What is Total Value Locked in DeFi? TVL Definition

Investing
Updated: 8th Oct 2021
Written by Andrew
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Going down the DeFi rabbit hole will expose you to countless new terms and metrics. Among those, few are more important to understand than “Total Value Locked,” or TVL.

Here’s all you need to know about TVL.

Brief Background on DeFi

Before getting to TVL, let’s quickly cover DeFi. Essentially, DeFi is blockchain-based finance that uses smart contracts on decentralized blockchains to let people:

  • Trade cryptocurrencies like ETH and Solana
  • Speculate on an asset’s price movements
  • Lend and borrow money
  • And even earn interest in a savings-type account

DeFi is attracting some of the smartest minds the world has to offer — the industry is moving at lightning speed. This rate of innovation is creating tons of value, which brings us to TVL.

What is Total Value Locked (TVL)?

TVL represents the total value of the assets currently staked by a protocol, secured by a DeFi platform, or locked in a smart contract.

For most DeFi platforms, TVL directly affects the interest yields for users – more assets equal higher yields – and the ability of a lending market to supply liquidity to borrowers.

To use a more familiar analogy, let’s take crypto out of the equation and think about a traditional brick-and-mortar bank

The bank holds $1 million in all of its members’ savings and checking accounts. In this case, the bank’s assets under management — the bank equivalent of TVL — would be $1 million dollars.

That is $1 million that the bank can “borrow” from to lend mortgages, personal loans, and other financial products.

In return, the bank shares a small portion of its loan profits by depositing interest earned into your savings accounts.

As such, the bigger its assets under management, the more loans it can give, and the more interest its members can earn.

TVL works similarly using decentralized assets (cryptocurrencies) instead of more traditional (fiat) currencies.

>> More: Best Crypto Exchanges

How to Calculate Total Value Locked (TVL) Ratio

Calculating TVL is simple. To do so, multiply the amount of funds (for instance, the total number of coins) locked in a system, protocol, or contract by the current price of the asset. So, your equation would look like this:

(Total Number of Bitcoins in a Smart Contract) x (Current Price of Bitcoin)

To calculate the TVL ratio, you take the total circulating supply of the asset in question and multiply it by the current price. Then, you divide the result by the TVL, as such:

Calculate Total Value Locked

Total Value Locked Frequently Asked Questions

Why is TVL Important in Crypto?

The TVL ratio is primarily used to gauge the health of a DeFi protocol by determining a DeFi asset’s valuation. Usually, if the ratio falls under 1, it’s a sign of undervaluation. But if you go much higher, the liquidity pool is said to be more saturated, which can lower your returns.

Another way to consider TVL is the decentralized alternative to the P/E, or price-to-earnings, ratio in the stock market. Both metrics are calculated the same way, and both give you a pulse on the asset in question. However, you can’t just take the TVL or P/E ratios on their face; you have to consider the underlying asset to gain a full picture of the token’s worth or potential.

How Does TVL Ratio Affect Value?

Theoretically, the higher the TVL ratio, the lower the value of the asset must be to generate a bigger return. However, you also have to account for the asset itself. For instance, an asset with a TVL ratio of 0.1 may seem undervalued on paper – but if the platform doesn’t see much utility, that could account for the supposed undervaluation.

Why is TVL Important in Decentralized Finance?

When the TVL of a DeFi app rises, it tends to gain three things:

  • Liquidity
  • Popularity
  • Usability

These all translate to rising confidence in a DeFi platform or dApp (decentralized application), which strengthens the underlying system. However, a rising TVL ratio can also reflect a price increase of the locked tokens, so accounting for nuances becomes crucial.

Bottom Line: What is Total Value Locked (TVL)?

Total Value Locked is one metric by which decentralized financial platforms can be measured. By taking an asset’s TVL ratio, you can begin to determine its popularity, usability, and liquidity, which can translate proportionally to your potential returns.

However, you can’t look at TVL in a vacuum. As with traditional assets, you need to consider the platform, the security, and other underlying factors too.

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Andrew
Andrew
Andrew is an editor-writer living and working in Southern California. While he’s previously focused on editing for financial publications, he’s now dabbling in the writing pool as well. Hobbies include listening to podcasts, and learning about all things financial. (Just don't ask him about logarithms.)