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Ask CryptoVantage: What is Total Value Locked in Decentralized Finance?
One of the main draws in cryptocurrency is Decentralized Finance, where people can earn much higher rates of interest on their holdings than through traditional centralized means like savings accounts through their bank, or bonds.
These decentralized services are able to pay out higher rates of interest because all of the digital asset value locked into the platform’s smart contracts (in the form of cryptos like Bitcoin and Ethereum) is provided by users.
This value is called Total Value Locked or TVL. This value is then weighed against an asset’s market cap to get a Market Cap to TVL ratio.
But how is this ratio calculated, how does TVL ratio affect a decentralized service’s value, and how can you use TVL ratio to help determine if a decentralized financial service is under or overvalued? We will answer all of those questions in this edition of Ask CryptoVantage.
How TVL Ratio is Calculated
There are three main factors to take into consideration when calculating and looking a decentralized financial service’s market cap TVL ratio: Circulating Supply, Max Supply and current price.
Let’s use Uniswap as an example, as it is one of the most well known DeFi providers. Uniswap currently has a circulating supply of around half a billion UNI, with a max supply of 1 billion UNI.
In order to get the current market cap of Uniswap you simply multiply the circulating supply by the current price of UNI. Then to get the TVL ratio you take that market cap number and divide it by the TVL of the service and you get the TVL ratio.
For Uniswap it is over 2, meaning there is only about half of the value locked into the platform as the platform is valued at. When you take into account the max supply the TVL ratio becomes even higher at over 4.
How Does TVL Ratio Affect Value (in Theory)?
From a purely theoretical standpoint, the higher the TVL ratio, the lower the value of an asset should be, this is not always the case in reality (like with Uniswap), but there are more factors than solely TVL that affect a DeFi token’s price such as the number of services available and utility of the token. In any case, theoretically you should want the price to be closer to 1 or under 1, because the more saturated the pool, the lower your returns.
How can you use TVL ratio to help determine if a DeFi asset is under or overvalued?
One of the easiest ways to use TVL ratio to help determine if a DeFi asset is undervalued or overvalued, is simply by looking at the ratio. Generally speaking, if it is under 1, it is probably undervalued. But there are caveats here. Venus (XVS) for example has a very low TVL ratio of under 0.2, in theory this should mean XVS is undervalued, but if you actually dig into XVS and its role in the platform, it does not have very much utility, and this helps explain the price of the asset. Conversely, if it is well over 1, it might be overvalued.
The key thing here is to do research into the DeFi asset you are interested in and then also use TVL as a tool to help you decide what may be undervalued (since you do not want to buy anything overvalued). Look at how it is used on the platform, how it is distributed, and just the general tokenomics of the asset.
