Module 1.3: Understanding Key DeFi Metrics
Welcome to Lesson 1.3, where we’ll delve into the world of decentralized finance, or DeFi. We’ll uncover the secrets of key DeFi metrics, learn how they help understand the true value of projects, and how to apply this knowledge in assessing their reliability. In a world where DeFi evolves at an incredible pace, with new protocols and projects constantly emerging, it’s challenging to stay updated on the latest trends and determine what truly deserves your attention. Although there’s no single, perfect way to evaluate all DeFi protocols, today we’ll introduce you to a range of key indicators that will become your reliable compass in evaluating the trust and potential of various protocols.
The first key indicator we’ll look at is Total Value Locked, or TVL. This metric reflects the total amount of funds that have been invested in a decentralized finance protocol. Essentially, TVL shows us how much liquidity providers have deposited in the protocol. Take Uniswap in February 2023, for instance: its TVL was over 4 billion dollars. This staggering figure indicates a deep trust from users willing to invest significant sums into the platform. TVL is a reliable tool for assessing the popularity and trust in a specific DeFi protocol, allowing us to see which ones attract the most value. Overall, a high TVL suggests that the protocol is stable and trustworthy.
Let’s move on to the next important indicator — market capitalization, often simply called “Market cap.” This criterion is crucial for all cryptocurrencies but is especially significant for DeFi protocols with their tokens. Market capitalization is essentially the total market value of a cryptocurrency. It’s calculated by multiplying the current price of a token by the number of tokens actively circulating in the market. It’s important to note that this calculation does not include tokens that are locked, reserved, in escrow, or staked. This allows us to get an idea of the real market value of a cryptocurrency based on the current supply and demand in the market.
Now, it’s essential to underscore the difference between market capitalization (Market cap) and Fully diluted market cap — two concepts that are easy to confuse. Fully diluted market cap is calculated by multiplying the current price of the crypto asset by its maximum possible supply. This maximum supply is the total amount of tokens expected to be issued. Usually, this number is set at the creation of the cryptocurrency and can be either fixed or variable. For example, many tokens have a predefined limit, whereas most stablecoins are created with the assumption of an infinite supply. This important distinction helps us assess the full potential economic weight of a cryptocurrency in the future.
When analyzing the token supply dynamics within a DeFi protocol, it’s crucial to determine whether this supply is increasing over time or, conversely, decreasing. We need to understand whether the supply model is based on inflationary or deflationary principles and how quickly these changes occur. Take Bitcoin as an example: its supply increases, but the rate of this increase gradually slows down — a measure designed to protect the value of existing Bitcoins from depreciation. It’s worth noting that inflation is not always negative, but its excess often leads to price declines.
It’s also important not to overlook the significance of monitoring the number of tokens on centralized exchanges. Sellers often place their tokens on these platforms to take advantage of their high liquidity. Therefore, if a large number of a particular protocol’s tokens are present on an exchange, it could signal potential selling pressure for those tokens. However, there’s not always a direct correlation. Many traders prefer to keep their tokens on centralized exchanges for the convenience of trading. That’s why it’s crucial to track changes in token volumes on these platforms. Any significant fluctuations could indicate possible future volatility waves in the market.
Another metric that deserves our attention is the price-to-sales ratio. It plays a key role in determining whether a DeFi protocol is undervalued or, conversely, its value is inflated. To calculate this ratio, we divide the Fully diluted market cap of the protocol by its annual revenue. If the resulting ratio is low, it may indicate that the protocol is undervalued. In the case of a high ratio, it may suggest possible overvaluation. This criterion is not new to the financial world and is often used in traditional markets to analyze stocks. It allows us to see the true value of DeFi projects with utmost clarity.
Just as in the world of traditional applications, user activity plays a key role in the success of DeFi protocols. To understand how people use these systems and what trends are emerging, we can analyze the number of unique wallet addresses — our equivalent of unique users in the world of web applications. It’s also important to pay attention to transaction volumes. However, keep in mind that these data can be subject to manipulation. Some may create multiple unique addresses and artificially inflate transaction volumes to simulate activity. Therefore, it’s important not only to collect this data but also to carefully analyze it, comparing it with other indicators and context to gain truly valuable insights to distinguish genuine activity from noise. In the DeFi world, where speculation can distort the real picture, it’s crucial to be able to identify true activity.
Another aspect to consider is the participation rate in governance or voting processes within DeFi protocols. Many DeFi projects offer governance tokens that allow holders to vote on key decisions affecting the protocol’s future direction. High participation rates in governance can indicate a committed and active community, which is often a good sign of a project’s health and longevity. Conversely, low participation rates might suggest a lack of engagement or interest from the token holders, potentially signaling issues with community trust or the perceived value of governance rights.
Liquidity ratios are also essential metrics in DeFi. They can provide insights into how easily assets within a protocol can be converted into cash or other tokens without significantly affecting the asset’s price. High liquidity ratios suggest that there is sufficient market depth, allowing users to execute large transactions with minimal slippage. On the other hand, low liquidity ratios might indicate thin markets, where transactions could lead to significant price movements, increasing the risk for both liquidity providers and traders.
The concept of impermanent loss is specific to DeFi and particularly relevant for those participating in liquidity pools. Impermanent loss occurs when the price of tokens in a liquidity pool changes compared to when they were deposited, potentially leading to a loss compared to simply holding the tokens. Understanding the factors that contribute to impermanent loss and the protocols’ mechanisms to mitigate it is crucial for anyone looking to provide liquidity in DeFi.
Lastly, the rate of new DApps or integrations being developed on a DeFi platform can serve as a gauge of its innovation and growth potential. A high rate of development activity often indicates a vibrant ecosystem with ongoing innovation, attracting more users and developers. Conversely, a slowdown in development activity could signal that a protocol is losing momentum or falling behind its competitors in terms of features and user experience.
In the next section, titled “Examples of DeFi Services,” we’ll take a closer look at specific applications of DeFi, including stablecoins, decentralized lending and borrowing platforms, and decentralized exchanges. By examining these examples, we’ll gain a deeper understanding of how DeFi is reshaping the financial landscape and what it means for the future of finance.
All Educational modules list:
Module: 1.1 Differences between TradFi, DeFi and CeFi
Module 1.2: The History of DeFi
Module 1.3: Understanding Key DeFi Metrics
Module 2.1: Decentralized “Deposits” (Staking)
Module 2.2: Understanding Stablecoins
Module 2.3: Diving into Decentralized Borrowing and Lending
Module 2.4: Dive into Decentralized Exchanges (DEXes) and Swaps
Module 2.5: Decentralized Derivatives
Module 3.1: Providing Liquidity in DeFi
Module 3.2: Yield Farming in DeFi
This course was prepared by Julia Palamarchuk (co-founder of Aqua Protocol — the first CDP stablecoin on the TON blockchain, over-collateralized by liquid staking tokens).
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