DeFi industry broke out: TVL indicators are facing three challenges

Decentralized finance (DeFi) has become one of the most popular topics for discussion in the encryption field, with dozens of new projects being launched every month. In essence, DeFi applications support the creation of automatically executed smart contracts. Generally speaking, these smart contracts facilitate the issuance, lending, trading, and management of encrypted assets.

In view of the wide range of DeFi applications, it is difficult for us to measure its adoption from the overall concept of DeFi. After all, transactions and loans are two completely different operations, and they are not comparable. To solve this problem, the industry has adopted an indicator called “TVL” (Total Value Locked) to measure the adoption of DeFi projects.

Whether it is a loan or transaction DeFi application, almost all users need to deposit encrypted assets (such as stable coins) as a pledge. The TVL of the DeFi protocol can be simply understood as the sum of the value of all collateral in the application. Therefore, through TVL, we can compare lending markets (such as Aave) and decentralized exchanges (such as Uniswap).

Since 2019, DeFi has experienced exponential growth. TVL has become a standard for measuring the actual adoption of DeFi, and it is also one of the most important indicators on Coin Metrics (open source blockchain data and analysis projects). In this article, I want to share some factors that affect the accuracy of TVL in the calculation, and some deficiencies in using this indicator to evaluate DeFi protocols.

We have summarized the three major factors that hinder TVL from becoming a robust indicator.

1. Total 

The agreement is quickly updated and iterated, and the total amount of pledge is difficult to calculate

Decentralized finance is still in its early stages of development, and new protocols and applications appear almost every day. Among these new projects, some are just re-engravings of existing projects, and the other are entirely new designs. When valuing a certain blockchain, the more projects carried on this chain, the more difficult it is to evaluate.

Some DeFi agreements can raise billions of dollars in collateral within a few days, which is a blockbuster. For example, in September 2020, according to Sushiswap, which was created by Uniswap, its TVL rose from a few thousand U.S. dollars to more than 1 billion U.S. dollars overnight.

DeFi industry broke out: TVL indicators are facing three challenges

Sushiswap’s TVL skyrocketed at 9.7. Source: Coin Metrics

How to explain this amazing growth? In its essence, the incentive mechanism in the DeFi protocol is highly permeable. In the example of Sushiswap, users who bought its native token SUSHI in the early stage will get more revenue, so so much money will flow into this nascent project overnight.

This kind of incentive mechanism is a pioneer and may be imitated by countless projects since then. With the continuous emergence of new projects, it is almost impossible to track all pledges on a blockchain in real time and accurately. The frequency with which the new agreement is launched is too high, which will naturally lead to a low evaluation of TVL by data providers. Take Ethereum as an example. To accurately calculate the TVL of Ethereum, data providers must repeatedly re-evaluate the old data to calculate new agreements and pledges. As the new agreement is launched faster and faster, it becomes increasingly difficult to keep accurate estimates of the project’s TVL.

In addition to the issue of new agreements, another issue is that existing agreements may also change. In order to incorporate these changes into the calculations, new versions of existing agreements and contract deployment must also be continuously monitored. For example, Uniswap is already the third iteration, and the pledged assets tracked by each version are slightly different. Therefore, Uniswap’s TVL is the total amount of pledge of its 3 versions, which must be evaluated separately.

In the future, DeFi may stabilize around a set of norms or standards. Once standardization is achieved, it will be much easier to calculate the new protocol. But standardization is not a panacea, because there is no guarantee that all protocols can strictly follow the standard. As we have seen in the implementation of the ERC20 standard, there are still many variants that require manual review. Therefore, in the short to medium term, when it comes to new protocols, the standardization of DeFi is unlikely to bring a qualitative leap to TVL analysis.


Pledged assets are diverse and difficult to accurately price

The DeFi protocol can support almost all types of assets as pledge. Although some agreements limit the types of pledges, there are also many agreements that do not.

DeFi industry broke out: TVL indicators are facing three challenges

2020.1.1-2021.7.21 The number of assets that can be pledged in DeFi continues to increase

Data includes Uniswap v1/v2/v3, Sushiswap, Curve, Aave v2, Compound, Maker

The data in this chart does not reflect the entire DeFi industry. It only contains data on several mainstream DeFi protocols, and the type of assets involved is limited to ERC20 tokens. Nonetheless, this data gives us a glimpse of the rapid growth in the types of pledges in the DeFi industry and the impact of the tokenization trend.

The sheer size of collateral types complicates value estimation. All these assets can be traded on multiple platforms, from centralized, off-chain exchanges to decentralized, on-chain protocols. Therefore, collecting price data from these places has become a difficult task, but it has to be done, because only in this way can the assets used as pledges be accurately priced by the index value on each platform.

Even if the data provider generates index values ​​from all trading venues, it is difficult to calculate all the data based on the collected surface value. Just like the problem of correctly calculating the market value of encrypted assets, the pricing data in the DeFi liquidity pool may be manipulated, which will ultimately undermine the accuracy of value evaluation.


Assets can be pledged repeatedly, and calculations may be repeated

Finally, the most subtle but most important challenge facing TVL is to understand the composition of pledged assets. When evaluating the TVL of an agreement, one might assume that pledged assets can only be used in the agreement. In other words, pledged assets are “locked”.

However, from the perspective of the design of the DeFi market, this assumption is wrong. DeFi can create asset derivatives to achieve “re-pledge”. Simply put, the pledged assets in one application can be used in another application, or in other applications, and so on, repeatedly pledged. There are some DeFi applications specifically designed to support remortgage and provide users with leverage. Although this is nothing new, it may affect people’s understanding of “lock-in”.

In short, some of the assets used as collateral in DeFi applications are derivatives, which represent existing claims on other collateral. This triggers a multiplier effect that can greatly increase the valuation of TVL, because both “real” pledged assets and re-pledged assets are counted, and existing TVL calculation methods cannot distinguish between the two. Therefore, according to the agreement, the pledged assets may be double-counted.

To illustrate this point, consider the following example:

The user deposits $1,500 worth of WETH into Maker and gets $1,000 worth of DAI (the pledge ratio is 150%).

Then the user deposits the newly minted DAI and USDC worth 1,000 USD into the USDC-DAI pool of Uniswap V2. In return, users will receive LP tokens, representing their $2,000 shares of liquidity in the pool.

Finally, users can pledge these LP tokens to Maker again, and get another DAI of $1,960 (the pledge rate is 102%).

In simple terms, TVL can be calculated like this:

DeFi industry broke out: TVL indicators are facing three challenges

A more complicated method is to use only $1,500 of WETH and $1,000 of USDC as “real” pledges, and the final calculation result of TVL is $2,500. This method does not calculate claims on other pledged assets, such as DAI (loans generated by pledged assets) and Uniswap DAI/USDC LP tokens (representing claims on Uniswap V2’s DAI/USDC liquidity).

This adds additional complexity, because repeated pledges add implicit leverage to the TVL value.

4. Is there a better DeFi indicator?

In order to better explain and properly measure the DeFi system, we can treat DeFi assets as new asset-backed securities (ABS). ABS is a financial derivative, which represents the claims on the pledged asset pool. In the DeFi field, these derivatives provide the basis for the trading, lending and management of encrypted assets. Compared with the traditional financial system that issues ABS, DeFi attempts to improve asset transparency and realize automated risk management.

In this case, TVL measures the total size of the leveraged market. As stated in this article, TVL is misleading because it is amplified by the multiplier effect of leverage, is highly price sensitive, and lacks integrity.

For the above reasons, before we conduct TVL valuation on our own, it is important to distinguish between real pledged assets and re-mortgage assets. Similarly, tracking TVL in the native units of the agreement is also important because it eliminates price sensitivity and better demonstrates the current state of application development. In addition to better calculation of TVL, there is another potential indicator, which is similar to DeFi’s “open positions”, but it is simpler. This indicator calculates the total number of contracts that support the application, not the value.

5. Conclusion

In short, TVL (Total Value Locked) may seem simple, but it is complicated. The 3 words that make up TVL represent the 3 challenges it currently faces:

“Total” means to track all versions of the protocol, even versions on multiple chains (such as Ethereum) and Layer 2 (such as Matic, Fantom).

“Value” means finding a stable price for thousands of assets that can be pledged.

“Locked” is actually a misnomer, because in most protocols, the flow rate is very fast. This also means clarifying the connections between each asset to avoid double counting.

The DeFi industry needs to integrate better methods to measure the development of its applications, and we look forward to better indicators.


Posted by:CoinYuppie,Reprinted with attribution to:
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