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13 February 2020

How to interpret Total Value Locked (TVL) in DeFi

This report is part of a weekly series where we explore and evaluate the fundamentals of Open Finance. You can view prior reports here.

If you’ve been following crypto over the past year, you’ve likely seen this chart measuring the amount of value locked in DeFi. Since most applications require capital to be deposited, often in the form of loan collateral or liquidity in a trading pool, it has been used as the de facto metric to show the growth of decentralized finance. Recently, the total value locked surpassed the $1 billion mark, a milestone that was as celebrated as the $10k mark for the price of bitcoin. While the growth in TVL is a positive sign for the burgeoning world of DeFi, it needs to be taken with a grain of salt and interpreted correctly. To state the obvious, this figure is highly reliant on the price of ETH. As its price has doubled since the beginning of the year, so too has the value locked in DeFi despite any there being any other meaningful contributors to its growth.

Another slightly less obvious flaw is that it is also heavily influenced by the price of SNX. Currently, there is $125m of SNX locked and towards the end of last year, it accounted for over one-fourth the total amount in DeFi. Not only did the price increase ~3,000% in 2019 but the figure is also somewhat misleading as its an inaccurate measure of the true value of that amount staked. For one, there is 80% of the total supply staked so if one were to sell that it would be worth orders of magnitude less. And to make matters worse, SNX is relatively illiquid trading less than $1m per day, so the slippage on trying to realize that value would be immense.

That being said SNX is still an important piece of the DeFi puzzle and should be taken into account in some format. Unfortunately, there has not been a metric released to account for these shortcomings, but there is an easy remedy for the overreliance on ETH price by simply looking at the amount of ETH locked up. Viewing it from this lens, the biggest difference is seen at the start of 2020. The number of ETH locked has only increased by 5% compared to 70% when denominated in USD. Other than that though, the trend is still clear - the value in DeFi has been increasing substantially over the past year.

So now this begs the question, what is that really showing us? More often than not, it is used to show that the general world of DeFi is growing. There is a fundamental problem with that thinking though, and that’s because value locked can increase without any new users or value coming into DeFi.

Take for example someone who owns ETH and wants to lever up. They can go to Maker and use it as collateral to draw additional Dai to then buy more ETH. Now let’s say that counterparty was also an ETH holder but wanted to earn interest without being exposed to price risk. So they transferred their ETH for Dai and then lent that out on Compound. Another user who wants to arbitrage the difference in Uniswap liquidity pools and interest rates could then lock up ETH on Compound drawdown that Dai and place some Dai and its related trading pair into a Uniswap pool. You see where I’m going with this?

In all of these transactions, the amount of value locked is increasing, which shows these protocols are being used for their intended purposes. But does it mean DeFi as a whole is really growing? I’d argue its really just showing how the same money is being moved around the system. It doesn’t necessarily mean that there are new users and fresh capital entering the system. This isn’t all to say that TVL isn’t a valuable metric. I believe it is. But understanding it requires nuance as to how its actually being calculated and what it truly means in order to correctly interpret the number behind it. Another way to look at it is that the value locked in these systems demonstrates not the general growth of DeFi, but the increase in faith in these systems.

These assets locked have tangible value and related opportunity costs of other productive uses. If users opt to continue to inject and hold more capital into DeFi they are forgoing any other opportunities because they believe there is real value to be obtained that justifies the inherent risks. That shared belief in both the concrete and ideological value of using these permissionless networks is very much a part of what will contribute to the growth of DeFi and crypto as a whole. If this belief continues to grow it will capture the attention of others and could one day bring these systems into the mainstream.

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