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Bulls, bears, and market watchers alike fixate on the total value locked (TVL) in DeFi as the ultimate indicator of platform health and ecosystem growth. Despite its widespread use, however, TVL is a flawed metric that's skewed by price volatility, doesn't equate to consensus or confidence, and doesn't always mean more transactions.
A better way to assess the health of a protocol is to consider additional metrics like active monthly users, audits, on-chain activity, and stablecoin-based TVL. This gives a more accurate picture of a project's popularity, growth, and risk.
Here's why: TVL is simply the total value of digital assets deployed across all DeFi protocols. However, because it's denominated in ETH (or other volatile assets), it's subject to the fluctuations of those underlying assets. Due to this volatility, market participants incorrectly believe that TVL, including staking, pools, and borrows, has dropped by over 80%, from a peak of $245 billion to $42 billion today. When normalizing TVL to account for the fall of asset prices, and including stablecoin-based TVL, the drop is closer to 50%.
TVL doesn't equate to protocol health
TVL doesn't equate to protocol health. A high TVL can simply mean that a protocol has hit a marketing hype cycle and users are flocking in, only to leave once the unlocking period ends. Worse yet, high TVL protocols can still be hacked, as was famously the case with the Ronin Axie bridge.
Users can be compromised even if the smart contract code itself is secure. This was the case with Terra Luna, the algorithmic stablecoin that de-pegged and collapsed, while staking users were locked in. And it happened earlier with Titan, leading the likes of Mark Cuban to lose hundreds of thousands of dollars.
High TVL doesn't mean more transactions, either. Once users flock to a protocol, it can become very tedious to continue using the app. Earlier this year, a DappRadar report highlighted that even as TVL rose, the number of transactions fell.
Standardizing TVL for ETH price volatility
TVL, or the total value locked in the smart contracts of DeFi platforms, is widely used to measure a project's popularity, the growth of the DeFi ecosystem, and assess platform risk. Stablecoins are an important tool for understanding TVL because they aren't subject to the volatility of ETH or other assets. This allows for a more accurate assessment of a project's value.
To do this analysis, we first need to make some assumptions. We assume that the price of ETH is the average of DeFi asset prices and therefore a leading indicator of the following analysis.
Then, we can compare today's ETH price with last December's to calculate the impact of price volatility on TVL. Back in December 2021, ETH peaked at $4,500. Today, it's trading around $1,280, a 70% decline. The peak stablecoin-based TVL was around $40 billion, and today it’s around $26 billion.
If we normalize December's non-stablecoin TVL, making it $205 billion, and apply the same 70% drop, we get a figure of $62 billion. Adding back in today’s stablecoin-based TVL, we get a total TVL of $88 billion.
Today's DeFi TVL stands at $42 billion, which is around 50% lower than the normalized TVL calculated above, rather than the reported 80% decline. A 50% drop is less than that of many publicly-traded tech stocks this year. For example, Facebook stock ($META) is down 70% this year, and crashed as much as 20% right after a bad earnings call.
Stablecoin-based TVL has held up remarkably well. In December, it made up 16% of the total TVL. Today, it's around 55%. This means that many users aren't leaving the ecosystem, they're simply swapping their ETH for stablecoins to avoid the volatility.
Moreover, the stablecoin-based TVL today is practically the same as where it was during the overall TVL all-time high. This is a strong sign of user confidence in the ecosystem.
The consequences of poor metrics in DeFi
The lack of reliable metrics makes it difficult for users to assess risk and make informed decisions about where to deploy their assets. The industry desperately needs better metrics that give a more accurate picture of platform health, growth, and risk.
Investors must be mindful of the limitations of TVL as an indicator, and use it alongside others to get a more holistic view of a protocol. In addition to normalized TVL, we should look at other leading indicators like active monthly users, audits, and on-chain activity.
If we don't have better metrics, we're in danger of making bad investment decisions, which could lead to more hacks and scams. We need to be careful not to repeat the mistakes of the past, where hype and marketing took precedence over investor safety.
About the author
Elie Azzi is the co-founder and CPO of VALK, building an ecosystem of powerful decentralized tools such as Merlin, the smarter DeFi portfolio tracker for retail and institutional DeFi investors. Elie was previously an entrepreneur in residence at R3 and a blockchain architect at BNP Paribas.
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.