Yield farming and the truth about APY

A protocol advertising 400% APY is not offering you 400%. Understanding why is the difference between farming profitably and providing exit liquidity to people who understood the mechanics.

What APY actually means here

APY is an annualised figure assuming a current rate persists for a year and that rewards are continuously reinvested. Both assumptions are usually false in DeFi.

A farm paying 1% a day is quoted at over 3,700% APY through compounding. But the rate almost never survives a year — often not a week — because it is set by emissions that decline, and because incoming capital dilutes it. The headline number describes a snapshot compounded into a fiction.

Where the reward comes from

Three possibilities, and only two are income:

• Trading or borrowing fees. Real revenue paid by users. Sustainable, usually low single digits to low tens of percent.
• Protocol issuance on a staking chain. Real, modest.
• Emitted governance tokens. The protocol prints its own token and gives it to you. This is not revenue — it is dilution of existing holders, used to rent liquidity.

The overwhelming majority of eye-catching yields are the third kind. And the mechanism is self-defeating: farmers receive the token, sell it immediately to lock in value, and that selling pushes the price down — which reduces the value of everyone’s future rewards. High emissions attract capital that destroys the returns it came for.

Working out the real number

Start with the advertised APY, then subtract:

• Reward token decline. If rewards are paid in a token falling 5% a week, that dominates everything else.
• Impermanent loss. If you supplied a liquidity pair, divergence between the two assets costs you against simply holding them. See impermanent loss explained.
• Gas. Entering, harvesting, compounding and exiting each cost a transaction. On a small position this can exceed the entire return — and the compounding the APY assumes is only free in the spreadsheet.
• Dilution. As more capital enters, your share of a fixed emission falls. The rate you signed up for is not the rate you get.

Run those numbers before committing. It frequently turns a headline 400% into something negative.

Risks specific to farming

• Contract risk multiplied. Farming often stacks protocols — supply here, deposit the receipt token there, stake that somewhere else. Each layer is a separate contract that can fail, and you are exposed to all of them.
• Reward token illiquidity. A token can show a high notional value and have almost no market. Selling a meaningful amount moves the price sharply against you.
• Exit congestion. When a farm turns, everyone exits at once, gas spikes and the reward token collapses. Modelled returns assume an orderly exit that does not happen.
• Deliberate traps. Some farms exist to attract deposits and then remove them. A very high yield on an unaudited protocol with an anonymous team is a plausible rug pull.

The honest summary

Sustainable DeFi yield exists and comes from fees people actually pay. It is unexciting — comparable to modest returns elsewhere, with considerably more risk.

Yields far above that are not free money that nobody else noticed. They are emissions, or they are payment for a risk you have not priced. Both are fine to accept knowingly. Neither is what the marketing describes.

What to read next

Next: impermanent loss explained, with numbers.