Decoding DeFi TVL: A Comprehensive Guide to Measuring Decentralized Finance Economic Activity

In the world of crypto, the onboarding process for newcomers is one of the most difficult problems. Beginners struggle with terminology and metrics that sound completely foreign and new. Completely solving this issue is close to impossible as the crypto industry keeps evolving introducing new concepts, terms, and ideas. However, it is hugely important to know the basics. TVL is one of them.

In DeFi, total value locked is a metric that reflects the volume of funds (digital assets, fiat currency, and other valuables) staked or locked in a protocol, platform, liquidity pool, or a combination of them depending on the context. 

For instance, you may come across a TVL number for a single liquidity pool or a combined TVL for multiple protocols. When it comes to DeFi platform comparison, it is important to use comparable metrics. Judging the performance of a platform by comparing its combined TVL to a single liquidity pool is an incorrect approach that yields questionable results.

Understanding what constitutes a TVL metric and how to use it to assess the potential and current performance of any given project is incredibly important for any DeFi investor. In this article, we will cover the most important basics in detail.

Assessing blockchain economic activity

The overly complicated nature of the crypto market makes it hard to make correct assessments of any given asset even for seasoned veterans with years of experience. The ever-changing landscape of the industry also creates additional difficulties. Understanding what each of the metrics means in the grand scheme of things is incredibly important just like paying attention to nuance. Many decentralized finance metrics are rooted in technology and rely on data like transaction throughput, hash rates, and more. Others are purely financial.

Total Value Locked is one such metric that incorporates only financial data. While it only focuses on assets locked in certain protocols, it can be used to obtain a variety of insights. Here are some of the bits of information you can extract from a TVL number:

• Liquidity pool dynamic. If you are investing in a pool on a decentralized exchange or automatic market maker, you have to pay attention to TVL as it is often representative of the demand for the pool and the level of trust from other investors. Higher TVL pools usually produce the most reliable results yet APRs are generally lower as you don’t expose yourself to excess risks.
• DeFi protocol valuation. TVL does not represent funds available to a protocol to invest in its own development or salaries. It may also be disconnected from the market capitalization of the native token and its performance. For instance, LIDO’s STETH pool has a massive $31 billion TVL yet the LDO’s market cap is just over $1.6 billion. On the other hand, Suilend has a combined TVL of $565 million and a $108 million market cap.
• Market sentiment can be deduced based on the blockchain economic trends including the TVL dynamic. A steadily growing TVL often indicates that the community of investors is slowly warming up to the project and the growth is likely fueled by word of mouth. Sudden spikes may be caused by social media hype and marketing instead of strong fundamentals and actual performance.

TVL is an incredibly useful metric if you are interested in obtaining actionable data from the market. It is one of the best tools for crypto liquidity measurement in DeFi since DEXes with higher TVLs usually perform better and have more resources to create a healthy trading environment. For example, Uniswap, the biggest DEX, has a high TVL of $6 billion while processing up to $18 billion in volume weekly. At the same time, Meteora on Solana has a $284 million TVL and reaches less than $200 million in weekly volumes.

TVL in liquidity pool analysis

DEXes, Bridges, and AMMs have close to $70 billion in combined TVL. It is a solid chunk of the DeFi market. Investing in liquidity pools is a good way to generate consistent profits while avoiding excess risks. Total Value Locked alongside utilization is the most important metric when trying to identify the most reliable and consistent pools to invest in.

Since TVL calculation methodology is quite straightforward as it simply shows the sum of staked funds denoted in a reference currency (usually, US dollar), you can compare different pools effortlessly and receive an informative result. However, it is a good idea to compare pools from projects in the same category. Value locked in a DEX pool is qualitatively different from the same metric for a liquid staking pool although it is still one of the most reliable cryptocurrency investment metrics.

As an example, let’s compare two different pools from various DEXes:

While 30-day averages do not represent the true performance of any given pool, the rate of utilization and generated revenues affect the actual APY. It means that liquidity pools with higher TVLs and higher utilization perform better. When it comes to gauging the decentralized finance performance, TVL is a good indicator that often shows which pools have a higher chance of producing satisfying outcomes for investors.

You should never rely solely on a single metric but keeping them in mind while contemplating contextual information is quite useful in any form of analysis.

TVL is not the best metric to pick a good target for capital allocation but it is a necessary one to consider during the decision-making process. Assessing crypto market liquidity without comparing TVLs and trading volumes may lead to wrong prognoses and incomplete analysis.

The range of applications for the kind of analytical process relying heavily on this metric is limited as it has some drawbacks. Let’s take a closer look at a typical TVL and its potential weaknesses from the point of view of an investor seeking additional insights.

TVL as one of the cryptocurrency economic indicators

While the upsides of using this particular type of data are enormous as it allows investors to measure potential risks and estimate performance, it is true that it can be misleading in some cases. The methodology also plays a role here. Here are several important issues with how TVL is calculated:

• TVL is often the sum of all assets locked in a platform despite them representing both assets and liabilities making it harder for regular investors to assess certain parts of decentralized finance economics.
• The data may be reported by protocols themselves or collected by aggregators via API. However, results can be slightly different with disparities remaining unexplained. Often, only technically savvy investors can estimate the correct TVL number sourcing data from multiple platforms. Measuring blockchain economic activity with TVL is often an inappropriate approach as you may not use the freshest and most correct data.
• TVL is just a snapshot of a particular moment in time. Many protocols brag about locked assets without updating their marketing materials with actual data. At the same time, issues with security may present additional problems as locked assets may be not protected well enough to represent the true risk level for an investment like in the case of Terra Luna which lost over $60 billion in a couple of weeks.

You can use this metric in DeFi ecosystem analysis but do not rely on it too much and make sure to source data from several platforms.