred to as a 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), allowing users to exchange tokens without the need to use intermediaries. For example, anyone can deposit funds into Uniswap's liquidity pools, which represent paired tokens
Token pairs like wBTC/ETH lock users' funds and turn them into liquidity providers (LPs). If other traders want to exchange a token, either wBTC or ETH, they would access this pool to drain it of its liquidity. Each liquidity pool has its own TVL, which shows how much cryptocurrency has been deposited in US dollars.
Source: Uniswap
LPs, in turn, receive a share of this token exchange. When all of these liquidity pools are combined, we can see the total liquidity of Uniswap. Then we can combine all liquidity pools from other chains outside of Ethereum: Arbitrum, Polygon, Optimism and Celo. Combining the value of all locked tokens in all pools, expressed in USD, Uniswap would have a total value (TVL) of $5.18 billion as of October 2022.
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The same calculation process can also be applied to lending dApps such as Aave or Curve as they use the same principle of liquidity pooling of smart contracts.
Nevertheless, TVL does not take into account the returns and outstanding loans that the LPs' deposits generate. Instead, TVL only reflects the value of smart contract deposits. When we move from dApps to the entire blockchain network like Ethereum, all dApp TVLs are taken into account. As of October 2022, Ethereum had a TVL of $31.43 billion.
Why is TVL important?
Total value locked measures the value of deposits and people's interest in a particular dApp or blockchain network. If people deposit more money in one bank than the other, this also suggests that one bank is more popular.
At the lower dApp level, TVL displays the state of the protocol. When the company has more funds, it has greater liquidity that allows it to serve more customers efficiently. Since users themselves are liquidity providers in decentralized finance, this is crucial for robust markets. Otherwise, the lack of liquidity will cause significant delays in token exchanges.
Additionally, too much demand that cannot be met leads to token price movements and therefore failed transactions. For this reason, slippage tolerance percentages are displayed in the liquidity pools for each token pair.
Source: Uniswap
If the token price rises above 0.3%, the token swap transaction will fail. A lower TVL on a dApp or a blockchain means that money in circulation is less stable. This could then lead to reduced rewards and the overall health of the protocol.
Is TVL trustworthy?
What if a dApp has a larger market cap than its TVL? In this case, this would indicate that the protocol is overvalued. For the same reason, if we divide the protocol's market cap by its TVL and the ratio is less than one, it is undervalued.
Nevertheless, this market cap to TVL ratio is dynamic, as we can see with the example of Uniswap.
Source: DefiLlama
Finally, the value of the market cap depends on the price of the native token multiplied by its total circulating supply. For the Uniswap protocol, this is a UNI governance and utility token. Its value is typically influenced by social media hype, stock market listing, new protocol upgrades, etc.
Since Uniswap's TVL is higher than its Mcap, it is slightly undervalued. Typically, any platform with a TVL of less than $1 billion should be approached with a risk-on attitude.
Single deposit
In addition to the Mcap/TVL ratio, whale activity is another factor that can distort TVL as an indicator of value. These high net worth individuals or institutions can temporarily inflate a protocol's TVL with a single deposit. Likewise, they can pop the TVL balloon with a single payout.
For this reason, it makes sense to note the total number of users of the protocol/blockchain. One of the best resources for this type of information is Dune Analytics. In the case of Uniswap, this statistic would fall under the community dashboard.
Series Disclaimer:
This series article is intended only as a general guide and information for beginners exploring cryptocurrencies and DeFi. The content of this article should not be construed as legal, business, investment or tax advice. For all legal, business, investment and tax implications and advice, you should consult your advisors. The Defiant is not responsible for lost funds. Please use your best judgment and exercise due diligence before interacting with Smart Contracts.
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