Annual Percentage Rate/Annual Percentage Yield
In decentralized finance (DeFi), the term “annual percentage rate” (APR) is used to indicate the rate of returns from a liquidity, farming or lending pool. APRs are a useful indicator for investors to estimate what their profit would be within a certain amount of time.
If an investor would earn 10% interest per quarter on a $1000 USDC deposit in a liquidity pool, and the investor decides to withdraw his received interest every quarter, he would receive $400 USDC after leaving his deposit for a year.
DeFi-protocols often use the term “annual percentage yield” (APY) as well. This term is used to indicate the rate of returns including the compound interest of a pool.
If the same investor would earn 10% interest per quarter on a $1000 USDC deposit, and he decides to leave his received interest in the liquidity pool, the pool compounds the interest. The same investor would receive $464 USDC after leaving his deposit for a year.
Defi-protocols usually recalculate a pool’s APR (or APY) every 24 hours. Pool APRs depend on various factors and because of this, high APR-pools typically can’t keep their APRs at the same high level for a longer period of time. Of course, whenever a pool is extremely popular, APRs tend to stay higher for a longer period of time.
The APR of a pool depend on the following factors:
- Pool popularity: If, for example, a liquidity pool contains a popular trading pair, many investors will use the pool to swap between its token-pair. Due to this, a higher amount of trading-fees is paid, resulting in a higher APR for liquidity providers.
- Additional token yield: This is often seen in both liquidity pools and automated yield-farms. Defi-protocols provide investors with additional token rewards, which is typically the platform’s governance token, on top of the pool’s earnings to incentivize them to deploy their assets in the DeFi-protocols’ pool or farm.
- Low liquidity: Some pools show sky high APRs, which are usually too good to be true. Unexperienced investors tend to ape into these pools, which usually result in a decrease in APR. This phenomena is caused due to the pool having low liquidity. Due to this, the trading-fees of swaps made within the pool are distributed over a smaller amount of liquidity. This results in higher APRs for each individual liquidity provider within the pool. However, as mentioned earlier in this section, pools that show high APRs tend to decrease rapidly over time, due to more investors start providing liquidity to the pool.
- Fake APRs: Some malicious defi-protocols show fake APR values to pursue investors to deploy their assets in the protocols’ malicious pools. Once investors have deployed their assets in the malicious defi-protocol’s pools, they will lose all their deployed assets with no way of gaining them back.