Factors that impact APR

As a DeFi Investor, you want to make the most out of your investments. Usually, by deploying your assets in DeFi pools, profits can be made. There are often pools on DeFi platforms that promise sky high APRs (that maybe seem to be too good to be true). But what exactly should you pay attention to before investing in such a pool? And what factors impact the APRs of these pools? We will answer these questions in this article.

The definition of APR #

In decentralized finance (DeFi), the term “annual percentage rate” (APR) is used to indicate the rate of returns from a liquidity, farming or lending pool. APRs are a useful indicator for investors to estimate what their profit would be within a certain amount of time.

For example:

If an investor would earn 10% interest per quarter on a $1000 USDC deposit in a liquidity pool, and the investor decides to withdraw his received interest every quarter, he would receive $400 USDC after leaving his deposit for a year.

DeFi-protocols often use the term “annual percentage yield” (APY) as well. This term is used to indicate the rate of returns including the compound interest of a pool.

For example:

If the same investor would earn 10% interest per quarter on a $1000 USDC deposit, and he decides to leave his received interest in the liquidity pool, the pool compounds the interest. The same investor would receive $464 USDC after leaving his deposit for a year.

Factors that impact the APR #

Defi-protocols usually recalculate a pool’s APR (or APY) every 24 hours. Pool APRs depend on various factors and because of this, high APR-pools typically can’t keep their APRs at the same high level for a longer period of time. Of course, whenever a pool is extremely popular, APRs tend to stay higher for a longer period of time.

The APR of a pool depend on the following factors:

• Pool popularity: If, for example, a liquidity pool contains a popular trading pair, many investors will use the pool to swap between its token-pair. Due to this, a higher amount of trading-fees is paid, resulting in a higher APR for liquidity providers.
• Additional token yield: This is often seen in both liquidity pools and automated yield-farms. Defi-protocols provide investors with additional token rewards, which is typically the platform’s governance token, on top of the pool’s earnings to incentivize them to deploy their assets in the DeFi-protocols’ pool or farm.
• Low liquidity: Some pools show sky high APRs, which are usually too good to be true. Unexperienced investors tend to ape into these pools, which usually result in a decrease in APR. This phenomena is caused due to the pool having low liquidity. Due to this, the trading-fees of swaps made within the pool are distributed over a smaller amount of liquidity. This results in higher APRs for each individual liquidity provider within the pool. However, as mentioned earlier in this section, pools that show high APRs tend to decrease rapidly over time, due to more investors start providing liquidity to the pool.
• Fake APRs: Some malicious defi-protocols show fake APR values to pursue investors to deploy their assets in the protocols’ malicious pools. Once investors have deployed their assets in the malicious defi-protocol’s pools, they will lose all their deployed assets with no way of gaining them back.

Joining a high APR pool: reducing the risks #

In order to reduce the risk of joining a high APR pool that ultimately ends up in a rug pull or starts crashing down, investors need to do their due diligence.

Whenever you come across a pool of interested, make sure you perform the following steps:
1. Is the defi-protocol legit? Check our website Rugdoc.io to find out if the website has been reviewed by our team. Based on our risk rating, you’ll have some idea whether the masterchef contract doesn’t contain any exploits, who the token owner is, whether there are one or multiple token holders, if there’s an anti-whale function in place, if the masterchef has a timelock and if the token-fees are safe.
2. Is the team behind the protocol or token known? Make sure to check whether the team anonymous, if they have social media and if they have a Telegram group you can join to ask them questions.
3. Are the smart contracts of the protocol audited? Before continuing, make sure you check whether the smart contracts of the protocol have been audited (by a legit company). Malicious protocols tend to put fake audited badges on their websites in order to gain trust of new investors. Make sure you check with the auditing company whether a badge is legit or not.
4. Now that the pool or farm passed all the rug pull tests, you need to check the liquidity volume. Is the liquidity of the pool extremely low? Pass the pool, or deploy your assets for a short period of time.
5. You have found out that the pool contains a healthy amount of liquidity. Now it’s time to check whether the APR is high because of popularity/demand or extra token yield. Usually, the pool will show any extra earning when you hover your cursor over the pool’s APR value. Do you expect this token to rise in value over time? Also, check the emission rate of the token. Farms often reduce their token emission, for example, on a weekly basis. This emission reduction impacts the APR.
6. At least, check the token popularity on websites such as coinmarketcap.com or coingecko.com. The more popular the token is, the better. Popular tokens tend to be hot for a certain amount of time – So make sure you make the best of it.

Conclusion #

Pool APRs are a good indication for investors to estimate their returns over time. However, most APRs are refreshed on a daily basis and typically tend to not stay high for a long period of time. This forces investors to deploy their assets in such pools for a shorter amount of time. By following the steps in this article, you should be able mitigate any risks prior to joining a high APR pool or farm.