Total Value Locked (TVL) has become an increasingly important metric for investors to consider when determining their crypto allocation. TVL tracks the amount of capital locked within a blockchain protocol, providing insight into the amount of investor trust and activity occurring within the network. By analyzing TVL, investors can make more informed decisions about which cryptocurrencies to allocate their resources towards and how much risk they are willing to assume.
What is Total Value Locked?
Total Value Locked is a term used to describe the amount of assets locked within a blockchain protocol. It’s a metric that is commonly used in the decentralized finance (DeFi) industry to track the growth and activity of various projects. TVL is calculated by adding up the value of all assets locked within a specific smart contract or protocol. These assets can include cryptocurrency tokens, stablecoins, and other types of assets that are deposited into the protocol.
TVL was first introduced in 2020 as DeFi projects began to emerge on the Ethereum blockchain. It was designed to provide investors with a clear view of how much trust and activity was occurring within these new decentralized systems. Today, TVL is used across a variety of blockchain protocols, such as Uniswap, Compound, and Aave, to name a few.
How can TVL help investors determine crypto allocation?
TVL can provide investors with valuable insights into the health and potential of a blockchain protocol. It gives investors a better understanding of how much capital is locked within the network and how many users are participating in the protocol. This information can be used to determine the level of trust and interest in the protocol, which can be valuable when deciding which cryptocurrencies to allocate resources towards.
For example, consider a DeFi protocol that has a high TVL. This suggests that the protocol is attracting a lot of user activity and investor attention. It also suggests that there is a significant amount of trust in the protocol, as investors are willing to lock up their capital within it. As a result, an investor may want to consider allocating a larger portion of their portfolio towards the cryptocurrency associated with that protocol.
On the other hand, a low TVL could potentially indicate that a protocol is not attracting much activity or investor interest. This could be a warning sign for investors, indicating that the project may not be as promising as initially thought. As a result, an investor may want to reconsider their allocation towards that cryptocurrency or take a more cautious approach.
TVL can also be used as a tool for diversification. By investing in a variety of blockchain protocols with varying TVLs, investors can spread out their risk and potentially achieve higher returns. Diversification can also help investors avoid investing too heavily in one particular sector or cryptocurrency, which can be risky.
Are there any limitations to using TVL to determine crypto allocation?
While TVL can be a valuable tool for investors, there are some limitations that must be considered. First, TVL only provides a snapshot of a protocol at a specific point in time. Market conditions can change rapidly, which could affect a protocol’s TVL and potentially impact an investor’s allocation decisions.
Additionally, TVL does not provide insights into a protocol’s long-term potential or the potential risks associated with investing in a particular cryptocurrency. Therefore, investors should consider other fundamental factors, such as the team behind the project, the technology being used, and the market demand for the cryptocurrency.
In conclusion, Total Value Locked can be a valuable tool for investors to consider when determining their crypto allocation. TVL can provide investors with insights into the health and potential of a blockchain protocol, as well as potential diversification opportunities. However, investors should also consider other fundamental factors when deciding which cryptocurrencies to allocate their resources towards. By doing so, investors can make more informed decisions and potentially achieve higher returns.
As digital asset investment management continues to gain popularity, it stands to benefit from the techniques and lessons learned in traditional finance. From portfolio construction methodologies to regulatory frameworks, leveraging best practices from decades of research in traditional asset management will help accelerate crypto’s broader adoption.
While both traditional and digital asset portfolios often use market capitalization as a weighting methodology, complementing it with some measurement of a blockchain’s usage may enhance portfolio construction. One way to do that is with total value locked (TVL), which represents the value of assets deposited on a blockchain. A higher TVL suggests greater economic activity and potentially better prospects of future activity or a larger active user base.
By taking the ratio of market cap-to-TVL (MC-TVL), we may glean a more fundamental sense of an asset’s utility beyond the superficial view from market cap, similar to how equity investors use ratios like price-to-book (P/B) to discern a stock’s value. A higher MC-TVL suggests an asset’s capitalization may be bloated, with a valuation that disproportionately exceeds its usage. Conversely, a lower MC-TVL may imply an undervalued blockchain, where markets haven’t yet priced in its activity.
A simulation was run on a top-10 index weighted by market cap versus one weighted by MC-TVL. The MC-TVL approach produced better full-period returns in this hypothetical scenario, driven by outsized positive performance in 2021. Over the period, daily returns between the two had a 0.85 correlation, suggesting that while the weighting methodologies are similar (by design), meaningful differentiation still exists between them.
Despite the limitations of this simulation, it is intended to encourage more nuanced analyses of crypto-specific properties and how they can be integrated into portfolio construction. As crypto’s track record unfurls in real time and new, richer on-chain data emerges, investors should monitor how fundamentals-based adjustments to portfolio construction could assist digital asset investment management.
Overall, integrating blockchain usage into passive products may improve overall market exposure and help investors better align themselves with crypto fundamentals. The lower MC-TVL approach may prove a useful indication of assets with greater network usage versus higher MC-TVL assets, whose size alone may not completely reflect their value within the digital asset universe. As the industry continues to mature, keeping an eye on fundamental indicators like TVL could provide a new edge for savvy investors.