Whether you have just taken your first steps into the world of DeFi or are a veteran in the field, one thing is certain: it is not risk-free. Cryptocurrency price action is very volatile and sometimes all you can do is wait for the price to go up. But the more savvy users can use their crypto assets for yield farming, lending, or staking their tokens to earn returns. And in crypto, returns of up to 10,000% per year or even more are not uncommon, but it is important to know how these returns are calculated and whether you are actually getting the returns shown.
While providing liquidity on DeFi can be very profitable, users face another risk known as temporary loss that can quickly impact your earnings. In some cases, the effects can be quite catastrophic. And although the term is widely used in the DeFi space, many users still don’t know what a temporary loss is and how it works. Without getting too deep into the technical aspects, we will delve into the various elements of cryptocurrency return calculation and impermanent losses.
What is APY in Crypto?
APY, which stands for Annual Percentage Yield, measures the yield when users deposit their funds into various lending and yield farming protocols. The APY accounts for the effects of compound interest, which can turn low daily or hourly returns into huge amounts over time. Because the APY reflects the return on investments over a one-year period, you should only expect to receive the interest rates shown if your money is deposited over that time horizon. Yields can also vary at any time due to a variety of factors such as token price and additional token incentives.
How is APY calculated in crypto?
With cryptocurrencies, the APY is often calculated differently depending on how often the yield is paid out. For example, rebase tokens like Olympus, Wonderland, and Klima allow depositors to earn rewards every epoch, typically every 8 hours. This means that your deposited tokens actually earn interest three times within a day, resulting in a much higher APY than if your tokens only earned interest daily.
However, the APY can also fluctuate depending on the token price and the total amount deposited. Some protocols usually offer returns in the form of other tokens, which require users to manually claim the tokens, sell them, and offset against their initial deposit. The APR displayed is then the return that depositors can expect by manually compounding interest on a daily or weekly basis. For example, Sunny is a yield aggregator on Solana that provides rewards in the form of SBR and SUNNY tokens that can be claimed together with a single click.
As a general rule of thumb, the higher the number of compounding periods, the higher the APR. Sometimes, instead of the APR, a log will show the APR or the annual percentage. The key difference is that the APR can be viewed as a simple rate that does not take into account the effects of compounding. Both protocols might have the same APR, but the APR can vary wildly depending on how often new tokens are continuously added to your initial deposit.
What is the difference between APR and APY?
Although both terms refer to the return you would get on your deposits, unlike the APR, the APR does not take into account the effect of compounding, which is why it is typically much higher than the APR for any investment. Below is the APR for Trader Joe’s farms, highlighting both the return for providing liquidity and the bonus returns from using the LP tokens in the relevant farm.
Assuming your return increases each month, investors could earn interest on top of the interest earned in the previous months, resulting in an additional return that can be quite significant over the long term. If the income is generated annually, the APR and the APR should be exactly the same.
Depending on the level of liquidity as well as trading activity associated with a particular liquidity pool, depositors can typically expect a generous return, especially if they are particularly early or own a large portion of the liquidity pool. But as we mentioned, temporary losses pose a risk for liquidity providers everywhere, even the most seasoned yield farmers.
So what is a temporary loss?
A temporary loss occurs when liquidity providers receive different amounts of assets upon withdrawal than when they initially deposited them into a liquidity pool at an Automated Market Maker (AMM) such as Uniswap or Sushiswap. This is due to changes in the token price affecting the composition of the liquidity pool, causing you to have slightly less or more of a given token. For example, even if you deposited your funds 50:50 at the beginning, there is no guarantee that you will end up receiving the same amount from each fund. This can result in liquidity providers receiving less value in assets than if they instead chose to simply keep the tokens in their wallet.
Here is an example. Let’s assume that the price of 1 ETH equals 1000 USDC. Most AMMs require the same token value to be escrowed on both sides of a token pair. Let’s say Alice wants to provide liquidity to the ETH-USDC pool. She needs to deposit 1,000 USDC for each ETH unit she wants to deposit or vice versa. Alice deposits 1 ETH and 1,000 USDC into the liquidity pool, which now contains a total of 10 ETH and 10,000 USDC. In other words, Alice’s deposit of $2,000 now accounts for 10% of the pool, which has a liquidity of 100,000.
It is important to note that since AMMs do not have order books, the price of assets is determined by the ratio of assets in the pool. If the price of ETH rises to 4,000 USDC on other exchanges, arbitrageurs will take advantage of price discrepancies on the AMM, trading more USDC for ETH until the price is roughly the same everywhere else.
If nobody withdraws their liquidity, it should remain constant at 100,000. However, the ratio of ETH and USDC in the pool has now changed and consists of less ETH and more USDC. With a price of 4,000 USDC, there should currently be 5 ETH and 20,000 USDC in the liquidity pool. Since Alice owns 10% of the pool, if she decides to withdraw her assets, which would be worth $4,000, she would receive 0.5 ETH and 2,000 USDC. If she held just 1 ETH and 1,000 USDC instead, her money would have been worth $5,000.
© CoinGecko Research
By providing liquidity, we can see that Alice made less money than she could have made by simply holding. Although she didn’t technically lose her initial capital, she experienced what we know as a temporary loss that becomes permanent after she withdraws her tokens. Assuming she leaves her assets in the pool until the price of ETH falls back to 1,000 USDC, the temporary loss will be reversed and she might even make some money from the trading fees charged by the AMM.
How to calculate temporary loss?
Now that you understand how temporary losses occur, how do you calculate exactly how much you’ve lost providing liquidity? If the price of assets in a pool changes by a certain amount, it will affect the total value of your deposits and we can easily plot these results on a graph. Since it is a price change, it doesn’t matter if the price of the assets goes up or down as you would still be better off holding the assets instead.
© Alex Beckett, Understanding Temporary Loss
For example, if the value of one of the assets in the pool doubles, you will suffer a temporary loss of 5.72%. However, this assumes that the weight of both assets in a liquidity pair is equal. Some DEXs allow users to create liquidity pools with different weights or more than two assets, e.g. B. Balancers and KyberSwap. In this case, the temporary loss would be calculated differently.
Depending on the level of liquidity as well as the trading activity associated with a particular liquidity pool, depositors may experience a positive return if the fees earned exceed their temporary loss or not at all. These fees, which depositors can expect, are usually quoted as APY.
closing thoughts
DeFi has opened up many opportunities for users to stake their assets. Instead of keeping them in the wallet long-term, their tokens can be used to generate returns by providing liquidity to different platforms. To attract more users, new protocols usually introduce various campaigns and incentives where depositors can earn the protocol’s native token.
In most cases, the price of newly minted governance tokens skyrockets, either due to excessive demand or low liquidity. In both cases, the APR for deploying and providing liquidity will increase enormously, which will attract even more depositors. However, as we have seen on numerous occasions, this form of liquidity reduction is not sustainable and will not last long. Therefore, it is important to determine how income is generated and calculated. High APYs don’t do much good if the protocol doesn’t last long.
And even if the liquidity mining program results in a steadier and more sustained issuance of rewards, depositors should also consider the impact of temporary losses. Cryptocurrency prices are always volatile, and unless you’re very experienced, you could make a lot more by holding liquidity rather than providing it. Sometimes being a lazy investor goes a long way, but if you’re not too lazy you can also get the most out of your income strategies by using our new APY and Impermanent Loss Calculator.
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Khor Win Win
Win Win is an avid gamer interested in navigating the vast world of NFTs and the cryptoverse. Follow the author on Twitter @0x5uff3r
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