A step-by-step guide to a key metric in DeFi
Total Value Locked (TVL) is one of the key indicators that help us understand the value of a smart contract protocol. Smart contracts mimic traditional finance by codifying and automating contract logic.
As smart contracts enable the development of decentralized finance (DeFi), TVL measures the amount of crypto funds locked through these programs. As a result, TVL is the primary indicator showing public interest in a particular protocol, commonly known 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 having 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, turning them into Liquidity Providers (LPs). If other traders want to exchange a token, either wBTC or ETH, they would tap into this pool to withdraw its liquidity. Each liquidity pool has its own TVL, which shows how much crypto funds have been deposited by people denominated in USD.
Source: Uniswap
LPs, in turn, get a share of this token swap. When all 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 locked value (TVL) of $5.18 billion as of October 2022.
Uniswap votes to launch V3 on zkSync
Leading DEX for Layer 2 deployment after raising $165 million in funding round
The same calculation process can also be applied to lending from dApps like Aave or Curve as they use the same principle of liquidity pooling in smart contracts.
Nonetheless, TVL does not take into account yields and outstanding loans that LPs’ deposits earn. Instead, TVL only reflects the value of smart contract deposits. When we move from dApps to the whole blockchain network like Ethereum, all dApp TVLs are taken into account. As of October 2022, Ethereum has $31.43 billion TVL.
Why is TVL important?
Total locked value measures the value of deposits and people’s interest in a particular dApp or blockchain network. When people put more money into one bank than the other, it shows that one bank is more popular.
At the lower dApp level, TVL shows the state of the log. When it holds more money, it has deeper liquidity that can serve more customers efficiently. Since the users themselves are liquidity providers in decentralized finance, this is crucial for robust markets. Otherwise, the lack of liquidity will cause significant delays in the token swap.
Additionally, too much demand that cannot be met will lead to token price movements, resulting in failed transactions. This is why you see the slippage tolerance percentages in the liquidity pools for each token pair.
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 circulation is less stable. This could then translate into lower rewards and the overall health of the log.
Is TVL trustworthy?
What if a dApp has a larger market cap than its TVL? In this case, it would indicate that the log is overrated. If we divide the protocol’s market cap by its TVL and the ratio is less than one, it is undervalued for the same reason.
Apart from that, this market cap/TVL ratio is dynamic, as we can see with the example of Uniswap.
Finally, the market cap value 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 impacted by social media hype, public listing, new protocol upgrades, etc.
Since Uniswap’s TVL is higher than its mcap, it is slightly undervalued. Typically, any platform with less than $1B TVL should be approached with a risk-taking mindset.
single insert
Besides the mcap/TVL ratio, another factor that can skew TVL as an indicator of value is whale activity. These wealthy 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.
Because of this, it makes sense to note the total user count of the protocol/blockchain. One of the best sources for this type of information is Dune Analytics. In the case of Uniswap, this statistic would fall under the community dashboard.
Disclaimer for the series:
This series article is for general guidance and information only for beginners participating in cryptocurrencies and DeFi. Nothing in this article should be construed as legal, business, investment or tax advice. Consult your advisors for all legal, business, investment and tax implications and advice. The Defiant is not liable for lost funds. Please use your best judgment and exercise due diligence before interacting with Smart Contracts.
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
Comments are closed.