APY stands for Annual Percentage Yield, and is a figure which represents the financial gain as a percentage of an initial investment, per year. Yield, displayed as APY, is offered as a reward to users who lock funds in a variety of DeFi instruments, such as liquidity pools, lending vaults or staking contracts.
APY may be paid in a project’s native token, in a partner project’s token as an incentive mechanism, or as a combination of the two. Many investment strategies use yield-bearing tokens to accrue yield automatically, saving users the need to claim and redeposit rewards manually, and the associated gas fees.
The idea behind APY is to convey the projected gains of an investment in annual terms, all else being equal, taking into account the effect of any compounding (see below) of the underlying assets that may have occurred within that year.
However, such a rate in DeFi is rarely constant as market conditions vary. This can have an effect on a user’s returns in many ways. The price of the tokens in which yield is paid may be volatile, resulting in earned yield increasing or decreasing over time, or a project may decide to adjust rewards on certain strategies, for example, to incentivise a new liquidity pool.
In this sense, APY gives the yield that would be generated if funds were locked in for a year under the same market performance conditions. While this may not turn out to be the case (especially for higher APY investments, which are usually seen as short term investments by yield farmers) APY is a useful metric given that most of our mental models rely on measuring time in terms of years.
Compounding occurs when the returns earned on an investment are added to the initial investment.
Let’s say a bank in the world of traditional finance offers a savings account with an interest rate of 10%. If you were to start with a deposit of $100, you’d have $110 at the end of the year (i.e. starting amount + 10%). The next year, the 10% interest is calculated on the new balance of $110, resulting in $11 interest earned. In the third year, the interest would be 10% of $121, i.e. $12.10. As interest is compounded, the earnings increase with time as the principal (the balance on which interest is calculated) grows.
However, in DeFi, many platforms offer strategies which automatically compound yield on much shorter timescales, measured in blocks rather than years. This increases the speed at which the principal grows, and returns become more lucrative due to the rapid compounding rate.