APY in cryptocurrencies: what it really is and how it works

When you start exploring ways to earn on cryptocurrency assets, you will inevitably encounter the term “APY.” But what exactly does this abbreviation mean, and why is it so important for your portfolio? Let’s break it down from the basics.

The Essence of Annual Percentage Yield

APY (Annual Percentage Yield) is a metric that reflects how many percent you will earn over a year on your invested capital, taking into account the effect of compounding. In other words, it’s not just a simple interest on your principal amount, but a sum that grows because the earned interest itself becomes the basis for the next calculation.

The effect of compounding is what distinguishes APY from a regular interest rate. Imagine a snowball that grows not just by adding snow, but by each layer attracting more snow. That’s how compounding works in finance.

APY and APR: Understanding the Difference

People often confuse two similar terms: APY and APR (Annual Percentage Rate). But they are not the same.

The main rule: APY accounts for compounding, APR does not. If you are thinking about long-term investing, APY is your metric. For short-term operations, APR is more appropriate.

How APY is Calculated: Formula and Example

APY is calculated using the formula that considers the nominal interest rate and the number of compounding periods:

APY = ((1 + r/n)^n - 1)

Where:

• r - nominal interest rate (in decimal form)
• n - number of compounding periods per year

Let’s look at a practical example. You invested $10,000 at 6% annual interest. If the bank compounds interest once a year, at the end of the year you will have $10,600.

But what if the same bank compounds interest monthly? Then each month your base grows, and the final amount will be $10,616.78. The difference of $16.78 may seem small, but over 10 years, it results in a significant capital increase.

How APY Works in the Cryptocurrency World

In the crypto space, the logic of APY remains the same, but there is one important difference: payouts are made in the cryptocurrency you invested, not in fiat money.

For example, if you earn 6% APY on 1 Bitcoin, after a year you will have an additional 0.06 BTC. Fluctuations in BTC’s dollar rate do not affect the amount of bitcoins you earn — it’s a fixed amount in cryptocurrency.

This creates an interesting effect:

• On rising markets, crypto APY can be much more attractive than traditional investments
• On falling markets, attractiveness decreases because you earn in a coin whose price is dropping

Methods of Earning Income

Cryptocurrency platforms offer several ways to generate income:

• Staking - participating in validating blockchain transactions via proof-of-stake networks and earning rewards in the form of new tokens
• Liquidity Farming - providing a pair of tokens to a decentralized exchange to facilitate trading and earning commissions
• Crypto Lending - lending your assets to other participants and earning interest

What Affects the APY for Crypto Assets

Token Inflation

Each crypto network has a certain inflation rate — the pace at which new tokens are introduced into circulation. If inflation exceeds APY, your real return may turn negative. This is a key parameter for assessing true profitability.

Supply and Demand Balance

Like in traditional economics, interest rates for cryptocurrencies fluctuate depending on how high the demand for a specific token is. When many want to borrow a token, interest rates rise. When supply exceeds demand, rates fall.

Frequency of Capitalization

The more frequently compounding occurs, the higher the final APY. That’s why daily or weekly compounding usually yields better results than annual.

7-Day APY: The Standard in the Crypto Industry

In traditional banks, interest is accrued once a month. In the crypto industry, shorter periods are used. The most common option is 7-day APY, where capitalization occurs weekly.

This approach is chosen for three reasons:

1. High volatility of cryptocurrencies requires more frequent recalculations to keep the indicator relevant
2. Shorter periods allow investors to verify the platform’s honesty and ensure no manipulation
3. Beginners find it easier to evaluate returns over short timeframes

Why Crypto APY Is Higher Than in Traditional Finance

The difference is striking: traditional banks offer about 0.28% on savings accounts and 2-3% on some loans. Crypto platforms offer APYs in the range of 5-18%, and sometimes higher.

Reasons include:

• Less regulation - the crypto sector is less controlled than traditional banking, allowing platforms to offer higher rates
• Higher risk and volatility - increased risks justify higher returns
• Reduced operational costs - digital nature of operations lowers expenses
• Liquidity concentration - a few major players set rates on the market, often higher to attract capital

An Important Risk: Impermanent Loss

When choosing a way to earn on cryptocurrencies, you should not forget one phenomenon — impermanent loss (impermanent loss). Liquidity pools often offer the highest APY, but this comes with risk.

If you provide liquidity in a token pair, you deposit an equal amount of each. Significant changes in the price ratio between them can lead to losses, even if both tokens increase in dollar value.

Conclusion

APY is a compass in the world of crypto investing. It’s a metric that allows you to compare different income opportunities and choose the most promising options.

Remember, high APY always involves a certain level of risk. Before investing your assets, analyze not only the APY itself but also the factors influencing it: token inflation, market demand, and the type of compounding.

When comparing different platforms for crypto placement, pay attention to the APY and remember that this value constantly changes. Regularly studying new educational materials will help you stay updated on the latest trends and make informed investment decisions.