Why is the APY in Crypto different from traditional banks?

If you’re looking for ways to earn passive income from cryptocurrency, the APY (Annual Percentage Yield) figure will definitely appear on your screen. But what does APY crypto really mean, and why is it much more attractive than a traditional savings account?

What is APY and why is it important?

APY (Annual Percentage Yield) is the annual interest rate that calculates accumulated interest over time, taking into account compound interest. This is the main difference compared to simple interest (IR).

With simple interest, you only earn interest on the principal amount. With compound interest, you earn interest on both the principal and the accumulated interest from previous periods. For example: depositing $10,000 at 6% annual interest, if the bank compounds monthly instead of yearly, you will have $10,616.78 at the end of the year instead of $10,600 — this difference arises from the power of compounding.

How to calculate APY using the formula

To calculate APY, use the formula:

APY = ((1 + r/n)^n - 1)

Where:

• r = nominal interest rate (before inflation)
• n = number of compounding periods per year

Nominal interest rate is the initial rate promised to you, while the number of compounding periods refers to how often interest is calculated (daily, weekly, monthly). The more frequent the compounding, the higher the APY.

APY vs APR: Don’t confuse them

Although both APY and APR (Annual Percentage Rate - annual percentage interest) relate to interest rates, they are completely different:

• APY = accounts for compounding → used for long-term investments
• APR = does not include compounding → used for loans or short-term investments

When comparing investment opportunities, always use APY because it provides a more accurate picture of actual returns.

How does APY in cryptocurrency work differently?

Unlike traditional banks, when investing in crypto, you receive interest paid in the same type of cryptocurrency you deposited, not in USD or other fiat currencies.

For example: investing 1 BTC with an APY of 6% will give you 0.06 BTC at the end of the year, not 0.06 USD. The dollar value of Bitcoin can go up or down, but the amount of cryptocurrency you receive remains fixed.

This means: in a bullish market (Bull market), crypto APY is extremely attractive. But in a bearish market (Bear market), you still only earn interest in that cryptocurrency, even if its price drops.

Ways to generate passive income from Crypto

To earn high APY on your crypto, investors often use Yield farming methods:

1. Staking cryptocurrencies
By validating transactions on a blockchain (Proof of Stake), you earn rewards. The more crypto you stake, the higher your chances of being chosen as a validator to add blocks to the blockchain.

2. Providing liquidity (Liquidity)
Providing equal values of two cryptocurrencies to decentralized exchanges (DEX). You earn profits from accumulated trading fees, with APYs often very high.

3. Lending cryptocurrencies
Through decentralized finance platforms (DeFi) or centralized intermediaries, you lend out cryptocurrencies and earn interest.

One important factor: liquidity pools (Liquidity pools) offer the highest APYs, but come with the risk of impermanent loss (Impermanent Loss). When the price of one of the tokens in the pair fluctuates significantly, your profits can quickly diminish.

Why is crypto APY often many times higher?

Traditional banks only offer around 0.28% APY for savings accounts, and lending rates are only 2-3%. In contrast, crypto APYs can reach 12% or higher for savings, and borrowing rates from 5-18%.

The reasons are:

• Less regulation: The crypto market is less strict than traditional finance, allowing higher interest rates
• Higher risk: Price volatility and market uncertainty lead to higher interest rates to compensate for risk
• Token supply and demand: Like any economy, when supply is limited, lending interest rates increase

7-day APY: How to evaluate actual returns

Most crypto platforms calculate compound interest on a 7-day cycle rather than annually. The formula for 7-day APY:

APY = ((A - B - C) / B) × (365 / 7)

Where:

• A = price at the end of 7 days
• B = price at the start of 7 days
• C = accumulated fees during the week

This figure gives you a clearer view of your weekly earnings instead of waiting a whole year.

Factors affecting APY

Inflation: If the rate of new token issuance exceeds the APY, your returns will be eroded. Tokens with high inflation will have a negative impact on APY.

Supply and demand: When many people want to stake or borrow a token, interest rates can decrease due to abundant supply. Conversely, when tokens are scarce, interest rates can rise sharply.

Frequency of compounding: Daily or weekly compounding yields better results than annual compounding because you earn “interest on interest” more frequently.

Conclusion

APY is an essential tool for comparing investment opportunities in crypto. Although crypto APY is much higher than traditional banks, it also comes with higher risks. Before investing, carefully consider inflation, token supply and demand, and compounding frequency. Regularly monitor APY to adjust your investment strategy according to market conditions.