Does APY represent the crypto equivalent of snake oil? A cure for financial woes that ultimately turns out to be of little worth to investors. The LP Token Price Method offers a better solution.
There is an established trend among DeFi protocols to attract users and investment via Annual Percentage Yield (APY) usually with an unrealistic percentage attached. A two or three-digit APY seems to trigger the same urge to invest as Black Friday triggers when it comes to impulsive shopping. This is the hook used to attract the true degens. However, advertised APYs can often be misleading and don’t give a complete picture of a protocol’s performance. Most of the time, the advertised APY is very different from the actual yield obtained during the investment period.
Indeed, most APY advertised by protocols only reflect information about their revenue, and not their cost. Take the example of an AMM displaying a 100% APY for a given pool. On the surface, it looks like a great investment opportunity. However, this number does not take Impermanent Loss into account. This phenomenon — which affects most AMMs — causes a decrease in a pool’s value when the prices of the assets it’s made of diverge. In this particular case, Impermanent Loss might be 95% or even 105%, which sets the net APY between -5% and 5%. All of a sudden, the investment is much less attractive given the level of risk. In the traditional finance industry, this gap between an advertised return and the actual return would be considered fraudulent behaviour.
This example shows that DeFi is still a very immature industry and presents a significant roadblock to the mass adoption of DeFi as a true alternative or even a successor to TradFi. Unrealistic or in many cases unachievable APY calculations serve to disappoint users and reduce their confidence in DeFi. They also discourage institutional investors who are the heart of TradFi and who’s conversion is a key factor to the long term success of DeFi. How can we work to change this and improve DeFi as a whole?
Building a Solution
Swaap has designed a transparent method for analysing the actual performance of protocols. We call it the Protocol NAV Method. This method calculates the price of LP tokens, which are similar to the Net Asset Value (NAV) of a traditional fund. By calculating the LP token price, we take into account both the revenues and costs of the protocol. This provides an accurate picture of a protocol’s performance.
There are several advantages to using the LP Token Price Method.
- It guarantees transparency for users which are aware of their actual return on investment.
- It allows users to fairly compare the performances of different protocols.
- The data is accessible to anyone in real-time as it lies on the blockchain.
Suppose an Automated Market Maker (AMM) has a TVL of $1000 and has issued 100 LP tokens. Suppose the pool is initially made of 10 ETH and 10,000 USDC. The price of ETH is thus 1,000 USDC (10,000/ 10). The initial value of the pool is $20,000. An LP token is thus worth $200.
Imagine now that one year later, the price of ETH has climbed to $4,000. The pool is going to be rebalanced with the evolution of ETH price. The new balance is going to be 5 ETH and 20,000 USDC. Let’s also assume that the trading APY during this period (what is usually displayed on the pool’s performance section) is 20%. So, the pool has accumulated 1 ETH and 4,000 USDC in fees and has a total balance of 6 ETH and 24,000 USDC.
The total value of the pool is therefore $48,000. There are still 100 LP tokens in the pool — an LP token is now worth $480. So, you think that everything is great but this is not the case in fact. In order to compute your net APY, you need to compare to your benchmark which is HODL in this case.
So, if you had HODLed, what would have been the value of an LP token? In fact, you would have held: 0.1 ETH + 100 USDC per LP token, which would be worth $500 end of year.
So, your trading APY is +20% while your real net APY using the NAV method is -4%
The beauty of the NAV method is that it can be applied to any protocol, any timeframe and is not impacted when people withdraw / join the pool (new LP tokens being burned / minted).
Beyond correctly calculating the performance of protocols, it is also important to consider the level of risk involved. In the traditional finance industry, this is done through risk assessment tools such as Value at Risk (VaR), stress testing or mean-variance analyses inspired by Markowitz’s portfolio theory. DeFi protocols could apply those frameworks and leverage the potential of blockchain technology to offer real-time insights on the level of risk incurred by the capital they manage.
There are a number of other protocols who are working hard to provide a more accurate model for APY that is takes into account potential downside in token value, impermanent loss and other factors. APY.vision has found in their interactions with users that having a trailing view of metrics like APY in a base currency like US dollars can give better context to a position. Stated APY figures are often quoted based on the current market price of the token, which means in order to earn that quoted figure one must assume the price of the token will not go down, which is unlikely if the token is being distributed as a reward!
Stated APY numbers also assume that no new users will enter the liquidity pool. Everytime a new user enters the pool, the number of reward tokens emitted per user goes down. New users entering the pool will drive down the true APY of the position. Stated APY figures assume that emission rates will not change over time, which is often not the case.
APY.vision takes all of these factors into account and reports historical APY data based on real world returns.
In conclusion, it is important to look beyond just the advertised APYs when evaluating the performance of protocols. By using the LP Token Price Method, we can get a more accurate representation of a protocol’s actual performance by considering Impermanent Loss. Being more transparent about the level of risk will also be a crucial step going forward. This will ultimately lead to a more mature and transparent DeFi industry.