Measure blockchain. How important is the TVL indicator

Measure blockchain. How important is the TVL indicator and how to calculate it correctly Correct calculation of the TVL indicator can provide information about the investment attractiveness of a cryptocurrency project We explain the importance of the indicator, how to calculate it correctly, and how to use it when assessing the investment attractiveness of blockchain projects

Total value locked (TVL) is one of the key indicators that help to understand the value of a service, protocol, or application running on a blockchain. The use of smart contracts in such applications allows us to rethink traditional solutions in the field of finance by automating contractual logic, without requiring an intermediary in the form of familiar financial institutions (banks, exchanges, or others).

Smart contracts provide the development of decentralized finance (DeFi). Due to the transparency of the blockchain as a public ledger of transactions, the TVL indicator allows seeing the number of funds involved in a single smart contract, as well as in a whole ecosystem of applications based on the blockchain (for example, on Ethereum). TVL acts as the main indicator, demonstrating the interest of the audience in a particular protocol, which is called a decentralized application (decentralized application, dApp).

How TVL is calculated

As an example, you can take one of the largest decentralized exchanges (DEX) - Uniswap. It became a pioneer in developing automated market makers (AMM), thanks to which users got the opportunity to exchange tokens without resorting to intermediaries.

Anyone can deposit funds into Uniswap’s liquidity pools, which represent paired tokens. Pools for such token pairs, such as ETH/USDT, lock up users’ funds, turning them into liquidity providers (liquidity provider, LP). When other traders want to exchange a token (USDT or ETH), they connect to the corresponding pool to use its liquidity. Liquidity providers, in turn, receive a percentage of the token conversion.

Each liquidity pool has its own TVL, showing how much total cryptocurrency funds in dollar equivalent have entered the pool. If you take the total amount of funds in each of the pools on Uniswap, you can determine the total liquidity of the exchange. Similarly, you can combine all the liquidity pools of other networks that also support Uniswap - Arbitrum, Polygon, Optimism, Celo, and others. As of early July, the total value of all locked tokens in all Uniswap pools is $4.11 billion, according to DefiLlama service.

A similar process of calculating TVL can be applied to such lending protocols as Aave or Curve, as they use the same principle of combining liquidity smart contracts. However, TVL does not take into account unpaid loans and returns that liquidity providers earn on deposits. Instead, TVL reflects only the value of deposit smart contracts. If you calculate TVL not for a specific protocol, but for a whole blockchain network (for example, Ethereum), it will include the total amount of TVL of all applications. As of July, the TVL of all dApps in the Ethereum network is $26.77 billion - about 60% of the entire DeFi market.

Why TVL is important

TVL clearly shows the value of deposits and people’s interest in a particular protocol or blockchain network. Similarly, when one bank receives more deposits than another, it means that the first bank is more popular.

In addition, TVL allows for assessing the overall condition of a particular protocol. If it holds more funds, it means that it has higher liquidity and can operate more efficiently. Since in decentralized finance, liquidity providers are users themselves, this is extremely important for market stability. Lack of liquidity leads to significant delays and increased commissions when exchanging tokens.

Moreover, significant demand or an attempt to exchange too large an amount on a decentralized exchange can cause fluctuations in token prices, resulting in failed transactions. That is why slippage percentages are set for each pair of tokens in the liquidity pools. For example, if the price of a token rises above 0.3% when exchanging, the transaction is canceled.

A lower TVL in a dApp or blockchain means less stability of money circulation. This can lead to a decrease in the size of the reward for liquidity providers and a deterioration of the overall condition of the protocol.

How reliable is TVL

If the market capitalization of a dApp is higher than its TVL, it is considered that the protocol is overvalued. At the same time, if you divide the capitalization of the protocol by its TVL, and the ratio is less than one, you can say that the protocol is undervalued. However, the ratio of market capitalization and TVL for DeFi services is often dynamic.

Market capitalization depends on the price of the native token of the service, multiplied by its total circulating supply. For Uniswap protocol, such a token is a UNI governance token. Its price is usually influenced by market hype, token listing on exchanges, protocol updates, and other significant events.

Since at the time of publication, TVL at Uniswap is lower than its capitalization ($4.11 billion versus $4.127 billion), it is slightly overvalued. As a rule, any platform with TVL less than $1B should be considered a risk.

Another factor that can distort TVL as an indicator of project value is the activity of so-called whales. These are investors or organizations that have significant capital in crypto assets. They are able to increase or collapse the TVL of a project with just one large deposit or withdrawal.

In this regard, it is worth paying attention to the total number of users of the protocol or blockchain. One of the best resources for getting information is DefiLlama or dashboards on the Dune analytics service. For example, this is what a dashboard for Uniswap looks like.

Due to the growing popularity of airdrops, - giveaways of tokens as a reward for users for activity in blockchain projects at an early stage - ecosystems of services that are expected to issue tokens inevitably face artificial activity boosts. Airdrop hunters use bots and farms from thousands of accounts to maximize actions in protocols, expecting to get a larger share of the airdrop.

Since this one way or another requires financial injections from them, their total activity can greatly inflate the TVL of a project candidate for an airdrop. According to representatives of some such projects, such an indicator as developer activity (number of updates in code) can be more objective than TVL. You can track developer activity in project repositories on GitHub or through the Developerreport service.

Measure blockchain. How important is the TVL indicator

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