In many articles about decentralised finance, you will read the acronym TVL. But what does TVL stand for and how does it work? You will find answers to that in the article below.
What is TVL?
TVL stands for total value locked. It defines the spot value (usually denominated in USD) of all assets that are staked in a protocol. It’s generally used as an indicator of how healthy a protocol is. Assets staked in a protocol can be:
- Staked in simple yield protocols that pays out an interest rate on the deposited tokens, similar to a savings account.
- Staked in lending protocols as collateral for loans.
- In liquidity pools in an automated market maker exchange.
- As collateral for synthetic assets, futures contracts, and options.
- As liquidity for payment protocols that facilitate the transfer of assets from layer-two blockchains to the Ethereum mainnet.
In decentralised finance, the TVL locked would be the total value of all assets staked in the DeFi system. That excludes leverage created by these assets. Think of the funds a bank holds as a reserve when it engages in fractional reserve lending.
How is TVL calculated?
Since TVL is used to assess how healthy a protocol is, the total value locked of an asset can be interpreted as how much of the asset’s capital is utilised across the entire Defi ecosystem. In other words, you get an idea of how useful an asset is by looking at its TVL. The TVL Ratio is generally used to make the metric more comparable across different assets with different market caps. It is defined as:
TVL Ratio = Total market cap of locked asset / Total value locked
The market cap is either the total supply or the circulating supply. One problem with this ratio is that it is not 100% accurate since assets can be double-counted. For example, say, an investor stakes 10 ETH in a protocol and receives 10 Staked ETH (sETH) in return, and they use the 10 sETH in another protocol as collateral for lending. The investor inserted 10 ETH in the system, but both protocols will count 10 ETH each for their respective TVL, thereby inflating the real number of value in the system. Therefore, total value locked is not a completely precise way to measure how many assets are in circulation.
How useful is TVL?
By measuring the TVL ratio as the market cap of the locked asset divided by the value of assets, a lower TVL ratio could be seen as better since this implies that saturated staking pools will return a lower ROI (return on investment) per token. Hence, the higher the TVL ratio, the lower the value of an asset should be.
Not all tokens are created equal in DeFi, though. A token is impacted by more than just its price. For instance, its utility matters as well, as tokens that don’t generate yield make the TVL metric almost useless. In conclusion, while being an imperfect way to measure protocol health, TVL is still a useful indicator for investors.
