Elk Academy Lesson 5: Compounding and Yield Aggregators
Today we’ll cover an easy strategy that can supercharge your returns over time. Best of all, it’s almost entirely passive! Pick up any financial advice book, and you will likely see a reference to “the miracle of compounding.” The idea is simple: take the interest earned from a savings account or dividend stock, and instead of letting it sit there gathering dust, put it back to work by reinvesting or “compounding” them. Through this process your underlying principal will grow, which over time will boost your returns exponentially.
This same premise is easily adapted to the rewards earned through yield farming. Instead of holding your rewards, you can convert them back into more LP tokens, increasing LP position and the rewards you earn from it.
APY vs. APR
As you’ll recall from our lesson on yield farming, your basic reward rate is typically expressed as a percentage known as an APR, or Annual Percentage Rate. This number represents your annual return relative to your LP stake without compounding any of the rewards. Compounding interest is so popular, however, that there is actually another number, known as APY or Annual Percentage Yield, which represents the same annual return with compounding taken into account.
Since the basic APRs in DeFi yield farms are already high relative to traditional investing options, APYs can be truly staggering. For example, a yield farm with an 300% APR — which is not uncommon — promises annual returns of over 3,100% with daily compounding. It’s important to keep in mind, however, that to realize that return you would have to compound your rewards every day for an entire year with that APR in place. What’s more, since compound growth is exponential, the real benefits take some time to truly take effect. Still, patience can really pay off.
Auto-Compounding and Yield Aggregators
In yield farming, it is often the case that the reward token you earn is different from the underlying tokens that make up your LP. This makes compounding a little tricky, since you have to split your rewards back into equal values of the underlying tokens in order to reinvest them back into the pool. On ElkDex, the process is easier since all pairs include the $ELK token, which is also the farming reward. You only need to convert half of your $ELK rewards back to the pair token in order to reinvest, which minimizes the amount of swapping required.
The benefit of this manual compounding approach is that you can reinvest as much as you’d like as often as you desire. If you think your reward token will spike soon, for example, you might wait to convert the reward token back to LP until it has risen. Similarly, you may not want to reinvest all of your rewards, so compounding manually gives you an opportunity to keep some of the rewards as profits while reinvesting the rest.
One major downside to manual compounding is that it takes effort. Since the returns from compounding generally increase the more frequently you do it (ignoring fees), if you really want to maximize your profits, you will need to invest a significant amount of that other priceless asset: time.
Luckily, there is a solution, which involves locking your LP tokens into a special type of smart contract that will automatically compound your rewards back into LP tokens without you having to do anything! Platforms that specialize in auto-compounding contracts are called yield aggregators. Since auto-compounding appeals to passive investors who plan to leave their LP staked for long periods of time, these smart contracts are often referred to as “vaults.”
How do Auto-compounding Vaults work in DeFi?
On the user level, vaults work just like farms. Once you’ve generated your LP tokens by pooling your assets, you can deposit them into the vault just as you would a farm. The difference is that, with a vault, your LP tokens are pooled together with other users into a single contract, which is then entered into the farm as a single large deposit. There is some risk involved in this, since you are in essence handing over your LP tokens to the yield aggregator in order to benefit from their auto-compounding service. Trustworthy sites will clearly display the amount of LP tokens you have deposited, which will allow you to keep track of your position and easily track your growth.
Apart from being automated, the main benefit to yield aggregators also lies in this crowd-sourcing aspect. Since many peoples’ LP tokens are pooled together, it becomes possible to compound more often, since the fees from swapping the rewards are split among everyone.
Different platforms offer a variety of strategies for compounding. Some are simply programmed to compound set intervals (say, 3x per day), while others are optimized to compound only when enough awards have accumulated to offset swapping fees. There are even creative solutions, such as Yield Yak, which give back users a portion of the accumulated rewards in exchange for pressing a button to reinvest for the group.
Stack Earnings for Maximum Profit
Since yield aggregators provide what is potentially an extremely valuable service, they generally charge a fee, which is deducted as a modest percentage (5–10% is typical) of the rewards pool. It is up to you to determine whether the fee they take from rewards is worth the benefit you’ll receive from auto-compounding.
But wait! This is DeFi, and we must always remember Professor Elkstein’s Rule #2: if something can be tokenized, it will be. In this case, many yield aggregators have their own token, which they distribute as an additional reward simply for using their platform. Often, the reward is more than enough to offset the platform fees (and many sites also cleverly set up their tokenomics that the fees will be used to promote the value of the platform token).
To summarize, yield aggregators can be incredibly valuable tools for maximizing profits, all while saving you time through passive reinvestment strategies. Many yield aggregators also offer their own incentives and reward tokens, which provide yet another bonus on top of the double-dip returns from liquidity mining and yield farming.
And that, my dear students, is what we call a triple dip!
