With its many opportunities for income generation, decentralized finance (DeFi) revolutionized the financial industry. As a result, numerous ways exist to increase profit potential and generate passive income. However, since the adoption of DeFi, financial market experts have been looking for ways to measure its performance. So, how can you determine the actual value of DeFi investment? The most common metric in the DeFi ecosystem is the total value locked (TVL).

What is Total Value Locked (TVL)

Total value locked (TVL) is the total value of all assets deposited in DeFi protocols that have earned rewards, interest, new coins and tokens, fixed income, etc. This means TVL is the number of users' funds deposited in a DeFi protocol. These funds could be invested in the project for various purposes, including staking, liquidity pools, yield farming, and lending. TVL does not show the number of outstanding loans or the interest rate on these deposits. It merely displays the deposits' current value. Therefore, the total locked-up value will change if investors withdraw or add money to the project.

However, the TVL of a project does not only change when users make new deposits or withdraw their assets. Instead, it is constantly changing to the fluctuating dollar value of all cryptocurrency assets in the protocol. Its native token mostly denominates asset deposits in a DeFi protocol. Thus, when the protocol's native token appreciates, so does its TVL.

The characteristics that determine a DeFi protocol's success, such as high liquidity, acceptance, and usability, are reflected in a TVL. As a result, an increasing TVL is advantageous to investors as well because they receive returns and liquidity that are significantly higher. However, a lower TVL means less money available, which means investors will not receive enough rewards if they choose to stake the protocol's token.

TVL is a critical metric for DeFi platforms that specialize in lending and swapping. It is significant because it is the most essential DeFi indicator. Therefore, a project's popularity is indicated by the number of users actively using it. In addition, it is a valuable tool for assessing a project's reliability.

How to calculate TVL?

Similar to market capitalization, TVL can be compared to other metrics to provide evaluation context. The market cap to TVL ratio provides a straightforward comparison. Market capitalization demonstrates the "value" that the market "believes" a project to have, while TVL demonstrates the actual value that has been invested in a platform.

Consider a trader who decides to invest in the DeFi protocol and contributes $2000 worth of assets from his portfolio to a pool that verifies and approves blockchain transactions for a set period in exchange for rewards. He invested $1000 of his cryptocurrency asset in a crypto lending platform for interest while remaining on the same DeFi protocol. He also decided to add $2000 to the pool to help traders exchange tokens and earn commissions. As a result, the trader's total locked valve in the protocol would be $5000.

However, TVL is calculated by multiplying the total number of locked tokens by the asset's price. The TVL metric can help determine whether a project is overvalued or undervalued to its fundamental value before investing in any DeFi-related project. To do this, divide the asset's market capitalization by the total value locked.

To calculate a DeFi protocol TVL ratio, there are factors to consider: the current price of the tokens, the maximum supply in circulation, and the number of locked tokens. The first two will calculate the locked assets' market capitalization and divide them by the locked tokens. TVL Ratio = Total Market Capitalization of Locked Asset / Total Locked Value.

However, if a project accepts deposits in multiple tokens, the TVL for each token must be calculated and added to obtain the project's TVL. For instance, if a DeFi protocol permits you to stake three different tokens; Token A, Token B, and Token C. You will need to multiply the total number of Token A staked by the current dollar value of each Token A (i.e., if you stake $1000, and the present value of each token is $2.35. You will have $1000 x $2.35 = $2350). Similarly, the same procedure would be repeated for Token B and C. The results of all three token types would then be added up (Token A + Token B + token C = TVL) to determine the TVL for the entire protocol.

How Different DeFi Protocols Calculate TVL

To calculate the TVL of DeFi protocols, the metric must be measured across different product categories. Each DeFi protocol has its own set of structures, and these differences affect how TVL is calculated.

DeFi Lending

Defi platforms offer loans to users based on the collateral they place through the Defi Loan process. On these platforms, the lender and the borrower's assets deposited in the smart contracts are used to calculate the TVL.

Decentralized Exchanges

Decentralized exchanges (DEXs) are DeFi protocols that make it easier for traders to complete crypto transactions. Because smart contracts govern DeFi protocols, these exchanges aid in trading DeFi assets by providing services such as liquidity pools. Regarding DEXs, the TVL is the total amount of funds held in the DEX smart contracts, including funds in liquidity pools.

Derivatives

A derivative is a contract that allows a buyer and a seller to make predictions about the future value of a financial asset without actually purchasing it. These are assets whose value is derived from another underlying asset, and their use in Defi has proliferated in recent years. In derivative protocols, the TVL is determined by the value of assets deposited in smart contracts, which serve as collateral for synthetic assets and financial contracts.

Payments

These are tools meant to give users options for completing transactions more efficiently and quickly. Regarding payment protocols, TVL is determined by the number of assets that have been put in smart contracts and moved to the sidechain of the payment protocol.

Assets

Asset refers to stablecoins and cryptocurrencies that have been tokenized using smart contracts. The quantity of tokenized coins is used to calculate the TVL in assets. The exchange between these tokenized assets and the underlying asset is 1:1.

How to track DeFi project TVL?

Instead of manually calculating the total value locked on a protocol, with the help of metrics provided by third parties in the DeFi space, DeFi projects TVL can be monitored. The most well-known service that keeps tabs on DeFi providers and ranks them according to Total Value Locked is DeFi Pulse Metric. The metric monitors the exchange of Bitcoin, Dai, and Ether within a protocol. The DeFi indexes are powered by TVL, which calculates their weights based on the value locked in the project's smart contracts. DeFi Pulse calculates the total assets locked in a smart contract and multiplies them by the dollar value the asset could sell for on the open market. On the other hand, the metric does not require the double-counting of assets. The DeFi Pulse only counts new cryptocurrency assets created by a deposit channeled elsewhere, and the metric does not consider other digital assets locked.

Final Takeaway

TVL is a reliable metric of a project's present performance. However, just like every other indicator, TVL has flaws. Sometimes, it can give a distorted picture of the vitality and activity of a specific DeFi protocol. Therefore, despite TVL being a crucial indicator, it should not be considered alone. Instead, it should be carefully examined and paired with other metrics when deciding whether or not to stake or invest in a particular platform. This means you should consider the DeFi industry's volatility while assessing the TVL metric.