What is TVL in DeFi? Why is it important?

tvl

What is TVL in DeFi? Why is it important?

Total Value Locked (TVL) is the value of assets locked in a DeFi protocol in the form of staking, yield farming and loan collaterals. TVL has been a yardstick for measuring how usable and popular the entire DeFi ecosystem or a particular project is. In addition, it can be used as a signal for the overall DeFi market conditions. In this article, we discuss what TVL is, why is it important and how to check this useful indicator.

What is TVL?

Let’s begin by noting that the decentralized finance (DeFi) ecosystem is based on the blockchain network, where there is no central authority. This means the contributors (or stakeholders, if you will) who run the system are in a decentralized network. To have an up-and-running decentralized financial system, the contributors put (lock) their assets in a liquidity pool. The liquidity pool can include amounts that are staked, farmed or put as loan collateral. TVL measures the total value of these locked assets. 

But how is TVL calculated? It is a pretty straightforward mathematical procedure. The amount of TVL is calculated by multiplying the assets locked as collateral in an ecosystem by the current price of the assets. Simply put, we can say:

Total Value Locked = invested assets * the assets’ price.

Here, the key parameter to look for is that TVL depends on the transaction fees of the Ethereum network. The reason is that DeFi is, in essence, built on the Ethereum platform, and the transfer fees of DeFi tokens are paid with the help of the Ethereum network. However, the critical point is that there is a negative correlation between Ethereum network fees and TVL. This means that when the world’s second-biggest cryptocurrency transaction fees increase, the total value locked decreases.

In addition, the overall market conditions and the first coin of the cryptocurrency market, i.e., Bitcoin, also impact TVL. When you stake your tokens, based on the contract that you have signed, you cannot access your tokens for a while. So if the market conditions are bad, fewer investors will want to lock their tokens because they believe their value will decrease if their assets are locked somewhere. Nonetheless, long-term investors still see staking and yield farming as one of their viable options during a bear market.

Why is TVL important?

As DeFi grows in interest amongst investors, new projects are introduced daily. With so many new projects coming into existence, hearing about scam projects is not surprising. One needs to check some indicators to ensure a project is trustworthy and healthy. Market capitalization and the volume of trade can be good indicators to look into before investing in a DeFi project. But TVL is another factor that has a special meaning in the world of DeFi. The higher the TVL, the more reliable and healthier project. In addition, it can be used as a signal for the overall DeFi market conditions.

In addition, some investors use TVL to see if the project they intend to invest in is overvalued or undervalued. This can be done by calculating the TVL ratio. Three factors are critical for calculating the TVL ratio: 

  • project’s supply
  • maximum circulating supply
  • current price

To get the TVL ratio of a DeFi project, do the following two steps:

  1. Multiply the project’s supply by its current price. This gives you the total market capitalization of that project.
  2. Divide the market cap by the maximum circulating supply.

If the resulting figure is below 1, the project is undervalued and thus attractive to investors. But if it is above 1, it probably is overvalued and less attractive for investment. 

Conclusion

TVL is the value of total assets that are locked in the world of DeFi. TVL can act as a benchmark for the overall conditions of the DeFi ecosystem and individual projects. In addition, TVL is a reference measure for the usage, value and credibility of a DeFi protocol.

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