Banks and investment corporations use these terms to advertise their products. When a bank wants more people to borrow, it will say that they apply an APR creating a situation where a borrower pays slightly less. If a company wants customers to bring in money, they will say that they use APY allowing them to earn slightly more.
The difference may seem negligible when we talk about small sums of money, but it can be a game-changer for large deposits.
What does APY mean in crypto?
It is unnecessary to redefine the term for the crypto industry as the underlying principle is the same. APY is a compounding interest on your investments which is something heavily advertised by crypto companies introducing staking to obtain liquidity and funding. Different DeFi platforms may have unique propositions offering up to 20% in APY with monthly compounding which translates to roughly 21.93% annually.
Earning APY on crypto seems like a lucrative endeavor. Advertisers often position their products in a way that defies high risk and promises steady returns convincing users to stake their coins for prolonged periods. APY is used as a strong talking point since staking often means locking liquidity and funds for years creating notable inconveniences for capital holders.
- Believing these promises is not the best strategy. Annualized yield that takes into account monthly compounding may indeed be quite profitable compared to other investment options. However, you need to consider potential downsides and nuances.
- Many advertisers may not directly mention a compounding period. Investors assume that they stake for monthly compounding APY, but the term may be a quarter or half a year. A 6% APY in the first case will be 6.17%. If compounded quarterly, it will translate to 6.13%.
- Long-term staking does not necessarily mean that it is safe or reliable. In many scenarios, it is wiser to lock your money for shorter periods and extract value when possible. Since Ethereum introduced staking, it could be a good way to invest in the distant future, but ETH staking is quite expensive.
You may receive a payout only after the contract is completed. Unlike with banks, DeFi platforms lock your funds and do not have a mechanism to pay them back until the staking period is over. Stakers may miss out on valuable opportunities or not consider the ramifications of locking their funds for years to come. They rely on APY crypto meaning that their funds are no longer theirs until the end of staking contract.
What is the APY formula?
You may wonder why we have different estimations depending on how compounding works for each particular case. The formula is based on the fact that the interest is accounted for each month with consequent additions taking compounded interest into consideration. The calculation is done via the formula below:
APY = (1 + r/n)n – 1, where
n — number of periods;
r — annual rate.
Depending on the number of periods, you will have a different outcome in the end. When calculating APY return, you need to read between the lines when advertisers fail to mention significant aspects of their proposal. The number of periods plays a huge role as we see in the formula below. This is how APY works in general.
Examples of how to calculate APY earnings
We will look into three distinct scenarios with each demonstrating a specific case for a staking opportunity advertised on the internet. While all of these examples will use a 12% annual interest on a 10,000 tokens stake, the conditions will change each time.
1. 12% APR. As mentioned previously, APR meaning in crypto is slightly different from APY. It takes the flat rate and applies it to the deposit at the end of the staking period. In our case, the return will be 1,200 tokens (flat 12% at the end of the year).
2. 12% APY compounding monthly. In this case, we will have a slightly different outcome. Using the formula above, we will get 12.68% or 1,268 tokens as a return on the same investment which is a marginally better outcome.
3. 12% APY compounding quarterly. The reduction of compounding periods affects the final payout. We will get 12.55% or 1,255 tokens. It is an improvement over the APR case, but a little bit less than we would have gotten from monthly compounding. The difference is 0.13% which can be significant in certain cases.
It is hugely important to remember that each crypto APY calculator uses a different approach because it is close to impossible to create a user-friendly app without simplifying it and making assumptions during the calculation. Most CEX platforms featuring staking will have their version of a calculator.
The problem is that it will usually account for conditions presented in their products specifically or ignore some meaningful aspects like the number of periods and define APY in their terms which may differ from what other staking systems use.
The APY meaning in crypto
Staking is a relatively new concept in the world of cryptocurrencies. First introduced in 2012 by researches Sunny King and Scott Nadal, the idea of proof-of-stake was to reduce the price of maintaining the Bitcoin network that required about $150K per month at the time. Despite the cost of running the network growing by this day, the PoS mechanism did not take off.
However, the concept was deemed worthy of exploring. In 2013, Peercoin was launched and used the PoS mechanic. Then, Blockcoin also joined the pack. Both tokens failed to captivate the crypto community, but Ethereum and Cardano soon announced that they will be exploring the idea of switching to PoS.
Ethereum did so by merging with its Beacon sidechain. Cardano is also using the PoS protocol and will introduce its own version of staking in the first quarter of 2023.
Staking reduces the environmental impact of mining and allows networks to work faster enabling improved scaling and interconnectedness. While these advantages make it seem that the PoS version is great, some skeptics pointed out that it has several notable weaknesses.
- The initial launch may encounter distribution issues. Stakers reap rewards meaning that first coins have to follow a unique distribution rule set which has to be defined by founders and may seem unfair to other members of the network.
- Centralization is also a big issue. People who are able to stake a lot of coins will take the vast majority of issued tokens and may affect the network by controlling the validation process via staked liquidity. Some experts pointed out that Ethereum became more centralized with some entities controlling large shares of staked tokens (51% attack).
- NoS or Nothing at Stake. It is a hypothetical issue which will unlikely arise in the future, but a situation where nodes do not have anything at stake for verification purposes may theoretically affect any PoS network.
Ensuring that the network has sufficient liquidity and enough tokens staked to conduct validation smoothly is the key priority for any PoS network. It means that such projects have to keep the pool of staked tokens full enough for the ecosystem to function as intended. Hence, the significant focus on advertising their APY-driven staking systems.
The true APY meaning for crypto
When the market is bullish, it is a great time for crypto APY investments. The core of exclusivity and appeal of staking tokens is that you reap rewards not in fiat currencies, but in corresponding coins. Some projects even introduce special cryptocurrencies that are used as a medium for returns. The complicated Shiba Inu system with BONE, SHIB, LEASH, and TREAT is a perfect example.
Many investors who are big on crypto believe that the true value of staking not in receiving the immediate return in USD or other fiat, but in the potential appreciation of assets themselves. We will give you a hypothetical example.
Imagine that you purchased 10 ETH at $1,200 ($12,000) and staked them for 4% APY compounding monthly in a pool. The comparative scenario is the one where you deposit $12,000 at a bank with the same conditions. Over the year, ETH appreciated by 50% and reached $1,800.
- Scenario 1. 10 ETH staked for 12 month will result in 0.403 ETH sold at $1,800 which translates to $725 at the end of the staking period. In USD, it is a solid 7.25% return.
- Scenario 2. The same APY is applied to your bank deposit of $12,000 which will bring a return of $483 during the same period.
The difference is quite big. The first scenario awards you with $242 more after a year-long investment period with funds locked in place. In terms of percentage points, you receive 3.22% more when counting in USD.
Our example uses a plethora of assumptions like unchanging staking conditions and the bullish crypto market. Note that predicting the short-term perspective of the crypto industry is close to impossible, but the distant future looks bright for the blockchain technology and decentralized finance meaning that stakers who lock their funds for years to come expect huge rewards due to upcoming strong bullish trends.
Many enthusiasts wholeheartedly believe in crypto APY meaning that they are all-in and hope that the next decade will be the time for significant change in the crypto industry and the global economy that shifts closer to digital globalization with each year. It is easy to explain APY nuances to newcomers and the market enjoys regular influx of new investors allowing PoS networks to thrive even during notable downtrends.
Timing is crucial
Any DeFi APY calculator counts staking in years regardless of compounding periods. While not a big issue in general, you need to remember that many DeFi platforms, exchanges, and centralized pools may have much shorter staking programs with some allowing users to lock their funds for just three or six month.
This type of staking is useful for retail traders interested in earning a little extra during moments of crisis in the market. The 2022 “crypto winter” is a great example when prices went down, but many enthusiasts switched to DCA buying, staking, and moving their assets to cold storage.
The first quarter of 2023 is expected to be much more interesting for crypto enthusiasts and many decided to simply wait it out by locking their funds with different pools and exchanges. During the spring, they will extract their rewards and continue trading on an uptrend that will happen inevitably happen sometime in the future.
When is APY paid? This question should be asked at the beginning of any investment endeavor related to staking. You need to know exactly when you will receive your coins back. Many investors who put money into the Beacon network were confused when they learned that their staked coins will be paid out when the merge will be fully completed in March, 2023.
Poorly informed individuals thought that they will get their rewards after the initial phase of the merge on September 6, 2022.
Should you use an APY crypto calculator?
It is always a good idea to do your own research and calculate APY returns manually using publicly available formulas. An APY calculator for crypto that you can find on an exchange website or on a web page of a particular DeFi platform will be insufficient for calculations with specific conditions and terms.
There is nothing wrong with using independent tools and specialized mini-apps, but you must understand their limitations and downsides. Different calculators will show wildly varying outcomes when fed the same initial data. Remember that APY in crypto is a relatively vague term requiring some investigative work to be fully understood by investors.
We strongly recommend all investors to do their due diligence and inquire with support employees of DeFi platforms before making financial decisions. Talk with other users on forums, ask developers, and acquire the data needed for precise calculations. Use the formula to find the true outcome and start staking only if you are sure that you understand the mechanic behind the staking feature.
Also, compare results of your market activities with potential returns. Many retail traders outperform APY-based investment plans and can earn more money by opening smart market positions instead of locking their liquidity in staking pools.
The main takeaway
Using investment programs advertised as featuring APY is a good idea. While the difference between APR and APY seem insignificant, with large enough investment they start affecting your bottom line. With $1 million at stake, you will notice even minute changes in percentage yields. Just 1% of that sum is already $10K.
Using APY crypto calculators should be something that you do for fun. Hopefully, you understand the intricacies of compound interest after reading this guide and can calculate potential returns independently without relying on mini-apps designed to be as simple as possible.