Cryptocurrency investing is all about making more profits than losses. You simply don’t want to be in a scenario where you’re racking up losses trade after trade.
That’s why APY is one of the most important measures of your success as an investors.
So, what is APY in crypto? How does it work? And more importantly, how does it determine how much you earn in a year?
Find the answers to these questions and more in our article!
Understanding APY: The Basics
APY refers to Annual Percentage Yield, and is a measure used to show how much money you can earn from an investment over a year, including when the interest you earn also earns interest.
In crypto investments, APY is important because it helps you see how much you could grow your crypto holdings by staking or lending them. People often look at APY to decide where to invest since higher yields means more potential earnings.
It’s like choosing a cryptocurrency savings account; you’d probably prefer the one that grows your money faster.
APY vs. APR: Unraveling the Difference
APY and APR (Annual Percentage Rate) are both ways to measure the interest earned, but they tell you slightly different things.
For one, APR is more straightforward—it shows the yearly rate charged for borrowing or earned through an investment without factoring in compounding. So, it’s the basic rate before any extra interest gets added from compounding periods.
APY, on the other hand, does consider compound interest, showing how much you’ll earn on an investment after a year, including any interest that compounds over the year. This makes APY a bit higher than APR if there’s compound interest involved.
So, with regards to crypto investments or loans, APR lets you know the basic rate, while APY tells you what you’ll actually end up with after the compounding interest does its thing over the year.
Simple Interest vs. Compound Interest
Simple interest is calculated on the original amount of money you invest or borrow, called the principal. So, if you invest $100 at a 5% simple interest rate for 5 years, you’ll get 5% of $100 every year, which is $5. After 5 years, you’ve earned $25 in interest.
Compound interest, on the other hand, is like interest on interest. It’s calculated on the initial amount plus any interest earned. So if you start with $100 at a 5% compound interest rate, the first year you earn $5, just like with simple interest. But the second year, you earn 5% on $105, which is $5.25, and it keeps growing because you’re always earning interest on a larger amount.
The Mechanics of APY in Crypto
In the crypto space, annual percentage yield in crypto works by showing how much you can earn from your crypto assets over a year, considering the effects of compounding periods.
Staking and Lending
For instance, you can earn APY by staking your crypto tokens or lending them out.
Staking involves locking up your tokens to support the operation of a blockchain network, while lending means providing your tokens to others through a platform, and in return, you earn interest.
Compounding
Unlike a simple interest rate, APY takes into account the frequency with which your earnings are compounded. This could be daily, weekly, or monthly. Each time your earnings are compounded, they are added to your initial investment amount, increasing the base on which future earnings are calculated.
Rewards and Variable Rates
In some crypto projects, rewards from staking or lending can be distributed in additional crypto tokens. These rewards themselves can sometimes be reinvested or restaked, enhancing the compound interest effect.
APY can also be highly variable in crypto, reliant on factors like network demand, the price of the cryptocurrency, and the total amount of tokens staked or lent.
How to Calculate APY in Crypto
Here’s the formula to help you calculate APY in crypto:
APY = (1 + r/n)n – 1
In this example,
The variable in the equation are as follows:
R = the annual interest rate (usually expressed as a decimal number)
N = the amount of compounding periods per year.
1 = a baseline that stands for your investment.
Factors Influencing Crypto APY
Here are some of the factors that determine crypto APY:
Market Demand
If many traders and institutions are looking to borrow a particular crypto asset, perhaps for trading on margin or for other investment strategies, the interest rate they’re willing to pay increases.
This drives up the APY for those lending out their crypto. Conversely, if demand to borrow decreases, lenders might see lower returns.
Network Participation
In staking scenarios, the more participants who stake their tokens, the more secure and robust the network becomes.
However, as more tokens are staked, the reward distributed to each staker can decrease because the same reward pool is shared among more participants.
This dilution effect can reduce the individual APY unless the total rewards are adjusted by the network.
Crypto Volatility
When the crypto market is volatile, it can significantly affect APY. If the price of a staked or lent cryptocurrency drops significantly, the real-world value of the returns diminishes.
On the other hand if the price surges, the value of interest earned could increase, making the investment more profitable. This volatility adds a layer of risk and reward, influencing the attractiveness and stability of the annual percentage rate.
Interest Rate Changes
Many DeFi platforms use dynamic interest rates determined by algorithms, which adjust based on the current supply and demand for funds.
For APY, the implication is that it can fluctuate more frequently and unpredictably compared to traditional finance, as it responds to real-time market conditions.
Protocol Changes
Another factor that affects crypto annual percentage rate is changes to the underlying protocol of a blockchain. When this happens, the staking rewards or terms can change, which directly affects annual percentage yield.
For example, a blockchain might undergo an update that changes the inflation rate or the number of tokens released as rewards, which could either increase or decrease the APY for stakers.
Risk Factors
The perceived risk of an investment is directly correlated to its APY. In crypto, higher APYs might be tempting, but they often come with higher risks, such as the platform’s security, the asset’s liquidity, or the stability of the underlying smart contract.
These risks require careful consideration as they can impact both the principal and the returns.
Lock-up Periods
With some crypto investment opportunities, it’s compulsory to lock up their funds for a predetermined period.
The longer the lock-up period, the higher the annual percentage yield offered, as a reward for the investor’s commitment. This can be particularly relevant in staking or in certain DeFi lending scenarios where liquidity is valuable.
The Concept of 7-Day APY in Crypto
The concept of a 7-day annual percentage yield, in crypto refers to the interest rate you could earn on a cryptocurrency investment over a year. This time, it’s calculated based on the returns from a 7-day period.
This short-term data is annualized to predict how much you might earn in a year if the weekly returns stayed consistent.
Here’s an instance to illustrate the concept:
You put some money into a crypto investment that offers returns each week. You check how much you’ve earned after one week. The 7-day APY takes that one-week return and estimates what your yearly return would be if every week was just like this one.
As you can see, this measure helps investors get a quick sense of potential earnings from different crypto investments.
Crypto Investments That Earn APY
If you’re wondering which crypto investments can earn some APY, here are a few:
Staking
By staking your coins, you participate in network operations such as transaction validation on a proof-of-stake blockchain. In return, you earn staking rewards, which contribute to the annual percentage yield.
DeFi Yield Farming
Yield farming rewards are often in the form of transaction fees, interest from borrowers, or governance tokens. The APY for yield farming can vary widely depending on the protocol and market conditions.
Crypto Lending Platforms
You can also earn interest when you lend your crypto assets to other users. Using the right platform, you get to be matched with a borrower, and the interest earned generates the returns for you, often reflected as an handsome APY.
Liquidity Pools
In liquidity pools, users lock up their assets to provide liquidity for trading pairs on decentralized exchanges
Here, you can earn a portion of the trading fees generated from the trades that occur in their pool, which can significantly contribute to the overall annual percentage rate.
Fixed Income Products
Some platforms offer crypto-based fixed income products or bonds, where you can invest your crypto and receive a fixed return over a set period.
These products can provide a stable annual percentage yield and are becoming more popular as the crypto market matures.
Dividend-Earning Tokens
Certain cryptocurrencies like Komodo and VeChain and Bibox offer dividends to holders, similar to how some traditional stocks pay dividends.
All you have to do to earn these rich rewards is to simply be a token holder, and hey prestor, you contribute to your overall annual percentage yield.
What’s a ‘Good’ APY in Crypto?
While this can be tricky to determine, a “good” APY in crypto can vary widely depending on the market conditions, the specific cryptocurrency, and the type of investment (like staking or a cryptocurrency savings account).
You should note, though, that crypto investments offer higher APYs compared to traditional financial products simply because the risk is higher. So, you can do some market comparison of similar investments in the crypto market.
Other factors determining how “good” a crypto APY is include:
The level of risk involved
How stable the returns are
The possibility of added rewards like extra tokens
If you’d like a fixed figure, you should know that most APYs in crypto might range from a few percent annually up to 20% or more for higher-risk projects.
If it goes higher than this, you can expect some big risks that could make you lose access to your funds.
Why Are Crypto APYs Higher Than Traditional Financial Products?
The reasons for this include:
There’s bigger risk, and subsequently the potential for bigger rewards
The inefficiency of the crypto market compared to the traditional market means there are more arbitrage opportunities to exploit
Unlike traditional financial institutions, crypto platforms don’t have overhead costs
There are better incentive structure, such as governance tokens
There’s also the possibility of speculative returns on the tokens used in various platforms.
Wrapping Up
Annual percentage yield is one of the unique key metrics in the crypto space as it gives a clearer picture of what you can expect to earn from your investments over a year, considering the power of compounding interest.
It’s especially appealing for those looking to grow their crypto holdings passively. Still, you should understand that a big annual percentage rate usually come with big risks.
So, take the time to understand how volatile the crypto is, how secure the platform is, and the investment terms.