For a long time, the cryptocurrency industry has been attracting not only technology enthusiasts, but also investors of all stripes. They are primarily interested in such ways of earning passive income as staking, yield farming, and cryptocurrency lending.
One of the key metrics used by crypto investors is the annual percentage yield — APY. This concept was borrowed from the traditional finance. Understanding APY is crucial for investors who want to maximize the return on their investments or minimize the lending rate when borrowing cryptocurrencies.
- APY, which stands for annual percentage yield, is a method to track the interest accumulation on the investment
- Unlike simple interest, APY incorporates the effects of the compounding interest
- The main factors that influence the APY rate are inflation, supply and demand, and compounding periods
- APY is usually used in crypto lending, borrowing, staking, and yield farming
What Is APY?
Annual Percentage Yield (APY) is the annual rate of return received from a one-year investment, taking into account the compound interest. Compound interest includes the interest earned on the original deposit plus the interest accrued on top of that.
APY is a measurement that determines the amount of interest you will earn. The type and the rate of APY depends on the product you are investing in: staking, deposit or liquidity pools. Typically, investors receive interest in the same cryptocurrency in which they deposited funds. However, sometimes payouts are in a different currency.
Simple Interest Rate vs. Annualized Percentage Yield
It is vital for trades to understand that APY is not the same as the simple interest rate. The main difference between the two is that simple interest does not take into account the effect of compound interest, while the APY does.
Compound interest is a powerful investment tool because it allows you to earn additional income over time. Compound interest is calculated based on both the initial principal and on accumulated interest from previous periods. In this way, you get an “interest on interest” accrual. The total amount at the end of the investment period is higher with APY than with simple interest.
How Does 7-Day APY Work in Crypto?
7-Day APY is the annual return on a crypto investment over a seven-day period, which takes into account the compound interest effect. It is a common metric used in the cryptocurrency world to compare potential returns on different investments.
You can calculate the APY using the following formula:
APY = ((1 + r / n) ^ n) - 1, where
r = annual interest rate;
n = number of compounding periods per year.
Compounding is a process whereby interest is accrued both on the existing principal and the interest already paid. If interest accrues daily, use 365 in the formula, monthly 12, quarterly 4, once every six months 2, once a year — 1.
Let’s take crypto with APY 10% as an example. Suppose you plan to invest $10,000 in Ethereum (ETH) on a staking platform with an annual interest rate of 10% and daily interest.
Substitute the numbers in the formula, and you will get ((1 + (0.1/365)) ^ 7) - 1 = 0.0019%.
So $10,000 in seven days would turn into $10,019.
Does APY Represent Final Earnings?
The APY is the rate of return on your deposited funds. The final amount of profit depends primarily on the principal amount and the period of investment.
Going back to the example above, where we calculated a 7-days profit, let’s calculate APY for a 1-year period.
Substitute the numbers into the formula, and you will get ((1 + (0.1/365)) ^ 365) - 1 = 10.51%
So $10,000 in one year would turn into $11,051.
As you can see, the longer term leads to an equally significant increase in the APY.
What Is the Annual Percentage Rate (APR)?
Another important metric for crypto investors is the annual percentage rate (APR). Various platforms encourage cryptocurrency owners to place their assets in their lending pools by offering them a high annual percentage rate (APR). So, APR is the income in the form of interest that investors can get in return for lending their cryptocurrency. The metric also takes into account the fees that the borrower must pay, but does not include compound interest.
Essentially, the APR is the regular interest rate applied to the principal amount of the investment or loan. If the investment or loan is held for a shorter period than one year, the interest will be charged accordingly to the period’s length. For example, a 1-month investment with a 10% APR will yield only 0.83% of the principal amount.
Factors That Influence Crypto APY
The size of the APY is not set randomly. It is determined by several factors, including inflation, supply and demand, and the compounding period.
The tokenomics of many blockchains are inflationary. This means that validators or miners are paid by newly minted coins. For example, Bitcoin has an inflation rate of about 1.7% per year and Cosmos — about 7%.
The inflation rate for a particular blockchain affects the profitability of staking. When a user delegates tokens to blockchain validators (sends tokens to staking), they begin to receive new coins as a reward for staking and. Therefore, the higher the inflation, the higher the APY.
Supply and Demand
Since trading and lending in the cryptocurrency market is subject to the market economy, APY is influenced by the law of supply and demand. Thus, the APY varies depending on the level of demand for the coin and its liquidity. High demand leads to a high APY. If users earn more than 5% on lending, it means that other users are willing to pay more than 5% interest to borrow that crypto-asset.
High APY is typical for new projects launched on decentralized exchanges (DEX). The first reason for high APY is that at the initial stage of the project’s existence, its coin’s price is very volatile and there is a high probability of a dump. Offering huge APY, these projects try to compensate for losses and attract users to continue providing liquidity instead of selling tokens. After a while, the APY usually decreases as the number of liquidity providers grows and the project stabilizes.
The APY is significantly affected by the number of interest periods — if the number of compound interest periods increases, so does the APY.
For example, if you deposit $100,000 worth of cryptocurrency with daily compound interest at 10% APR, your APY will be 10.51% = (1 + 0.1 ÷ 365) ^ 365 - 1. So by the end of the year, your balance will be $110,510.
And if compound interest is accrued monthly, your balance after one year will be less and will be $110,470 with an APY of 10.47% at the end of the year.
Crypto Investments That Involve APY
Whether you are an active DeFi user or just an investor looking to earn passive income from staking, you will sooner or later encounter APY metric. Below are the main ways of earning APY on crypto investments.
Crypto Lending and Borrowing
You may be familiar with protocols such as Compound and Aave. They are just two of the many decentralized cryptocurrency lending platforms that allow cryptocurrency owners to lend their assets as well as borrow them.
As strange as it may seem at first glance, you, as a cryptocurrency owner, can act as a borrower on decentralized lending platforms. This situation can arise when you urgently need free liquidity, but for some reason you do not want to sell your cryptocurrency. Cryptocurrency lending platforms allow you to use your cryptocurrency savings as collateral to take a loan.
However, it's worth noting that decentralized lending works with excess collateral, meaning you can borrow no more than 80% of the value of your collateral. The APY on taking loans is usually slightly higher than on giving loans.
Cryptocurrency lending platforms let you become a liquidity provider and earn interest on lending cryptocurrency to other users. Depending on the platform, interest rates range from 1% to 15%.
This passive income option is best suited for long-term investors familiar with the decentralized finance market.
Yield farming refers to receiving rewards for providing liquidity to DeFi-services — decentralized exchanges that use the mechanism of Automated Market Maker (AMM-DEX).
A farmer's income is made up of two components:
- A share of trading fees for buying and selling transactions of assets in the liquidity pool;
- Liquidity rewards paid in tokens of exchange management.
Generally, a certain number of tokens per day is allocated to each of the pools according to the exchange's liquidity needs for certain asset pairs. Rewards are distributed among all pool participants in proportion to their contribution.
APY is usually high at the launch of a new pool. But as the total value locked (TVL) in the pool grows, its yield drops sharply.
And the last case where you may come across APY is cryptocurrency staking. It allows earning passive income in blockchains with the PoS consensus algorithm. By delegating coins to validators, or being a validator yourself, you not only protect the network, but also earn cryptocurrency. Delegator and validator income is also measured in APY, which varies from 0 to tens of percent depending on the settings of a particular network.
However, remember that most of the time (but not always) staking implies that you lock your cryptocurrency for a certain period of time, during which you will not be able to use it.
What Can You Do with Earned Interest?
Income earned in any of the above options is credited to the wallet you use to interact with the blockchain. The cryptocurrency market offers a multitude of options of disposing this income — from continuing to earn interest, to converting profits into fiat.
One of the most popular ways to use cryptocurrency is spot trading (regular cryptocurrency exchange). The second popular option is trading derivatives, which are financial contracts whose value depends on the underlying cryptocurrency.
Overall, there are many methods to invest your earned funds. Choose the one according to your preferences and experience. However, if you earned significant amounts, it is better to diversify your risks and use different trading or investment tools.
Cryptocurrency investments require a metric that allows to compare different products and select the one with the higher profitability. The APY, or annual percentage yield, is an example of such a metric. It is applied both in traditional and crypto finance. The APY rates range depending on the crypto product. Also, there are certain factors which influence the rate, such as inflation and the coin/product demand.
What Does 7-Day APY Mean in Crypto
The 7-day APY is often used to compare the potential returns of different investments. For example, one crypto investment may offer a 7-day APY of 1%, while another may offer a 7-day APY of 5%. Accordingly, an investment with a higher 7-day APY will be considered more attractive because it offers a greater potential return on a seven-day investment.
Why Is the APY So High in Cryptocurrency vs Traditional Investments?
Typically, ultra-high APY can be obtained through yield farming or liquidity mining. A high APY is usually set in attempt to compensate for temporary losses that occur at the times of imbalance in the ratio of tokens in a particular liquidity pool. APY is typically higher for new crypto projects. But the yield drops over time. Most projects which have been on the market for more than a year have an average yield of the usual 5% per annum.
What Can I Do If My Savings Platform Cuts My APY Earn Rates?
There are several options. The first one is to continue earning with the platform, if it still offers competitive APY. The second option is to switch platforms by transferring your assets to another project offering higher returns.
In case you locked your cryptocurrency in staking, you do not have any other option but to wait for the end of the lock-up period. After that, you will be able to transfer your assets to another project.
What is the difference between APY and APR
The main difference is that the APY accounts for compound interest, while the APR does not. Thus, the more often interest is accrued, the greater the difference between the Annual percentage yield and the Annual Percentage Rate becomes.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.