Sometimes you can see incredible high APY in a different protocol. How this was calculated and how sustainable it is?
Let's me share an Investment Return Framework, which you can use to evaluate different investment opportunities.
- Estimates Returns: What are the assumptions and drivers behind the expected return? What is the probability?
- Source of investment return (positive expectation, competitive advantage, explicable market edge...) What are the sources of return in most DeFi protocols?
- Liquidity Provider/Lending fees: you are getting profit from providing liquidity or lending your assets ( $FTM - $TOMB LP, $USDC etc.)
Revenue (Earned Fees) = fee * volume/2
- Protocol revenue: part of the protocol revenue is shared with those who staking, farming, etc. in a pool with protocol tokens. In @beethoven_x 30% of fees is distributed to $BEETS holders. Check also detailed analysis:
- Emission rewards: native token is distributed to protocol participants (LP, lenders, borrowers...)
Revenue (Farm APR) = number of tokens * token priceA new protocol, with high emission and rising token price => high APY
- Deposit/Withdrawal fees: some of the protocols are charging you deposit and withdrawal. The fees can be further delivered to native token holders (like 1.1.2. Protocol revenue). If we have all of those components, APY can VERY high. How sustainable it is?
- The source of investment return must persist long enough into the future to be reliably exploited APY is extrapolating current revenue (how much we are earning now) to the next year. This can change a lot even in one day. Check this as example:
Let's consider now a simple example where we have a new farm and how its APY can get VERY high value.
- Farm is charging you a fee for depositing non-governance tokens ( $FTM, $MIM etc.). You are getting farm tokens as a reward.
APY = token emission * farm token price/7
- You are staking farm tokens from rewards in a staking pool. Now you are also earning rewards from this pool.
APY = token emission * farm token price + fees from the deposit (1st point)This APY is much higher because we have higher token emissions. We also earn part of deposits fees.
- If most people deposit their farming rewards, tokens are not available on the market and their price is rising.
Demand & Supply => price (investor's expectations based on value💡& mood🤔& momentum🚀)
Supply = Inflation/Vesting📈 - Buybucks🔥 - Staking/Locking📉Demand also is rising because we have high APY and the price of the token is also rising. When farm token price is rising, we have also higher APY because:
APY = token emission * farm token price
- We have a loop in which rising token price... increase the token price and this cause high APY
- When people start to realize that is not sustainable or they just want to realize some of the profit, token price is decreasing
- When the price is going down, we have also a lower APY, which makes this investment less profitable and people start selling their farm tokens. We also don't have an incentive to deposit other tokens, which is also part of APY...Can we prevent this?
Yes! We just cover the supply side of our equation. Demand consists of three components:
Demand = Real Utility🧰 + Financial Utility (earning in DeFi)💰 + Valuation Changes (Speculation)🗠
In our example we have only two components:
1. Financial Utility: staking token to a get a farming rewards
2. Speculation: buying/holding farm token to sell it at a higher price
If we have a Real Utility (Unique Value Proposition provided by protocol) we could achieve a sustainable APY (but lower), because if the price of the token drop we will still have the same utility (think about this as an equity share).
If a token is able to capture revenue from protocol, a lower token price means higher APY (we have the same share of protocol revenue) which should drive a price (people want to leverage this high APY).