What is APY in crypto?
APY stands for ‘annual percentage yield’. It allows you to figure out how much your crypto investment will grow over time and, most importantly, APY factors in the ever-changing nature of crypto yield products.
Here’s how APY works.
How to calculate APY in crypto
There’s a very simple equation that anyone can use to calculate APY in crypto.
This equation can come across as a little confusing at first, but fear not, we’ll try and break down the steps of this process as simply and as easily as possible.
The equation is: APY = (1 + r/n)n – 1.
In this example:
R = the annual interest rate expressed as a decimal (15% is 0.15).
N = the number of compounding periods per annum.
1 = the baseline that represents your investment.
Let’s go through how to calculate APY step by step.
First, we divide r by n. This divides the interest rate by the compound regularity to indicate the interest you earn during each compounding period (once agin, this is expressed as a decimal).
Then we add 1 to this number, so you can see the amount your investment will gain during each period of compounding.
Now we use the compound regularity (the n value) again to do a ‘power of’ equation. In short, this multiplies the same number by itself over and over again, taking into account the interest gained on each iteration. This calculation is tailor-made for exponential numbers and shows us exactly how much our investment will grow over the course of a year.
The final step here is to subtract 1. By doing this we’re taking away the ‘baseline’ figure of the original investment, leaving us with the pure yield.
APY in practice
Let’s say we invest in an Ethereum-based crypto yield product that markets itself as having an 20% interest rate which compounds every month.
The equation would be (1 + 0.20/12) to the power of 12 – 1.
0.20/12 = 0.0167
1 + 0.0167 = 1.0167
1.0167 to the power of 12 = 1.219
1.209 – 1 = 0.219
So the APY is 21.9%.
As we can see from this example, APY is pretty similar to an standard interest rate, but it’s slightly higher because of the compounding effect applied to the investment.
If you don’t feel up to doing these calculations by hand or you just want to an easier way of calculating APY, you can use an APY calculator like this one to more easily figure out how much money you stand to make from a yield-bearing product in crypto.
What does 7-day APY mean in crypto
A seven day APY is exactly what it is say it is. It’s the annual return on a crypto investment over a seven-day period, which takes into account the effect of compound interest. A seven day APY is a common metric to compare returns on short timeframe investments.
Here’s an example to help visualise the difference between different crypto products. Let’s say one crypto investment offers a seven-day APY of 2%, while another offers a seven-day APY of 9%.
Quite simply, the investment product with a higher seven-day APY will typically be considered more attractive as it offers a greater potential return on a seven-day investment.
What’s the difference between APY and APR?
This is something that many crypto enthusiasts, particularly those who spend a lot of time engaging with decentralised finance (DeFi) protocols struggle with.
Most investors and market participants are much more familiar with ‘APR’; the annual percentage rate, which is very common in the world of fiat-based financial products.
So, why don’t we use it in crypto?
APR vs APY explained
For starters, APR is typically more closely correlated with the ‘interest’ rate. In fact APR usually is the interest rate, just with fees factored in.
This means that the APR is great for flat, solid numbers, but doesn’t prove to be especially useful for compounding assets which multiply themselves at varying rates every few months.
As a general rule of thumb, crypto products tend to take the form of compounding assets, which is why you’ll more often see APY used over APR when figuring out what kind of returns you stand to make.
Factors that influence crypto APY
There a number of factors that influence the APY that gets paid on crypto investments. Here’s the main ones to be aware of.
Inflation is a key metric that determines the variability of APY. The tokenomics of many blockchain networks are inflationary. This means that validators and miners are paid in newly minted tokens.
For example, Bitcoin has an average inflation rate of around 1.77% each year.
The inflation rate of each particular blockchain affects the profitability of staking and rewards that are paid to individual users. When investors send tokens to blockchain validators (typically for staking purposes), they will receive new tokens as a reward for staking.
This means that the higher the inflation rate on a given blockchain, the higher the APY.
Supply and demand
Like all markets, trading in the cryptocurrency market is subject to the forces of supply and demand. Therefore the APY varies depending on the level of demand for the token in questions and its liquidity (the availability of a token on the market at a given time).
Put simply, high demand generally commands a high APY. If an investor earns more than 10% on lending an asset, it means that other market participants are willing to pay more than 10% interest to borrow that cryptocurrency.
High APY is the norm for new projects that launch on decentralized exchanges (DEX). The primary reason that APY is highest at the initial stages of a project’s existence, is because the token’s price is quite volatile and there’s a high probability of a drawdown.
By offering a large APY, these projects attempt compensate for any potential losses while simultaneously attracting new users to continue providing liquidity instead of selling their tokens. Generally, the APY offered on these tokens decreases as the number of market participants offering liquidity grows and the overall value of the project evens out.
The number of interest periods are the next major factor in influencing the overall APY of a project. If the number of compound interest periods increases, so too does the APY.
Consider this 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.
However, if the compound interest is accrued monthly, your balance after one year will be a little less and will come to $110,470 with an APY of 10.47% at the end of the year.
Why is the APY so high in cryptocurrency vs traditional investments?
A high APY typically means that investors and other market participants are desperate for quick cash, and are comfortable with offering massive yields in order to gain access to it. The reason that APY is higher in crypto is a direct result of this, as crypto investors are constantly looking for new ways to gain access to fast lines of credit.
However it’s worth noting here that just like the world of traditional finance, high yields almost always mean high risk investments. So, whenever you see a yield-bearing crypto product offering 20%, 30% or (god forbid) 100%+ APY, that’s often a very good yardstick to measure it as suspicious or at the very least, unsustainable.
It’s worth noting that, as a result of a prolonged bear market, the APYs of many crypto projects and lending protocols have actually declined significantly. In 2021, yield-bearing products offering annual returns of 20% to 30% were seemingly commonplace, but today, we’re typically seeing more conservative figures between 5% and 10%.
While some investors may shake their fist at these yield declines, on the whole its actually a good thing because it means that the market is maturing. It means that traders, investors and project owners, are less desperate for quick cash than they have been previously, further illuminating the fact that we seem to be entering a sustainable era of digital finance, at least when it comes to farming yield.
As cryptocurrency investments, particularly those in the world of DeFi are subject to more frequent change than those in the world of traditional finance, they require a special metric that allows us to compare these variable products and select the ones with the highest potential profitability.
The APY, or annual percentage yield, is one such example of a metric that can be well-utilised in the world of crypto, however it can equally be applied in traditional finance as well.