I have never really understood the obsession with “locking up” assets in decentralized protocols but this has been a common practice that just doesn't seem to go away.
Builders are obsessed with it, users (yappers essentially) are also obsessed with it but at the end of the day, the market doesn't consider it relevant for measuring what any given asset should be worth at any given time.
For those who may be confused by what I mean by parked capital, we are essentially talking about the process of locking up crypto assets or tokens in smart contracts and acting like that means everything by pushing metrics like “total value locked (TVL)” across the media.
TVL is a misleading metric, sometimes these locked assets are majorly native tokens that are centralized to a few addresses, but they remain a widely acknowledged metric simply because there's an active market pricing said tokens, often placing locked supply at several billions.
In the process, liquidity is accounted for, even though that plays a much larger role in the stability of a crypto asset. Most TVL evangelists believe that when a crypto asset has the majority of its supply locked away, that would magically lead to its market value per token going up, but the reality is that price performance is influenced by a lot more than TVL, especially in the long term.
There's technically not much difference between a token that has 100M max supply but 90M is locked up and one that has just 10M max supply and 0 is locked, if both measure up to the same economic output.
A token can have 100% of its supply in circulation and perform better than one with the majority of its supply locked up. But of course, when we are talking about parked capital or TVL in the broader sense, we mean more than just native assets locked up, so we are looking at inflows from other ecosystems including alternative stablecoins and secondary non-stable tokens.
Notwithstanding, a Cointelegraph report on a research piece on TVL shows that using the metric as an indicator for good assets to invest in proves non-effective.
A new study puts DeFi’s favorite metric to the test, revealing that TVL doesn’t give investors the edge many assume it does.
The study set out to test a simple but surprisingly overlooked idea: Does TVL actually predict returns?
To find out, the researcher analyzed over 300 tokens (leaving out Bitcoin and stablecoins), creating weekly portfolios based on their TVL-to-market-cap ratios. The strategy was to buy the top 25% while shorting the bottom 25%. The goal was to see if these TVL-based portfolios could generate “alpha,” a finance term for returns that beat the market trend.
The researcher went the extra mile to keep data accurate, and applied the tests to both raw TVL and a data set that excludes double-counting — a common issue in DeFi. The tests were also repeated by accounting changes in TVL over time.
However, all these tests came out with the same result, which indicates that making trades based on TVL doesn’t give traders any edge. Once the broader market trends were accounted for, any performance difference that might have seemed linked to TVL simply evaporated. — Cointelegraph report
It's cute that a couple of protocols can brag about $1 billion in TVL, but when it comes to things that would be an indicator of a smart investment like what's the monthly capital flow like in the ecosystem and how does that contribute to its revenue?
Questions like this pulls down the smoke screen that's called TVL because at the end of the day, parked capital creates very little value, so ecosystems are found choking themselves out.
But of course, we are not ignoring the fact that sometimes these locked assets contribute to ecosystem security when they are crucial to governance, yet that is a use case unique to the native assets making up the TVL so it doesn't take away from the fact that capital needs to actively flow and that brings us to something I've discussed on a couple of occasions:
Dual-token economies as the next step for decentralized platforms
We need an economic design that allows decentralized governance but at the same time afford significant capital flexibility.
Some might suggest liquid derivatives, where when X token is staked, a new token is minted, representing the position and can be used across the decentralized ecosystem.
The problem with such tokens however is that it is inflationary because if a capital is locked, but you're still able to use it, then you're essentially debt financing your operations without directly accounting for the risks and as I've often discussed this in the past, it gets to a point where this enables less real capital to extract a significant amount of value across the decentralized finance ecosystem and that is a problem we cannot afford as it eventually leads to liquidity extraction.
Dual-token economic designs is however something we can work with.
The dual-token here means that a protocol or ecosystem runs on a two token design, where token A is the native governance asset and token B, is preferably a stablecoin.
It's the most logical design approach because economic flows need to be in tokens with pricing that are pre-determined because at the end of the day, everyone loves stability and predictability.
Now of course, these tokens wouldn't function as standalones, but side-by-side, ensuring that both are connected in ways that allows growth in one to bring about an upside for the other.
Essentially, we have the capital flexibility of traditional economies but still maintain a value system that controls how this capital is created and utilized across the economic system.
But how would a dual-token economic system make capital truly flexible seeing that TVL includes much more than the native assets.
I think it all boils down to the individual products being built in the ecosystem and the focus generally, isn't on making TVL in a protocol flexible, it's about offering multiple options that do not involve locking up assets.
For instance, transactions using the protocol's native stablecoins can be free, effectively incentivizing users to adopt it. As we already know how decentralized stablecoins work, this generally creates a buy pressure on the native governance assets, which in turn improves its liquidity, on-chain transactions and revenue at the end of the day.
This in itself will attract more TVL as alternative ecosystems try to bridge to the native asset of said protocol. Having a means to incentivize on-chain activities that leads to revenue generation is the single most important thing.
Builders ought to start thinking about developing ecosystems powered by dual-tokens as that allows far more capital flexibility and that directly would attract more liquidity, creating an ecosystem with far more plausible and measurable value metrics for smart investment.