Annual percentage yield (APY), unlike the annual percentage rate, is the rate of return one can earn on a deposit when we take compounding interest into account. It means that the interest earned over a period of time on the initial deposit is added to the principal amount for each period. With this, the principal amount grows with every passing period and so does the interest earned on it.
Having been bored by the considerably low-interest rates of traditional investment schemes, the crypto community has found its new muse — the world of decentralised finance (DeFi).
As a decentralised financial ecosystem, DeFi lending and borrowing protocols depend on its users to add liquidity for borrowers to take loans from. The launch of Compound Finance lending and borrowing protocol introduced a new method of earning high yields, called yield farming.
Let’s see how.
How DeFi users generate high APY
The idea of generating high APY through DeFi lending and borrowing protocols revolves around yield farming. Yield farmers stake their cryptocurrency funds in different liquidity pools to generate the highest returns.
The first step to generating the highest possible yield is to spot the best markets that provide the highest return rates. One can find the rates across different protocols for different coins on DeFi Rate.
While the interest rates are already higher on DeFi protocols compared to a savings account in banks, the major benefit comes in two main ways. For example, if we consider the frontrunner of crypto lending, Compound, here’s how it works
- Lenders receive interest in the currency they deposited every 15 seconds
- Compound rewards its lenders in COMP tokens for their contribution to the network.
COMP is the governance token of Compound protocol and every time users add liquidity to a liquidity pool on Compound, they earn COMP tokens.
Even borrowers earn COMP as rewards from Compound Finance to borrow from the pool. And until recently, the rewards offered by most lending protocols were much higher than the interest borrowers had to pay for their loan.
Utilising this feature, many users borrowed funds from the liquidity pools and lent those funds to another liquidity pool, earning COMP tokens for both lending and borrowing. This helped them earn a high annual yield percentage using the Compound protocol.
The risks associated with DeFi
Weak codes are the biggest threat to DeFi protocols. They’ve already resulted in the loss of millions of dollars. As the DeFi sector is seeing increased investment and growth, there are also chances of poorly developed projects and exit scams that intend to make a quick buck. With the lack of any regulatory protection or insurance, there is also no way to claim your funds if you lose them to a hack or theft.
There’s no doubt that DeFi protocols offer better returns than most banks. It may easily lure people into putting in huge sums with the expectation of making easy money. However, it is equally important to be vigilant of the risks involved with it. With time, insurance of funds stored in DeFi protocols may add more security to users’ funds and push DeFi for further adoption.