Understand the total lock-up value (TVL) indicator

DeFi has become one of the hottest topics in the industry, and dozens of new DeFi projects are launched every month. DeFi applications make it possible to create financial contracts that can be executed automatically. In general, these contracts facilitate the issuance, lending, trading, and management of cryptographic assets.

In view of the wide range of DeFi applications, it is difficult for us to measure its adoption from the concept of DeFi. After all, trading and lending are very different in operation and difficult to compare. To solve this problem, the DeFi industry has adopted an indicator called “Total Value Locked (TVL)” to measure the popularity and strength of DeFi projects.

Whether it is a loan or transaction DeFi application, almost all users need to deposit cryptographic assets (for example, stable coins) as pledges. The TVL of the agreement is the total dollar value of all pledges in an application (no matter what type of function it belongs to). With TVL, we can compare currency markets (such as Aave) with decentralized exchanges (such as Uniswap).

Since 2019, the scale of the DeFi industry has grown exponentially. TVL has become a de facto standard for measuring DeFi adoption, and it is one of the most important indicators on Coin Metrics. In this article, we will share some of the challenges in accurately calculating TVL and the main disadvantages of using TVL to evaluate DeFi protocols.

In the end, we summarized the three main challenges that prevent TVL from becoming a robust indicator.

Under the diversity of agreements, the “total amount” becomes a mystery

DeFi is still in its early stages of development, and it will witness the birth and death of protocols and applications every day. Some of these newly launched DeFi projects are just re-enactments of existing protocols or new versions of existing systems, and others are brand new. In the overall valuation of a smart contract blockchain, the more projects carried on this chain, the more difficult the valuation will be.

Some DeFi agreements became famous all at once, accumulating pledges worth billions of dollars in just a few days. For example, Sushiswap, cloned from Uniswap, became famous in September 2020, and its TVL skyrocketed from several thousand U.S. dollars to more than one billion U.S. dollars overnight.

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Why is there such an astonishing increase? In essence, the incentive mechanism of the DeFi protocol has a high degree of scalability. The sudden emergence of SushiSwap was able to attract billions of dollars in pledges in a short period of time because it introduced the native token SUSHI and adopted a radical issuance mechanism to benefit early adopters.

This approach created a precedent that could be repeated indefinitely. Due to the frequent occurrence of protocol cloning, it is almost impossible to track all pledges on a blockchain in real time without fail. Data providers such as Coin Metrics must choose which protocols to track TVL separately, because integrating the TVL of each protocol requires some human labor.

Due to the frequent launch of new agreements, all data providers have naturally low valuations of the total value of pledges for all DeFi applications. In order to accurately calculate the TVL of a platform (such as Ethereum), the provider must constantly re-evaluate the previous measurement data to reflect the new types of protocols and pledges. As the new smart contract platform is rushing to DeFi, the endless new agreements make it difficult for data providers to accurately estimate the TVL of the entire agreement.

In addition to the issue of high frequency of new agreements, another complication is that existing agreements may also change. In order to count these changes in, data providers must continuously monitor the deployment of new versions and contracts. For example, Uniswap is currently in its third iteration, and the pledge tracking method for each version is slightly different. Therefore, Uniswap’s TVL is the sum of the pledge value of each version, and the data provider must evaluate the pledge value of each version separately.

In the future, the DeFi industry may stabilize around a series of specifications or standards. Once standardization is achieved, it will be much easier to integrate new protocols. However, standardization is not a panacea, because we cannot ensure that all protocols strictly adhere to the standard. As we have seen, with the vigorous development of the ERC20 standard, there have been many variants that still require manual review. Therefore, considering the release speed of the new agreement, in the short to medium term, DeFi standardization will not allow data providers to achieve a qualitative leap in data analysis.

Under the diversity of pledges, “value” becomes a mystery

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

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-The above figure contains data for Uniswap v1/v2/v3, Sushiswap, Curve, Aave v2, Compound and Maker-
The figure above shows the lower limit of the types of assets used as pledges in DeFi applications. The data does not reflect the situation of the entire DeFi industry, because it does not include all DeFi protocol data, and the type of assets involved is limited to ERC20 tokens. Nevertheless, this data can give us a glimpse into the trend of tokenization and the impact of the rapid increase in the types of pledges in the DeFi industry.

The wide variety of pledges complicates valuation. All these assets can be traded on multiple platforms, including centralized off-chain exchanges and decentralized on-chain protocols, etc. Collecting price data on these platforms has become a very difficult task, and it is not scalable like protocol integration. At the same time, this is what has to be done in order to accurately price the assets used as collateral based on the index value of the trading platform.

Even if data providers have enough bandwidth to generate indicator values ​​based on data from all trading platforms, it is difficult for them to directly use the collected par value to calculate. Just like calculating the market value of cryptographic assets, the price data of DeFi liquidity pools also has the risk of being manipulated, which ultimately affects the accuracy of value evaluation.

Coin Metrics reference exchange rates and other sound price sources provide at most the prices of assets in the top hundreds of market capitalization. The current prices of the remaining assets must be estimated based on the data of the exchanges on the chain, but the estimation results are not necessarily accurate, because we cannot ensure that such assets have a high enough trading frequency, or the liquidity of the exchanges on the chain is a natural inflow of.

Under the prevalence of re-pledge, “lock-up” becomes a mystery

Finally and most easily overlooked, one of the important challenges that need to be solved when using TVL is to understand the composition of the assets used as pledges. When evaluating the TVL of an agreement, one might assume that each unit of pledge value is exclusively owned by the agreement. In other words, the locked assets of this agreement are only used within this agreement and not used in other agreements.

However, from the perspective of the design of the DeFi currency market, this assumption is wrong. DeFi allows people to create asset derivatives to achieve re-collateralization. In short, an asset that has been used as a pledge in one application can also be used as a pledge in another application, and then repeatedly pledged. There are some DeFi applications designed specifically for realizing re-staking in order to provide users with leverage. Although this is nothing new, it is contrary to the common understanding of “lock-up”.

In short, some assets used as pledges in DeFi applications are actually creditor’s rights certificates against another pledge. This creates a multiplier effect, which greatly increases the valuation of TVL, because both the initial pledged assets and the re-collateralized assets are counted. The currently adopted TVL calculation method cannot distinguish between the two. Therefore, according to the agreement, the value of the pledge may be greatly overestimated.

To clarify the above point, let’s look at the following example:

  • The user deposits $1,500 worth of WETH into Maker and borrows $1,000 worth of DAI (the pledge rate is 150%).
  • The user deposits the borrowed DAI together with USDC worth 1,000 USD into the USDC/DAI pool of Uniswap V2, and then obtains LP tokens representing the corresponding liquidity share in the pool.
  • The user pledged LP tokens to Maker and borrowed $1960 worth of DAI (the pledge rate was 102%).

In simple terms, TVL can be calculated as:

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However, a more complicated calculation method will only treat WETH worth 1,500 USD and USDC worth 1,000 USD as “real” pledges, and finally conclude that TVL is 2500 USD. This calculation method does not count the assets representing the claims of a certain pledge, such as DAI (pledged loan) and Uniswap DAI/USDC LP tokens (representing the claims on the liquidity behind the Uniswap V2 DAI/USDC token pair).

This introduces additional complexity, because staking behavior will add implicit leverage to TVL.

Looking for better DeFi metrics

In order to better understand DeFi systems and reasonably value them, we can understand DeFi assets as a new type of asset-backed bonds (ABS). ABS is a financial derivative that represents the right to claim a basket of assets used as pledges. In the DeFi field, these derivatives provide the basis for the trading, lending, and management of cryptographic assets. Compared with traditional financial systems that issue ABS, DeFi attempts to increase transparency and automate risk management.

In this case, TVL measures the overall size of the pole market. As stated in this article, TVL is misleading because it is exaggerated by the multiplier effect brought about by leverage, is highly price sensitive, and lacks overallity. Without knowing the specific multiplier, we cannot measure the health of the system, and most importantly, cannot analyze the sensitivity of the system to price shocks. For DeFi systems, price sensitivity is important information.

In view of the above-mentioned reasons, we must first find a way to distinguish the two cases of initial pledge and re-staking before conducting TVL valuation. Similarly, we have to use “native value units” to track TVL, so as to eliminate the impact of price sensitivity and better understand the development of the application. Its dollar value). In addition to finding a better valuation method for TVL, we also need to calculate another interesting indicator: the total number (not value) of contracts that support an application-equivalent to DeFi’s “open contracts”.

Of course, it is quite challenging to solve all the above indicators at once. In order to better realize the automated data collection process, we are building a new set of tools to analyze smart contract data in a more scalable way. Taking into account the challenges of calculating the overall valuation, our DeFi indicator will focus on application-level risk management, as well as transaction data from well-known AMMs.

in conclusion

In general, TVL is not so reliable on the surface, but a deceptively complex indicator. Behind every word that makes up TVL is a challenge:

“Total” means to track all versions of a protocol, as well as the version of the protocol on multiple underlying blockchains (e.g., Ethereum, Binance Chain) and multiple Layer 2 (e.g., Matic, Fantom).

“Value” means finding a reliable price for each of the thousands of assets that can be used as collateral.

“Locked” is actually a misnomer, because in most agreements, the inflow and outflow of liquidity is very fast. This also means that we need to clarify the relationship between each asset to avoid double or triple counting.

The DeFi industry needs to integrate better methods to measure the development of DeFi applications. This will be a collaborative process, so we look forward to contributing better indicators while learning from the community.

 

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/understand-the-total-lock-up-value-tvl-indicator/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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