The hype surrounding decentralized finance is sometimes credited with triggering a wider market rally in July, as new protocols began releasing tokens that were immediately posting gains of many times their initial value. Despite undeniable price growth, however, it is not immediately clear if the sector as a whole has grown, as reliable metrics to measure the fundamental performance of DeFi protocols are incredibly hard to come by.
The projects lend themselves to fairly rigorous analysis methods, as they will often have well-defined revenues and expenses. But the rise of liquidity mining, or yield farming, is throwing the metrics off balance in some ways. Protocols reward their users with their own governance tokens, essentially as a payment for using the platform. A frenzied movement to maximize the yield for these tokens distorted the prevailing DeFi success metric, the Total Value Locked, or TVL.
A clear example of this is the Compound protocol where the value of Dai supplied to it surpasses its total amount of tokens by almost three times — $1.1 billion vs. $380 million in existence as of writing. This is due to Compound users entering leveraged positions on Dai — something that normally does not happen with stablecoins. While this led the community to discuss the merits of TVL, some other similar measurements have been distorted as well.
Evaluating a DeFi lending project
Valuation metrics will change slightly based on the type of project. In the case of lending protocols like Compound and Aave, TVL represents the supply-side liquidity of the project or the total sum of all deposits currently held by them. It is worth noting that TVL only takes the on-chain reserves into account. According to DeFi Pulse, there are only around 220 million Dai locked in Compound, not 1.1 billion.
DAI locked in Compound. Source: Defipulse.com
However, lending providers are generally evaluated based on book value, or how much is being borrowed. Since that is what generates…