The decentralized finance (DeFi) ecosystem has seen unprecedented growth since June 2020. To measure this growth, many tools rely on one metric: TVL (“total value locked”) or deposited value. However, this metric should be taken with a grain of salt, as we will see today.
TVL: the sacrosanct metric of DeFi
When talking about the DeFi ecosystem or a particular protocol, it is common to use TVL as a metric to measure the size and adoption of a protocol. Many sites provide tools to measure the TVL of a given protocol or the total TVL of the DeFi ecosystem.
In practice, the TVL represents the total assets that have been deposited on a given protocol. Indeed, most of the DeFi protocols require a collateral deposit to be able to take advantage of the proposed services. For example, DefiLlama currently estimates that the DeFi ecosystem is worth $111 billion, all blockchains combined.
Unfortunately, although widely used, this metric is neither accurate nor truly reliable.
A difficult metric to calculate
In an article published on July 27, CoinMetrics, a company specializing in blockchain data analysis, looks back at the various problems posed by the TVL as a metric for measuring the DeFi ecosystem.
First, CoinMetrics points out the difficulty of calculating this metric. Indeed, every day, new protocols emerge through the different blockchains with a DeFi ecosystem. As a result, it is almost impossible to effectively track the total value of the ecosystem, as adding new platforms proves to be a tedious task.
On top of that, there is the multiplication of collateralizable assets on these various protocols. Because when you say new protocol, most of the time you mean new cryptocurrency.
“The frequency of launching new protocols leads to a natural underestimation of the total value used as collateral in all DeFi applications by all data providers. In order to accurately calculate TVL for a platform, such as Ethereum, providers must constantly re-evaluate past measurements to reflect the addition of new protocols and collateral types.”
CointMetrics publication
The problem of re-hypothecation
However, the constant proliferation of protocols and collateralized assets is only part of the complexity of the LST problem.
As it stands, TVL computations assume that when an asset is deposited on a given platform, it is locked there and used only by said protocol. However, due to the composability of DeFi protocols, this assumption turns out to be wrong.
Indeed, the TVL calculations do not take into account the re-hypothecation phenomenon. In short, this means that collaterals deposited on one protocol can be used a second time on another protocol.
“There are DeFi applications specifically designed to allow re-hypothecation so that their users can benefit from leverage. While the existence of this phenomenon is nothing new, it should nevertheless challenge people’s understanding of what a ‘locked’ collateral represents.”
CoinMetrics publication
Consider the case of yield farming. In this situation, it is common to deposit assets on an MA, such as PancakeSwap. Subsequently, PancakeSwap issues tokens that represent the user’s deposit. These tokens can then be deposited on a second yield farming protocol to generate a return. Thus, the funds are accounted for in both the PancakeSwap TVL and the yield farming protocol TVL. As a result, the TVL of each of the protocols and the total TVL of the DeFi ecosystem on the BSC are in error.
Beyond user action, many protocols, such as Balancer, automatically reallocate funds deposited by their users to other DeFi protocols to increase perceived yields. In fact, the phenomenon we have just seen is further amplified.
Obviously, the lack of precision in this metric does not prevent the ecosystem from continuing to develop. Indeed, several protocols, such as SushiSwap, have just deployed a new version.
