The TVL soufflé

Tokenized derivatives may be dangerous and misleading with respect to the Total Value Locked (TVL)

Photo by Bhuwan Bansal on Unsplash

DeFi is often referenced as “money legos” due to its composability. Everybody loves legos. In traditional finance, composition is known as “derivatives”, which are more polarizing. Today, I explain the risk and delusion in DeFi composition, through an example. I avoid the use of real names by using tokens A, B, C, D, y1, y2, and some derivatives.

Let us start with some blockchain X. Then:

1. Stake $1 A, get $1 of stA.
2. Move both A and stA through a wormhole to any blockchain Y, resulting in WA and westA, $1 each.
3. Stake WA and westA in a liquidity pool, resulting in $2 LP-WA-westA. We get some yield y1.
4. We stake LP-WA-westA in a yield aggregator pool, which is going to automatically invest y1 into more LP-WA-westA. We get yWA, initially for the value of $2.
5. We may repeat with yWA from step 3 any time we want, or move to step 6.
6. We may repeat the previous steps for B, C, and D. Let us assume that we use $2 for each too.
7. After we have yWA, yWB, yWC and yWD (doing steps 3 and 4 for B, C, and D), we may put them together in a pool too. We get the poolABCD token, for an initial value of $8, and it gives us yield y2.
8. Then we can put poolABCD into some yield aggregator (the same one as before or a different one), to get ypABCD. Similarly, for $8 initially.
9. At this point we can repeat from step 3 or step 6. Until we have a very big house of legos. When we are done, we move to step 10.
10. Now we wait.

The TVL increases with each stake. If we stake $1 and get $1, we are counting $2 of TVL. Without going back in any step in our example:

1. We start with an initial TVL of $8 in blockchain X — $12 considering the staking, but only $8 bridged over.
2. The result is $40 in blockchain Y (original, LP, y1, pool, y2). Although it is potentially infinite.

For the misleading part: If the wormhole is hacked, and the original tokens stolen, what is the TVL in blockchain 2?1

The current way to measure TVL implies that TVL in blockchain Y is $40. However, after hackers move $8 within blockchain X, the resulting TVL in blockchain Y is arguably $0.2

For the risk, other than hackers: impermanent loss. In particular, impermanent loss in any of the lego pieces will propagate to all connected pieces. Let us assume that it is A in our example, and its value goes to 0:

1. Upstream pieces containing A go down to zero.
2. For downstream pieces, their parents or themselves may be exchanged for A. With B, C, and D going down to zero in numbers. The result is only A derivatives in the pools, which go to zero in valuation.

Both combined are more dangerous. Some people may not understand the true risk in impermanent loss and hacks. When they see the TVL, they may think: “People putting so many billions in this thing cannot be wrong. They would not risk that amount of money in some unsafe technology”.

However, what is the real amount of money and the risks involved? Are these the right questions? That, you will have to decide for yourself.

1

For some people this may be mind bending. Some other people may know that debt has been used by banks for a long time to create money. In fact, the original paper money were gold IOUs from banks. Similarly the gold could be stolen from the bank, which would be a problem for the value of the IOUs.

2

Elon Musk @elonmusk

June 27th 2021

23,980 Retweets307,604 Likes

Cross-posted from the Sigmoid newsletter