DeFi Takes APYs to Heights Inconceivable by Traditional Finance
In a time with historic low-interest rates in the traditional capital markets, DeFi offers double and triple-digit yields.
Traditional finance has always had high barriers to entry. In the pre-DeFi world, to become a liquidity provider, not only would you need professional qualifications and a large client base, but you would also need to be employed by a regulated financial securities trading company.
Today, the world is different.
Today, we have DeFi.
Thanks to DeFi, trading fees and commissions can now be collected by anyone willing to provide liquidity — in the form of digital assets — to a decentralized finance protocol on the Internet.
DeFi: The Home of “Astromonical” APYs
Decentralized Finance (DeFi) is a new open financial market where anyone can participate in providing financial services that do not discriminate against anyone. In DeFi, anyone can be a liquidity provider and earn fees as a reward.
For a thriving market, liquidity is essential.
DeFi, with its open arms towards participators, creates the potential for a very diverse liquidity profile since there are drastically lower barriers to entry compared to the traditional capital markets.
DeFi allows the “Average Joe” to earn fees that would typically only be available to Wall Street firms and brokers.
Anyone can trade, borrow, or lend to generate returns in DeFi, similar to traditional finance. However, unlike traditional finance, DeFi brings a new opportunity for investors: yield farming.
Yield farming is the act of providing liquidity to DeFi platforms for the sake of earning rewards in the form of interest or protocol tokens.
The platforms themselves act as liquidity providers as well, and other users can trade, lend and borrow on the platform with the liquidity provided by yield farmers.
DeFi Jargon: APR vs. APY
Let’s get into some of the jargon of DeFi to see how you can profit from providing liquidity — just like banks have for centuries.
Those familiar with investing know the terms APR and APY.
A quick recap for those not too sure:
APR stands for Annual Percentage Rate, which is the percentage of interest an investor or depositor will earn over a year. For example, if you invested $1000 at an APR of 10%, you would profit $100 at the end of the year (1000 x 0.10).
APY stands for **Annual Parentage Yield. **It is similar to APR, except that it includes the compounding of interest.
Compounding is simply applying interest on all accumulated previous interest as well, instead of just applying it to the initial investment. In other words, compounding is when you reinvest your profits from the APR instead of collecting the profit. This compounding growth rate is called APY, as shown below.
Yield-generating DeFi apps feature much higher APY rates than seen above for their investment instruments, called liquidity pools.
A liquidity (or trading) pool is a collection of pooled assets that allows traders to buy and sell these assets using the provided liquidity. Hence, the name liquidity pool. Each pool typically has trading pairs because usually, you deposit two digital currencies at once, with a value ratio between the pairs being a standard 1:1.
Pools are where you provide your liquidity in the DeFi world, and each one has its own APY that fluctuates due to market conditions.
Yield farming consists of utilizing these pools to deploy advanced strategies of depositing and moving funds from pool to pool on multiple platforms to take advantage of the highest APYs.
Since yield farmers move from platform to platform, all of the various platforms in the DeFi world, such as Cream.finance, Balancer, UniSwap, Curve.fi, PancakeSwap, Beefy.finance, and many more are collectively part of the same ecosystem.
They correlate with each other in terms of their individual performances due to their overlapping users and liquidity. This is why as a yield farmer, you must compare metrics — such as APY, TVL (total value locked), and token rewards — across platforms to profit as much as possible from the DeFi market’s high APYs.
Yield Farming APYs
Yield farming and its double to triple-digit APYs are exclusive to crypto. But just how different are they from traditional finance?
Well, take a look at the APYs on leading yield farming platforms and it won’t be hard to see why. For example, here are the current top pools and their APYs available on PancakeSwap:
Also, here’s a snapshot of another platform, Beefy.Finance:
As you can see, APYs in the DeFi markets can approach the 1,000% mark!
Imagine depositing $500 just to see it become $5000 in the course of a year.
This is unheard of in traditional finance.
To add to that magnitude, the APYs listed on PancakeSwap are actually APRs. The APY return would be even higher.
Another thing worth noting is if you look at the *Beefy.Finance **screenshot, you’ll see pools that say ‘Uses: Pancake*’. This is because those pools intake liquidity that users generated earlier as rewards for yield farming on PancakeSwap, allowing you to see how connected these platforms can be. All for the sake of yield farming, of course.
High APYs = High Risk
Although high APYs are the biggest allure of yield farming, a pool with a higher APY is correlated with higher risk.
High APY pools typically feature digital asset pairs that are less correlated with each other in their value. Since the currencies are less correlated, either of them could drop in price significantly relative to the other and that would cause liquidation since pools always have to maintain a set value ratio between the currency pairs, which is usually 1:1.
As the first currency drops in price, the pool will try to maintain the ratio by buying the dropping currency with the other currency in the pair. In the end, you could end up with a whole bunch of tokens for a currency that is not worth much anymore. This is known as impermanent loss.
If you are unfortunate enough to suffer from impermanent loss, then the $500 you were expecting to turn into $5000 could very well turn into $5 instead.
Not to worry, an investor looking to practice yield farming for the high APYs can mitigate their risk by following investing best practices. You would also have to make sure you understand the APY and token rewards model of any platform you use. Other than that, a deep understanding of how the DeFi ecosystem works is a must.
But without the requirements traditional finance enforces for becoming a liquidity provider, you are much closer to generating high yields than you could ever be without DeFi.