Investments should always be backed by thorough research and understanding. Before diverting your hard-earned money toward any asset, you should look at all the possible metrics. These include price-to-earnings ratios, historical returns, chart patterns, and so on.
An in-depth understanding of these metrics will help you ascertain an asset’s current value and future potential. Total value locked or TVL is another such indicator. It is an essential factor that investors should know and understand if they want to succeed in the decentralized finance space.
What is Total Valued Locked (TVL)?
Total value locked (TVL) is the amount of user funds deposited in a decentralized finance (DeFi) protocol. These funds could be vested in the project for several functions, such as staking, liquidity pools, or lending.
DeFi protocols are specialized and autonomous programs designed to address issues within the traditional finance industry. An example of a DeFi protocol is Uniswap — a leading decentralized exchange that allows investors to trade cryptos without any central oversite.
TVL does not indicate the number of outstanding loans or the yield these deposits earn. It simply reflects the current value of the deposits. Therefore, the total locked-up value will change if investors withdraw or deposit funds into the project. Plus, it constantly changes with the changing value of the US dollar.
DeFi protocols can operate on a single network or can be spread out over various networks. If they are spread out over multiple networks, they have an independent TVL on each network. So far, the largest network by TVL is Ethereum, with over five hundred projects currently onboard, as per a CoinDesk report. It accounts for almost half of the TVL in the DeFi industry.
Why does it matter?
TVL indicates the overall health of the DeFi market. The TVL of individual projects denotes the amount of investor faith in the protocol. A rapid increase in TVL shows that investors value the project, and more money is flowing through its network. It helps investors determine if a protocol is healthy and worth investing in.
A high TVL means high liquidity, high popularity, and high usability — the factors that define the success of a DeFi protocol. An increasing TVL also benefits its investors as they enjoy considerably higher liquidity and returns.
However, a lower TVL translates into lesser availability of money, which means the investors will not get enough rewards if they choose to stake the token of this protocol.
Investors can also use TVL to figure out if the native token of a particular protocol is undervalued or overvalued. A token can be overvalued or undervalued if its market cap is high or low relative to the TVL of the entire project/protocol.
Currently, the total value locked in the DeFi industry is a little less than $50 billion, with the MakerDAO protocol leading the table, as per data from DeFi Pulse.
The combined TVL of DeFi protocols has surged over the last couple of years. At the beginning of 2020, the combined Value was USD 630 million, with more than half of the share owned by MakerDAO. At the time of writing, the total Value of MakerDAO is nearly USD 10 billion.
How do you calculate TVL?
Calculating the TVL of a project is easy. Multiply the number of tokens deposited in a project by its current price in USD, and you arrive at the project’s TVL. If a project accepts deposits in multiple tokens, one will have to calculate the TVL for each token and then add them up to get the TVL of the project.
Next, to check if a project’s native token is under or overvalued, we need to calculator the TVL ratio of the project. For this, we need to divide the market cap by the TVL of the token. Market cap is nothing but the total number of tokens in circulation multiplied by its current price. An asset is undervalued if the TVL ratio is less than one and vice versa.
Is TVL accurate?
Like every other metric, TVL is not perfect. It can sometimes present a disproportionate image of the health and activity of a given DeFi protocol. This is because, DeFi protocols often have large investors known as whales who can sway the TVL of a project with a single deposit or withdrawal. This would give investors the wrong understanding of the project.
Sometimes, whales are also incentivized to hype a project by making significant investments. This can provide potential investors with an inaccurate reading of a project. Therefore, while TVL is important, investors must consider several other metrics to decide whether a token is investable or not.