What Is Total Value Locked?

Total value locked (TVL), in the context of cryptocurrency, represents the sum of all assets deposited in decentralized finance (DeFi) protocols earning rewards, interest, new coins and tokens, fixed income, etc. Because blockchain services are developed on peer-to-peer networks, there is no central authority to govern, build, or improve the ecosystem. Therefore, cryptocurrency investors themselves receive consideration for building these networks from the bottom up with their coins and tokens.

The metric is an important gauge of the overall DeFi market. Currently, TVL has reached a stunning $169 billion globally, with Ethereum deposits getting the biggest piece of the pie, compared to just $400 million two years ago. So what exactly are these DeFi protocols that compose TVL, and how can investors benefit from them?

Writing on a notebook with a Bitcoin logo and rising chart in the background.

Image source: Getty Images.

How is it calculated?

It's very simple. Let's say an investor connects their wallet to a DeFi platform and deposits $1,000 worth of crypto into a money pool to validate transactions on its native blockchain (staking) and receive rewards. Next, he lends out an additional $1,000 in crypto for interest on the same platform. Afterwards, he deposits $1,000 worth of coins in a money pool to provide trading liquidity for swapping between obscure altcoins and he earns trading commissions. If this were the only business the hypothetical DeFi platform was getting, then its TVL would be $3,000. That's all there is to it.

How to use the metric

Most DeFi platforms like Aave, PancakeSwap, and Uniswap issue namesake tokens so users can perform the aforementioned services. Hence, we can deduce whether or not these tokens are undervalued or overvalued by using the TVL as a gauge of fundamental value and then taking its market cap and dividing it by the TVL, similar to the price-to-book (P/B) ratio for stocks.

With stocks, the higher the P/B ratio, the more dangerous it is to buy in as there is little tangible value for investors to fall back on. Companies' market cap can exceed their book value the same way that the market cap for cryptos can exceed their TVL. The same philosophy for valuation applies here; the lower, the better. For example, Aave has a market cap-to-TVL ratio of 0.29, while that number stands at 2.40 for Uniswap and 0.85 for PancakeSwap. So by this gauge, Aave tokens are the cheapest out of the three.

What's more, one can also use the market cap/TVL ratio to evaluate the current state of investor psychology in the DeFi market. Dividing the total DeFi market cap by its TVL of $118.01 billion yields 0.70, indicating there's no imminent danger of euphoria. I would only start getting concerned when that value hits 3 or 4.

Finally, one can use TVL to measure the integrity of DeFi platforms themselves. Of course, we all want to earn high yields by depositing our tokens in DeFi protocols, but such offers from obscure, little-known platforms could very well be scams. Therefore, it's best to only use platforms with a TVL greater than $1 billion and audited by blockchain cybersecurity firms like CertiK. Its like how companies' financial statements are more trustworthy if auditors check them and the better their balance sheets, the more investors trust them. Overall, it is a critical metric for investors to understand if they want to either invest in DeFi tokens or take advantage of various lucrative services in the evolving ecosystem.

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Zhiyuan Sun owns shares of Aave, Ethereum, PancakeSwap, and Uniswap. The Motley Fool owns shares of and recommends Ethereum. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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