What Value in Total Locked Value?

Total Value Locked (TVL) is one of the more interesting metrics to emerge from the Decentralized Finance (DeFi) ecosystem. TVL is the total amount of cryptocurrencies or DeFi tokens locked in smart contracts in various DeFi projects at that point in time.

For example, the TVL of a DeFi-lending project will be a total of the market prices of tokens used as collateral by the borrower in its smart contracts. Similarly, the TVL of a staking project is equal to the value of a user’s staked tokens in smart contracts on the platform.

At the beginning of 2020, the TVL in DeFi protocols was roughly $605.61 million. As of this writing, it is $198.33 billion. Impressive as the figure sounds, it is still difficult to glean much meaning from it.

At the individual token level, TVL is the total market for that token and answers important questions related to it: how widely is the token used? What services use it? And what activities is it used for? The more demand for a given token for various activities, the greater its velocity in the DeFi ecosystem, and, consequently, the higher its total value. Investors use the TVL value as a data point to decide where to put their money.

In some respects, the dynamics of currency trading markets can also be applied to the DeFi market. Thus, a strong currency is one which has maximum demand and the biggest market. But currency markets have been around for decades, despite allegations of being manipulated, are considered mature. Given the infancy of the DeFI market, TVL calculations leave much to be desired.

Problems With Valuing TVL 

Simply put, the value locked in a given protocol is the sum of prices of coins trading at decentralized exchanges and in staking, lending, and liquidity pools. There are two underlying assumptions behind these calculations. The first one is that separate tokens are used for each transaction in what are purportedly independent and discrete activities. The second one is that a higher TVL number indicates a corresponding increase in the number of such tokens. Both assumptions are incorrect.

It is easy to double the use of each token across many platforms. For example, using Wrapped Bitcoin or Ethereum means that that you can use the same cryptocurrency, albeit in wrapped form, twice on different blockchains. 

Moving around tokens between various DeFi services also multiplies the overall TVL figure. For example, you might use Ethereum’s ether for a Collateralized Debt Position (CDP) on MakerDao to purchase its algorithmic stablecoin Dai. That Dai can, then, be used on a staking platform to purchase more ether from a liquidity pool. Or you can use it in a flash swap from the same pool. The total figure for Dai or ether within the DeFi ecosystem might remain the same or increase marginally due to these transactions. However, the constant shuffle between different platforms ensures an inflation of TVL figures.    

Of course, multiplying volumes on a platform to spur adoption is not exactly a novel idea. (Algorithmic trading is also a worry in mainstream markets). It might even succeed if there was inherent value or utility to the tokens. But that is not the case for a majority of DeFi tokens. Except for ether, other tokens within the DeFi ecosystem are still to demonstrate use cases beyond staking and lending.

Consider the case of Terra. According to DeFi Llama, it ranks second, after Ethereum, in TVL on its protocol. Terra is attractive to investors because it offers unrealistically high interest rates. Those interest rates induce more people to lock up their tokens in its smart contracts and increase its TVL. When new investors evaluate DeFi opportunities, they will put their bets on Terra leading to a virtuous circle of capital infusion into the protocol.

But the protocol’s tokens do not have use cases outside of its own protocol, much less in the real-world. There is the promise of future use cases, one in which algorithmic stablecoins like Terra become popular investment opportunities. But that future may or may not materialize.

And, so it is that the protocol with the most value locked is Ethereum. The dominance of Ethereum within the DeFi ecosystem is such that it determines the figure for TVL. When ether’s prices rise, the total amount of value locked in DeFi increases. When they fall, the TVL figure decreases.   

To be sure, the problems described above are not unique to the DeFi ecosystem. For example, gold is often rehypothecated to the extent that there is considerable skepticism about the total quantity of gold available in the world today. The house of cards that is the financial derivatives marketplace is also susceptible to crashes during times of high leverage.

When it was introduced to the world, DeFi’s rallying cry was a reinvention of financial infrastructure for transparency and to prevent future crashes. But TVL makes a mockery of that assertion. It is too early to say whether DeFi will succeed in reinventing traditional finance. With metrics like TVL, though, it sure seems a lot like it.

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