TVL as a key metric for assessing DeFi projects

Do you rely on TVL as a key metric for assessing DeFi projects?
Read this article first!

Over the multiple discussions I have had with Family Offices, Wealth Managers and Financial Institutions in the last few months, I have realised two things:

1. The majority of them see investments in blockchain assets as a relevant way of diversifying their portfolio WHEN the macroeconomic backdrop weathers the current energy/CPI/Ukraine crisis.

2. Most of them know very little about what is actually behind the metrics they are considering, in order to proceed to their investments.

I believe the widest misconception is around a metric called Total Value Locked (TVL) - used when it comes to considering and evaluating the adoption of a given Decentralised Finance (DeFi) project.

The present article is not meant to be a comprehensive explanation of what DeFi is about, but rather, a glimpse into what can go wrong when a metric like TVL is blindly relied upon in the allocation of capital to the DeFi sector.

DeFi and TVL; what are these?

DeFi is a sector of the Blockchain industry that mimics financial services (e.g. issuing, lending, trading, managing or creating synthetic representations of assets) in a decentralised fashion - i.e, without the need for intermediaries like banks, custodians, central securities depositories,
etc.

These activities are made possible by smart contracts which are, effectively, a set of pre-defined, shared and agreed-on set of rules (in the form of an algorithm) that are executed independently by the stakeholders interacting with a given DeFi project (more commonly called DeFi “protocol”).

Consequently, through the activities above mentioned that they support, DeFi protocols are accruing “value” (we will dissect this particular term later in this article) denominated in US dollars. For instance, it is necessary to “lock” (more on this term later on too) a certain amount of cryptocurrency tokens in order to issue a certain amount of dollars in the form of stablecoins. Should the dollar value of the collateral drop, the position would be automatically liquidated.

The main point here is that a certain amount of dollar value needs to be placed in the protocol so that it can support the activities that are being carried out by the stakeholders. Intuitively, the more popular and used a protocol is, the higher the dollar value that is being placed in it.

The term “Total Value Locked” was coined to refer to the total amount of US dollar-denominated value in the assets used to power the activities supported by a given protocol. That is why people mistakenly started to consider the TVL metric as an unbiased and clear measure that would reflect the strength of a DeFi project. Let’s see what is actually behind the term TVL.

A breakdown of each letter in T-V-L

The difficulty starts with “Total” as the DeFi sector is still very young (it emerged in 2020) and scattered, hence many protocols tend to have a very erratic life span on various Layer-1 blockchain ecosystems.

Aave - one of the most prominent DeFi protocols in the Lending category - is now deployed on multiple Layer-1 blockchains: Ethereum (where it started), Avalanche and Polygon to name a few. More protocols are created every week, added to or removed from Layer-1 blockchains regularly, duplicated from other DeFi protocols and then forked out into new ones and, to top it all off, a significant number of protocols are discontinued for various reasons when others evolve in new versions with different rules for counting for the assets used in the protocol.

How do you account for something that is so fleeting and shape-shifting in so many aspects, while evolving across so many different blockchains? It is impossible to keep track of everything; therefore, rules reducing the scope of what needs to be counted and considered are necessary. The first rule that is usually followed by the ones calculating and monitoring a TVL for a given blockchain is to limit the number of related DeFi protocols and assets only the most serious ones (a few hundreds). Systems that track the TVL do not scale easily precisely because of how scattered protocols and assets are (and also because it requires quite tedious manual work).

Equally complicated to assess is the “Value” of the assets used as collateral in a DeFi protocol. Here again, the variety of assets that can be used is very wide, and protocols like Sushiswap onboard more assets every month. Assets can be stablecoins, cryptocurrencies, digital securities, or NFTs for instance. The reader needs to bear in mind that these assets of various types are traded across multiple platforms (both centralised and decentralised) 24/7, which makes the task of consistently retrieving the pricing data - and hence the calculation of the value (denominated in USD) at stake for a given protocol - very difficult. Here, we are not even fully considering the fact that prices of assets in DeFi can sometimes be manipulated on some platforms (usually the decentralised ones), which brings an additional layer of complexity when it comes to cutting through the noise to measure the overall value at stake.

Last but not least, the “Locked” in TVL is - in my opinion - the most deceptive term out of the three.

Within the DeFi sector, it is easy (and even encouraged) to re-use an asset several times as a collateral to carry out different investment activities. The most astonishing part is that there is no limit as to how many times one can use a given asset as a collateral; which is in stark contrast with traditional financial markets where there are restrictions and structures in place to prevent banks and managers from using the same asset in multiple collateralised positions. These restrictions and safeguard structures only make sense when you are aware that the lack of them is one of the reasons that led to the collapse of Lehman Brothers.

To speak in very clear terms, collateralised assets in one DeFi protocol can also be used as collateral in one thousand other protocols, therefore artificially inflating the dollar value of assets that are supposedly “locked”. One could argue that all that needs to be done is to distinguish between “first-hand” collateral assets and reused collateral ones to calculate the TVL; however, this is easier said than done. As we saw above, DeFi protocols are numerous, scattered across different blockchains and provide different (i.e non-standardized) features regarding the multiple assets they can deal with. All of these elements make it highly difficult to track what is used as a hidden collateral.

Conclusion

When you are in charge of allocating capital into different projects and assets, a natural reflex is to compare things with one another; but, it is very important to bear in mind that not all projects, assets and collaterals are comparable.

There is a variety in DeFi applications and the danger resides in using one general metric (let alone a flawed one as we saw above) to compare them.

This being said, before getting lost in the ocean of data and metrics that DeFi can bring, what matters first is to identify clearly what the category of the project you are considering is (e.g. Exchanges, Lending platform, Asset Management platform, Issuance of Stablecoins or Derivatives). Depending on the category, some metrics will be relevant, while others will not be. We have seen what the shortcomings of the TVL metric are.

To avoid relying solely on TVL, other DeFi protocol metrics that could be considered include:

(i) the growth of the number of active wallets on a given protocol over a period of time (I personally like considering quarter and semester timeframes); and

(ii) the growth of the number of applications integrating a given protocol over a period of time.

However, given the amount and depth of information that would need to be shared, it is certainly a topic that we will cover in upcoming articles.

Anthony will guide you on how to navigate the growing sector of blockchain. He will be delighted to give a 30 minutes free Q&A interview to deal with any specific question you may have.

Send an email to [email protected] to book an appointment.