Why TVL is a Key Health Indicator for Blockchain Platforms

Blockchain is still in its relative infancy, which means there is a lot of change ahead as it figures out what it can do. People, companies, and notably investors, are seeing the tremendous potential as an investment vehicle and a core utility of many use cases.

If you are sold on crypto, then the next big question becomes where you should invest. How do you tell different platforms apart in terms of their success and potential value? And how do you know if a platform is on its way up (or down)?

Let’s take a look at one of the most popular metrics for assessing a DeFi platform: Total Value Locked (TVL). It would be helpful to understand how it works, how it compares to other traditional trading metrics, and how to gain insight that can help you make better decisions on your investments.

Definition

So what is TVL? Generally speaking, a DeFi protocol’s TVL is the sum of the coins that are currently being used in the protocol. Staking is a big part of this, as is lending/borrowing and liquidity pools. While coins are being deposited and withdrawn constantly, a snapshot of the balance becomes the TVL, and reflects the amount of overall activity happening.

Interestingly, TVL can also be used to measure a specific coin/asset. This is the amount being locked across all platforms, and is an indicator of how the larger community is using it. Moreover, a version of TVL called the TVL Ratio is also helpful for looking at a specific asset. It is measured by taking the total market cap as the denominator, and the total amount locked as the numerator. This shows the extent to which the asset is being actively worked, and can provide a number of insights.

TVL vs. Market Cap

While TVL is a DeFi-specific metric, how does it compare to the more traditional Market Cap metric? The Market Cap of a platform’s token is its total supply, but it could also be calculated as the total circulating supply. Both can offer at least some insight if compared accurately to another token, but as with many things in crypto, it gets a bit complicated.

Because some assets can be staked and the staked versions can be used for other activities, the market cap could potentially be double counted enough to affect the cap’s true value.

However, even with its flaws, market cap is helpful in gauging an asset’s potential (and therefore the protocol’s potential). TVL, on the other hand, shows what is happening right now, how popular a DeFi platform is at the moment, and with the TVL ratio, how saturated the asset is.

Interpreting TVL

While the definitions are actually straightforward, the interpretation of TVL can get—if not complex, then at least nuanced.

For one thing, a platform’s TVL growth rate is a very strong indicator of an expanding community, people getting wind of a performing platform, and as it continues growing, an indication that it has real value across a diverse set of investors.

For example, the Cronos ecosystem, though starting in late 2021, quickly amassed over 350k users, 120 Web3 Dapps, and achieved a $3.7 Billion TVL. The interpretation? In this case, we know that Cronos already had a strong community through its founder programs, and had developed momentum that culminated in a spectacular launch.

That said, the growth happened afterward, and in a trend that indicates strong word of mouth endorsement, this TVL grew at an exponential rate.

So we have TVL, which represents the amount (or ratio) of current activity in an ecosystem. What levers cause the TVL to change? In addition to the amount of crypto brought in and taken out, spikes and dips in those asset prices also cause the TVL to fluctuate.

This can be thought of as the level of stability for the platform. A less volatile pricing behavior (and hopefully a trend that points steadily upward) shows that the platform is picking stable, strong assets to manage. If there is volatility, but at a summary level the trend is fairly stable, this is seen as a good sign that the portfolio of assets is balanced.

Interestingly, there is some indication that an asset’s TVL Ratio can be a sign of a changing business model. If the ratio is very high, it means that the asset’s volumes are out there and being traded.

However, if the ratio is high it means that there are liquidity pools that might be getting full, causing the yields to lower as more users are staking and working their tokens, and the rewards for early contributors diminish as more investors join in. However, if despite this the TVL continues a steady rise, it may indicate that new traders aren’t motivated solely by high yields, and that some other form of utility in the token/platform is driving them to participate.

One final insight gained from TVL is—at least when the market cap is known—is when the two are compared. By analyzing the market cap and TVL difference, general insights can indicate a possible over- or under-statement of the market value; and the more extreme this difference is, the more it can indicate whether the token is priced accurately.

Conclusion

When investing in DeFi, it’s critical that you know what platforms and assets will provide you with the best benefit according to your needs and portfolio goals. Thankfully, even though the industry is young, there are metrics that can be used to gain insight on the potential of an asset, the current performance of the platform and/or the asset, and the likelihood that the asset is valued the way it should be.

With these tools, it should be much easier to identify which platforms and assets are worth investigating, and a great way to improve your odds of success in this ever evolving industry.