Where Does a 100% DeFi Yield Come From? APR, APY and the Real Risks of Yield Farming

On DeFi protocol dashboards, you'll often see numbers like 15% APY, 80% APY or even 1,000% APY.

Next to a bank account, those yields look unreal. So people ask: where does this money come from? Is it real?

The answer: the yield may well be real, but it always has a source, and it always comes with risk. Understanding where a yield comes from is the first step to deciding whether it's worth it.

Key takeaways

• APR is simple annual interest; APY includes compounding, so the same rate looks bigger as APY.
• DeFi yields come mainly from trading fees, lending interest, staking rewards and token incentives paid by projects.
• High yields paid in a project's own token often shrink dramatically as that token's price falls.
• Providing liquidity to a trading pool exposes you to impermanent loss, which grows with price swings.
• The higher the yield, the harder you should ask: who's paying, and what risk am I taking?

First, APR vs APY

• APR (annual percentage rate): annual return without compounding.
• APY (annual percentage yield): annual return with earnings continuously reinvested.

The conversion: APY = (1 + APR ÷ compounding periods)^periods − 1

The higher the APR, the bigger the compounding boost. Some projects prefer to show APY because the number looks better. But to actually earn that APY, you'd have to reinvest every day, pay fees on each transaction and hope the rate itself holds up.

The five main sources of DeFi yield

The first three have real payers: traders, borrowers or the network. Token incentives are essentially a project printing money to subsidize users, and their value depends entirely on what the token can be sold for.

Token incentives: the yield most likely to shrink

Say a new project advertises "deposit stablecoins, earn 200% APY," with rewards paid in its own token. You deposit $10,000. On paper, you'll earn about $20,000 worth of rewards in a year.

The catch: every participant is claiming and selling those rewards, so the token price tends to slide. If it falls 90% over the year, your rewards could end up worth a few thousand dollars or less. Worse, if the team disappears, you may not even get your deposit back.

The key question: what is the yield paid in? If it's the project's token, ask whether that token has real demand and value behind it.

Impermanent loss: the hidden cost of providing liquidity

On a decentralized exchange, you can deposit two tokens into a liquidity pool and earn trading fees. But when the price ratio between the tokens changes, your holdings end up worth less than if you'd simply held both tokens. That gap is impermanent loss.

In a standard 50/50 constant-product pool, impermanent loss looks like this:

Providing liquidity only pays off when fees earned exceed impermanent loss. The more volatile the pair, the larger impermanent loss tends to be.

Staking and liquid staking: steadier, but not risk-free

Take Ethereum: users can stake ETH to help secure the network and earn rewards, which have run at a few percent a year recently. Liquid staking protocols give you a token representing your staked ETH (such as stETH), so you can use it in DeFi while it keeps earning.

Keep in mind:

• Liquid staking tokens can trade away from ETH. During the market panic of June 2022, stETH could only be swapped for about 0.94 ETH at one point.
• Using staking tokens as collateral for loans stacks additional layers of risk.

For more detail, read our Ethereum staking guide.

Five questions to test any yield

1. Who's paying? Traders, borrowers, network rewards or newly minted project tokens?
2. What is it paid in? If it's a project token, can its price hold up?
3. Is the protocol audited, and how long has it been running? New and unaudited contracts carry more risk.
4. Can I withdraw anytime? Are there lockups, withdrawal limits or queues?
5. What's the worst case? If the contract is hacked, a stablecoin depegs or the token goes to zero, how much do I lose?

If a yield seems too good to be true and nobody can explain where the money comes from, you may be the one paying for it.

FAQ

Is a 1,000% APY real?

It might be for a very short time, but it almost never lasts. Yields like that usually come from heavy token emissions by a new project, and they collapse as more people join and the token price falls.

Is stablecoin farming free of price risk?

Your principal is less exposed to price swings, but stablecoin depegs, smart contract hacks and platforms disappearing are all still possible. See are stablecoins really stable?

Does impermanent loss always happen?

Whenever the price ratio between the pool's assets differs from when you deposited, there's impermanent loss. If the ratio returns to where it started, the loss disappears, hence "impermanent." But if you withdraw after prices have moved, the loss becomes real.

How can I reduce DeFi risk?

Stick to established protocols with long track records and multiple audits, don't put everything into one protocol, regularly review and revoke unused approvals, and stay skeptical of high yields. For the basics, read DeFi explained: DEXs, lending and the real risks.

Summary

High DeFi yields aren't magic: they come from real trading and lending demand, from token subsidies, or as payment for extra risk you're taking on. Know the difference between APR and APY, account for impermanent loss and falling reward tokens, and you'll be able to tell worthwhile yields from beautifully packaged traps. This article is for education only and isn't investment advice.