For many novice cryptocurrency traders, the absence of middlemen in decentralized finance (DeFi) is both an allure and a worry. There are no counterparties to intervene and control network behavior because DeFi’s decentralized applications (dApps) rely on blockchain technology.
Positively, users now have total control over their digital assets. However, DeFi’s peer-to-peer and privacy features make it vulnerable to security risks, including fraud and breaches.
One of the most popular methods for screening DeFi dApps and identifying the most dependable choices is to look at each platform’s total value locked (TVL). You’ll be more prepared to make secure decisions with your portfolio if you understand what TVL in cryptocurrency is.
What’s Total Value Locked in Crypto?
TVL is a measure that indicates the total amount of cryptocurrencies and other digital assets placed on a blockchain or decentralized application. TVL represents a real-time snapshot of assets committed to a specific Web3 protocol.
Users deposit bitcoins into blockchain-based “smart contracts,” which provide DeFi services such as intermediary-free lending and trading on decentralized exchanges.
So, because TVL primarily tracks the user deposits locked up in those smart contracts, it can provide information about a project’s present treasury when monies are held on the blockchain.
Why Is Total Value Locked Important?
Compared to centralized crypto platforms, DeFi lacks regulatory certifications and third-party control. Although this enables a trustless environment for traders, it also calls into question each protocol’s reliability and liquidity.
Reporting TVL allows DeFi blockchains and dApps to demonstrate the overall health of their projects. High TVLs are frequently associated with favorable characteristics such as strong investor trust, high utility, and better security.
Low TVL in DeFi protocols indicates lower user adoption, increasing the likelihood of scams and pricing inefficiencies such as slippage.
So, by comparing the TVLs of various DeFi protocols, crypto traders may receive immediate, actionable insights and better analyze the risks associated with alternative offerings.
What Are the Limitations and Risks of TVL?
Despite its widespread use, TVL is not necessarily an accurate metric. Here are the current constraints of using TVL to evaluate dApps:
- Lack of standardization: There is no standard method for calculating TVL; hence, each dApp utilizes its own definitions. This means that TVL estimations for different platforms may include or omit different digital assets, making direct comparisons difficult.
- High volatility: TVL is very volatile due to its reliance on volatile assets like Ethereum (ETH) and global crypto market cap fluctuations. TVL fluctuations can be influenced by market trends rather than a certain protocol’s effectiveness.
- Oversimplification: A seemingly “good” TVL may mask additional issues, such as inadequate security audits or governance inequities. Rather than relying too heavily on TVL, traders should incorporate it into a broader analysis.
- Potential to increase vulnerability: High TVL can attract unscrupulous actors, making dApps more vulnerable. Any dApp with a higher-than-average TVL requires enhanced protection against exploits and losses because it is more likely to become a target.
How Is TVL Calculated?
To calculate TVL, add the total value of assets held in a protocol’s smart contracts. This comprises deposits made to liquidity pools, tokens staked for incentives, and assets used for lending and borrowing.
dApps translate cryptocurrency values to fiat currency equivalents (usually USD) for convenience.
The simplest TVL computation involves subtracting total withdrawals from total deposits. For example, if a dApp received $500 million in deposits and $100 million in withdrawals, its current TVL is $400 million.
However, when DeFi protocols provide more complicated capabilities such as lending, staking, and borrowing, they frequently employ the following equation:
- TVL = total supplied assets + total staked assets minus borrowed assets.
Assume that a platform has $100 million in supplied tokens, $20 million invested in its native token, and $30 million borrowed. Its TVL will be determined as follows:
- TVL = $100 million + $20 million – $30 million = $90 million.
3 Key Considerations when Using TVL to Evaluate Crypto Platforms
TVL is a useful snapshot, but it should not be the only factor you evaluate when comparing DeFi alternatives. To determine the protocol’s reliability, assess its security, incentive structure, and user trust.
1. Assess Security
High TVLs across long time periods often indicate that a protocol is well-established and extensively used. However, dApps can artificially inflate their numbers by using short-term incentives or sophisticated token schemes to create a false feeling of legitimacy.
DefiLlama, a third-party aggregator that tracks TVL across the Web3 ecosystem, provides an unbiased perspective for cryptocurrency investors. Traders also consider third-party security assessments and team member transparency to gain a fuller view of a dApp’s reputation.
2. Compare Yield Opportunities
Traders may utilize TVL in conjunction with a DeFi platform‘s advertised yields to assess whether the incentives are sustainable.
For example, a platform promising extraordinarily high returns with a low TVL raises red flags, but modest yields and an increasing TVL indicate that the protocol has the necessary support to provide consistent payouts.
3. Identify Growth Potential
If TVL rises over time, it may signal more interest and acceptance of a specific dApp, which could lead to more opportunities and improved security. So crypto traders may use TVL trend analysis to investigate the growth potential of DeFi-related tokens.
Although it is a more speculative use case, using TVL to find growth prospects in the crypto market may assist traders in identifying interesting projects early on and evaluating how a particular DeFi protocol compares to competitors.
Closing Thoughts
Total Value Locked (TVL) is no longer a good indicator of growth as DeFi spreads throughout chains. It is now a flawed indicator that frequently misrepresents actual liquidity due to double-counting, shaky data pipelines, and incentive-driven inflows.
Verifiable and standardized metrics like Total Value Redeemable (TVR) and Verifiable TVL (vTVL), frameworks that distinguish actual, native capital from synthetic activity and let anybody check data immediately on-chain, are the key to the future of DeFi analytics.
