It’s well-documented that your average savings account in any developed country now offers you a tiny interest rate return compared to the 1990s.
Fortunately, you will not find such measly yields in cryptocurrencies, which has led more investors to flock to this financial instrument. Of course, the annual percentage yield (APY) is not unique to cryptocurrencies.
Yet, the exception is the APYs are a lot higher than with traditional financial institutions primarily because of the incentive for projects to attract as many investors as possible. Moreover, the regulation’s absence enables any interest to be earned or charged.
Understanding the annualized percentage yield (APY) is beneficial if you make any investment related to staking, yield farming, or lending. You can find such interest-bearing activities through many exchanges, DeFi (decentralized finance), and wallet applications.
In this article, you’ll learn what APY is, some of the factors influencing this metric, and the dangers of astronomical yields provided in DeFi.
What is the annualized percentage yield?
The APY is the yearly return rate that accounts for compound interest. In any investment, compound interest refers to what you earn from the principal amount (your initial deposit) and the accumulated interest over a certain period; interest on interest.
Your interest can be compounded over a day, week, 14 weeks, a month, three months, six months, or another fixed period in cryptocurrencies. However, we tend to look at overall earnings after a year.
Let’s explore a simple example illustrating how APY works by comparing it to simple interest. If you deposited $10 000 into a savings account with a yearly rate of 5%, you would have made $500 on your money.
However, if you did the same with cryptocurrencies using the same rate and a 6-month compounding period, your final earnings would be $512. This is how we got to this amount:
$500 divided by 365 days X 182.5 days = $250 (interest after six months)
At this point, your balance is now $10 250. 5% of this amount equals $512.5, representing the final amount you would have accumulated after a year from your initial $10 000. Therefore, the actual APY, in this case, is 5.12%.
It’s worth noting that compounding effects are only compelling after years of reinvesting. Lastly, we should mention that APY and APR (annual percentage rate) is similar but different.
APR also refers to annualized interest. However, this term is used exclusively on debt rather than earnings.
Factors influencing APYs in crypto
As one would expect, numerous factors affect the extent of crypto yields, considering that they are variable and not guaranteed as you would find with a bank or similar organization. One of the most significant is inflation, referring to the loss of value in a currency over time.
A blockchain network can have an inflationary or deflationary token supply. Inflationary distribution can negatively affect the APY because if more coins are created, their individual worth is perceived as less valuable.
Conversely, a blockchain with non-inflationary tokenomics (by having a finite supply or ‘burning/’ removing a certain number of coins in circulation) is more attractive for investors. The second influential element is basic supply and demand.
Generally, if there is more demand for a cryptocurrency from the market, we should expect greater yields; the opposite is, of course, true. Lastly, the other influential element is the compounding period. If compounding happens more frequently, the greater your potential earnings.
Crypto investments involving APY
Below are the types of investments in crypto where you will come across annual percentage yields.
This is where you put up your crypto assets on a lending protocol like Nexo or BlockFi, which then lends them out to other institutions or even borrowers on their platform. In the case of borrowing, you will be shown APRs.
Staking occurs on a proof-of-stake blockchain where holders ‘lock up’ their coins for a predetermined period to secure the network. The blockchain autonomously confirms transactions based on the size of your stake without any need for computer mining.
Yield farming is an all-encompassing term for earning crypto on your crypto, to which staking is a subset. However, in most cases, when referring to yield farming, we typically mean ‘locking’ up your coins in a DeFi automated liquidity pool to provide liquidity for a certain market (also known as liquidity mining).
The dangers of projects offering unusually high yields
The APY you can receive with investing in a cryptocurrency varies widely. If one stakes or saves any of the coins in the top 50 or so (e.g., Polkadot, Avalanche, Bitcoin, etc.), the most to expect here is around 10%.
With stablecoins, the maximum APY you typically find is 20%. The next category can start from this point up to several hundred or even thousands in percentage, which is prevalent with obscure altcoins listed on experimental DeFi protocols.
For context, the BCH-BNB liquidity pool (according to CoinMarketCap) on PancakeSwap offers a ridiculous 1065871% APY. You may be wondering how the potential returns can be so incredibly high and whether there’s more than meets the eye.
It all boils down to attracting many investors and price volatility. When a new cryptocurrency is listed, liquidity would be one of its main challenges. Therefore, one method is for developers to offer astronomically high yields.
However, in nearly all cases, investors would have bought an inflationary token.
As previously mentioned, the higher the inflation, the less you make in the long run, decreasing your rate of return. Coins in these protocols are known for having many whales who can buy thousands or millions of these tokens as they are typically priced pretty cheaply.
Therefore, if one or a few individuals sell their tokens, this will crash the price, leaving you with far fewer earnings. Ultimately, high-yield yield-generating programs are not the best investment. Put simply, the greater the APR, the greater the risk.
Having a good understanding of APYs can prevent you from falling into the trap of being attracted to projects offering above-average returns. When considering any yield-based crypto investment, you should observe the earlier-mentioned factors, such as the token supply and compounding periods.
Cryptocurrencies have opened a world of unimagined lucrativeness. However, we should always appreciate this financial instrument can be incredibly volatile, leading to a potential loss over time that any earned interest may not outweigh.