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Defining a new simple indicator based on TVL that can be used to better assess risk in DeFi
Risk management has become a hot topic after the UST collapse. Users and institutions are seeking ways to evaluate how safe DeFi protocols can be. Inherently, there is not a direct metric that can hint at the likelihood of an attack happening to a protocol. Most of the industry relies on due diligence over technical processes such as verifying that smart contract auditories are independently performed by reputed companies or through measuring indicators such as how much has the protocol operated without any exploit or how much liquidity is present in a protocol, like Total value locked (TVL). Individually, these metrics are not enough to measure risk.
Risk Vectors
First it is worth recalling how we evaluate risk vectors at IntoTheBlock. We have written extensively about it, basically the origin of an exploit in a protocol can be either technical, like a code implementation fault, or economic, like taking advantage of an inner working of the protocol that was not expected. Hacking in DeFi is a term often misused, since it is often referred in the news media as hacking to the act of exploiting programmatically a DeFi protocol, which both could have been due to a fault code implementation or by taking advantage of an oversight in the designed economic model.
Both smart contracts auditories and verification techniques tend to focus more on the technical side than in the economic side, maybe forgetting that the major incentive for an exploiter is the amount of capital that is locked in an smart contract.
TVL alone is weak
TVL in a protocol is the best metric to portray the incentive that a hacker might have over exploiting a protocol (“bug bounties” play a key role here, but that is a topic we will leave for another day). Comparing the current TVL of different protocols in a single day is very misleading and leads us to perceive falsely which DeFipProtocols could be safer than others.
For example, what would one consider safer? DeFi Protocol 1 that reaches $1 billion in TVL in a week or DeFi protocol 2 that has achieved an average of $500M during a year. Both have never been exploited, but the second protocol has been exposed for longer with a higher reward to be hacked.
The Incentives to exploit a protocol increase the longer a DeFi protocol is exposed to a high TVL. So, the sign that a protocol perdures over time without being exploited with a high TVL, can be a good metric to assess risk. This idea of evaluating TVL over time has been hinted by many before, and recently Curve tweeted exactly about that:
Source
Although we agree with how it can be measured, we believe that economic risks expose a protocol both to endogenous risks such as exploits from a malicious party as well as exogenous risks such as large market movements that put the protocol in a situation where its users lose their funds.
Practical Application
Measuring the impact of a value over time is the same as geometrically calculating the area that it embodies, or it is mathematically equivalent, to solving an integral of TVL over time:
Maker TVL via IntoTheBlock x Defillama.
The larger the area, the larger the protocol has been exposed over time. This is equivalent to the mathematical formula of an integral such as:
Simply, if we evaluate this through time we would get a series similar to:
This means summing up the TVL value recorded per day for each DeFi protocol : TVL(Day 0) + TVL(Day 1) + TVL(Day N)… In the case of Maker, we would get 6852.9B of TVL over time.
Comparing DeFi Protocols
By computing this value for several top DeFi protocols we can compare how they perform:
Although the TVL over time metric is aggregating daily dollar amounts, the value is not showing the dollar symbol to not mislead the idea with the current TVL of each protocol. We added Anchor because at some point it achieved an all time high of $17B. When putting that value into perspective over time it can be seen how back then still was performing lower than the usual top DeFi protocols. A similar case would be Lido, which topped at $20B and became the top 1 DeFi protocol by TVL but has done so throughout a shorter time frame
In this way, we presented how just using TVL as a safety indicator can lead to misleading results. The result is a simpler and richer approach that improves quantitatively how to evaluate risk based on TVL on DeFi protocols.
TVL Over Time As A Better Safety Indicator In DeFi was originally published in IntoTheBlock on Medium, where people are continuing the conversation by highlighting and responding to this story.
Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not reflect the views of Bitcoin Insider. Every investment and trading move involves risk - this is especially true for cryptocurrencies given their volatility. We strongly advise our readers to conduct their own research when making a decision.