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Decentralized finance is a great idea with potential to enable easy peer-to-peer (P2P) lending, cheap and fast remittances for unbanked populations and many other solutions – provided it achieves large-scale adoption. Since most DeFi applications require capital to be deposited, often in the form of loan collateral or liquidity in a trading pool – locking up value – the best measure of adoption so far is total value locked (TVL). This is the reasoning. But how sound is it really?
Putting TVL in perspective
TVL in DeFi recently broke though the US$ 1bn mark. This is undeniably a good sign for DeFi fans, yet it needs to be interpreted correctly. First of all, this figure is highly reliant on the price of Ether (ETH), whose price has doubled since the beginning of the year. As a result, TVL in DeFi has also spiked without any other meaningful contributors to its growth. It is also heavily influenced by the price of the Synthetix Network Token (SNX) there are currently US$ 125m of SNX locked. In late 2019, it accounted for over one-fourth the total amount in DeFi. Not only did the SNX token’s price increase around 3,000% in 2019, but the value is an inaccurate measure of the true value of the amount staked. SNX is also relatively illiquid, trading at a volume of less than US$ 1m per day, so slippage on trying to realize value could be immense.
But returning to the role of Ether, some revealing figures have been seen at the start of 2020. The amount of locked Ether coins has increased by 5% only, compared to a 70% jump in US$ value. This is clearly not an indication of DeFi adoption. The lesson is that value locked can increase without any new users joining or value growing in DeFi.
A case in point
Someone who owns Ether can go to Maker and use it as collateral to draw additional Dai and buy more Ether. If the counterparty is also an Ether holder, who hoped to earn interest without being exposed to price risk, he or she may have exchanged Ether for Dai and then lent that out on Compound. Another user who wants to arbitrage the difference in Uniswap liquidity pools and interest rates could then lock up Ether on Compound drawdown and put some Dai and its related trading pair in a Uniswap pool.
In the (granted) somewhat Byzantine example above, the amount of TVL increases, but does it mean DeFi is really growing? Or is money being moved around the system without new users and fresh capital entering?
So what now?
TVL is a valuable metric, but we need to understand how it is actually calculated and what it truly means in order to correctly interpret the figures. The assets locked have tangible value and related opportunity costs for other productive uses. In this regard, we should critically examine how assets are committed to DeFi projects. At the same time, let’s bear in mind that reaching a tipping point where DeFi becomes an attractive option and investment opportunity for the mainstream requires persistence. Even if the exponential traction gains suggested by US$ 1bn are over the top, incremental growth and increasing credibility look promising.
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