DeFi (Decentralized Finance) APY (Annual Percentage Yield) refers to the interest rate or yield earned by an investor or user in a DeFi protocol. DeFi protocols are decentralized financial platforms that operate on blockchain technology, which allows for transparency and security.
DeFi APY is different from traditional finance APY because it is not controlled by centralized institutions such as banks but by smart contracts on the blockchain. DeFi protocols use various mechanisms to generate yield, such as lending, staking, liquidity providing, and yield farming.
It is becoming increasingly common in DeFi and even on centralized crypto exchanges for projects to offer some method of earning APY. By doing so, protocols can attract liquidity or locked tokens for their network. Based on certain parameters set by the protocol, the APY may be variable or relatively constant, depending on how different actions are incentivized. For example, rewards may be paid in the project’s token or in returns of the assets deposited. Each platform has its own set of rules surrounding APY, so it is best to do the research to discover which is the right fit for your interests.
High APY is especially appealing in the financial world because it engages the power of compound interest, meaning that the amount you earn as a reward or interest can be added to your original investment, compounding your overall return. Note that protocols can wield different compounding periods or the amount of time an investor must wait before the earned revenue is reinvested. For example, suppose the compound period is one day. In that case, this means at the end of each day, whatever amount of rewards have been earned will be reinvested into the initial investment, hence generating more profit the next day. Some protocols do not auto-compound, so rewards will need to be harvested periodically.
The following formula is used to calculate APY:
APY= (1 + r/n )^n – 1
r = The interest rate
n = The amount of times the interest is compounded per year
Example: Let’s say protocol Z offers an annual rate of 20% on their $Z tokens, compounded every day (i.e. 365 times/year).
The APY would be : (1 + 0.20 / 365) ^ 365 – 1 = 0.2213
22.13% is how much you will earn in a year of daily compounding rewards.
So, if I buy and stake 1000 $Z tokens, at the end of the year, I will have 1,000 + a reward of 221.3 $Z tokens or whatever reward is issued. It is up to the investor to decide whether or not the value of his tokens now will be worth the passively earned reward tokens in a year.