Alright, so the title is a little dramatic. Annual Percentage Yield (APY) is incredibly important to assess the value of any investment. It is commonly used to give us a good way to compare opportunities in an apples-to-apples fashion, showing the expected gain over the course of a year divided by your initial principle. With Illuvium staking, APY makes the opportunity look incredibly sexy, with the core pools currently showing nearly 80% APY for the ILV pool, and over 550% for the Sushi Liquidity pool (you can read more about those here). However, when you evaluate what really matters in staking Illuvium, there are some serious limitations and inaccuracies in basing your expectations on today's APY. Today, I’ll share my perspective on the limitations of APY, and what I really care about regarding staking with Illuvium.
Before we dive into why I think APY with Illuvium isn't exactly helpful, let’s make sure we’re grounded on what APY means. People are probably most familiar with APY for savings accounts. Let’s say your traditional finance savings account is offering 0.5% APY. This means over a year, you expect to gain 0.5% of your initial balance in interest. For $1000 in a 0.5% APY savings account, in a year, you would expect to have a balance of $1005, meaning your reward was $5 for “staking” your fiat currency with a bank. APY includes compounding interest, and since most banks pay interest monthly, the $1005 actually includes the interest earned on your interest (compounding). Your annual percentage rate (APR) is actually 3.93% if interest is paid and compounds monthly. We won’t spend time on the math behind this, but as long as interest compounds, APR is always lower than APY, with APR ignoring compounding and APY including its impact on the value. This is why banks always highlight whichever rate makes them look better. If you’re taking out a mortgage or keeping a balance on a credit card, interest is reported in APR to ignore the extra compounding interest payments you’ll need to make over time. If the bank is paying you (e.g. a savings account), they want credit for the compounding interest, so they list the higher APY number. The same is true for CeFi crypto lenders like Celsius - they list APY, though the actual amount you’re paid each week is based on the lower APR. You can see how compounding makes a difference between these two numbers here.
Back to Illuvium. APY is immediately deceptive, as I’ve shared before, the rewards are only an instantaneous snapshot of your expected gains today, and the APY often changes within a 24 hour period as the following things happen - people join the pool, people leave the pool, ILV rewards are claimed from any of the staking pools, and in the case of the more volatile SLP rate, the price of ILV and ratio of the ILV and ETH price change. All of these will cause APY to change. That brings us to the first limitation of APY with Illuvium:
Illuvium staking pool APY changes constantly and generally trends down, so it should not be directly used to estimate your annual returns. APY is representative of short term reward expectations paid in ILV, not a long term promise of value.
The second reason why APY isn’t great to use for Illuvium is that APY implies compounding interest. In traditional banking, APY gives you a sense of the impact of compounding on your returns. In the case of staking with Illuvium, there is no compounding unless you claim your rewards. Claiming is a specific transaction and requires active participation on your part, and most importantly, it will require ETH gas fees to be paid. When you claim your rewards, the ILV claimed is immediately moved to the ILV staking pool at 2x weight, and it will earn the current rewards rate. This added ILV reward is NOT counted in the APY shown.
Illuvium staking pool APY ignores the compounding rewards earned from claiming ILV since it requires action on the staker’s part, and its impact will vary based on claim timing and frequency.
Now that we’re through the semantic reasons why APY doesn’t make sense, we’ll get into what I really care about. I am long ILV, and am a participant in both core pools. My primary objective of staking is to acquire as much ILV as possible as cheaply as possible. Obviously, I’m passionate about the project and believe in the long term success of Illuvium. So what do I really care about? Making as much money as possible. How do I do that? Get as much of an asset that I think will be more valuable in the future. In this case, that asset is ILV.
Here’s why APY doesn’t really reflect my “get rich” objective. We’ll focus only on the ILV core pool for now. If you’re interested in staking in the ILV pool, here’s what you have to do. (1) Get your fiat currency onto the blockchain. (2) Use that fiat to acquire ETH. (3) Take that ETH to Sushi.com and swap it for ILV. (4) Then, take that ILV to Illuvium.io and stake it for up to a locked 52 weeks to earn around 80% APY today. That APY is deceptive, and here’s why.
I’ll use an example to put this in perspective.
You have money. A guy comes along and says, “hey, you want in on an amazing investment? I’ve got these rocks. What I need you to do is take your money, buy shells over there, then come back here, and I’ll swap you rocks for those shells. Then, I have this hole where you can put your rocks for a year. Every day, I’ll give you more rocks based on how many rocks you added to the hole. In the end, you’ll own all those rocks. What do you say?”
Remember, I’m long “rocks” and I am committed to Illuvium financially. But this story is exactly what it means to be investing in Illuvium right now. We’re buying rocks, staking rocks, and getting paid in more rocks. Our investment hypothesis (i.e. our hope) is that those rocks will be much more valuable later. However, they are really just a cryptocurrency token, so there’s no inherent value. Arguably, rocks have more inherent value. You can build something out of them, or even throw them at the guy that convinced you to invest in rocks. All I have right now with Illuvium are some lines of code on the blockchain associated with my account. Here’s where APY breaks down. The APY of the ILV pool is measured in the number of reward "rocks" you earn divided by the number of "rocks" you staked. There is actually nothing specifically tied to the pool that relates to “real” money.
I’ll switch metaphors briefly to remind you of how the staking pools work. Each day, there is a set number of ILV that will be distributed to participants in each pool. Think of the staking pool as a pitcher of water, and those staking as an empty cup. The pitcher has a finite amount of water, and it distributes that water equally to all the eligible cups on a given day. The more cups, the less water (rocks) each one receives. Over time, the pitcher is filled with 3% less water/rocks/ILV every two weeks. So as time goes on, we should expect the number of cups to increase, and our rewards to go down.
But what does APY mean in this context? Let’s say you are staking 1 ILV. With an 80% APY, you would expect to earn 0.8 ILV over the course of a year being staked in the pool, if rewards were held constant. However, rewards decrease over time, so the APY really just lets you know how many rocks you expect today. Your expectation today is really 0.8 ILV/365, so 0.0022 ILV is your anticipated reward for today.
This amount is added to your claimable rewards, but will just sit there until you take action (and pay gas fees). Tomorrow, you’ll again put your cup out there with your 1 ILV, and depending on how many cups left or joined the pool, and if rewards dropped by 3% by moving to a new fortnight period, you’ll get more rocks. Since I live in the real world, and my mortgage can’t be paid in rocks, what I actually care about is the eventual value of those rocks. Just earning a high APY on rocks paid as rewards for staking rocks is only as valuable as the rocks are in the future. The APY of the Illuvium ILV pool represents the number of reward ILV received on an approximately daily basis, but the real value of those rewards is dependent on the eventual price of ILV.
Like almost everything in Illuvium staking, the Sushi liquidity pool (SLP) takes all of the above, and makes it epically more complicated and risky. Similar to the above ILV pool example, our rewards are paid in ILV, and the water pitcher metaphor still holds true - the pitcher has a certain amount of water, and that water is distributed into all the cups present on a given day. However, to convert this into an APY, we need to consider the value of our stake. For the SLP, our stake represents a percentage ownership of the liquidity pool, which is made up of both ETH and ILV. The value of our SLP position is therefore based on three things - the ETH price, the ILV price, and the ratio of the ETH and ILV price. Check out my articles on impermanent (divergence) loss to understand how the price ratio impacts your value. The value of our SLP stake is then used to calculate how many ILV we receive on a given day. Presuming we locked for 52 weeks and are currently earning about 550%, we can calculate our daily expected rewards. Let’s say we have $1000 in the SLP with the current APY of 550%. That means over a full year at this rewards rate, we would expect to earn rewards worth $5500. This actually means that we can expect todays rewards earned at the pace that would give us $5500 worth of ILV, at the current token price. Yes, that sentence is complicated. Here’s the full example to try to help.
You have $1000 worth of SLP, currently earning 550% APY. At that constant rate, in a year, you would expect $5500 worth of ILV. Divide $5500 by the current ILV price, we’ll say $550 to make math easy. That means in a year at this rate, you would receive 10 ILV. However, APY is only a short term snapshot, so you divide 10 ILV by 365 to estimate that you will earn 0.0274 ILV today. Tomorrow, as more people enter or exit the pool, or the prices of ETH, ILV, and their ratio change, the APY will change, and the number of reward ILV you could expect to receive may also change. Realistically, the number of reward ILV you receive won’t change much, but the APY could vary wildly due to the price and price ratio of ETH and ILV.
What do I really calculate?
In my calculators and my personal evaluation of my Illuvium investment, all I currently care about is the number of ILV I have, and how many I’m likely to have at the end of staking. Everything else is just noise, and APY is one of those noisy things that gets in the way and distracts us from what we really want (i.e. wen lambo?). In collaboration with Lelahel#6058, we just released a new and very updated version of our calculator. Our goal was to use the data available to attempt to predict expected ILV over time. Of course, what really matters in investing is the dollar amount at the end, but that’s really up to you on how much you think your ILV rocks will be worth when you sell. We can help predict how many rocks you’ll have. Only you can say what you think their projected price will be.
I remain optimistic for the long term success of the project. Aside from trying to acquire more ILV at as low a price as possible, I am largely indifferent to the current price of ILV. The only thing APY does for me is to provide information to calculate how many reward ILV that I can expect to receive on a given day. The reason I’m excited for a rising ILV price is that it helps to reduce the impact from new investments (new "cups" are more expensive), and it provides a psychological barrier that keeps others from investing at the moment. I want my cup to get filled as much as possible, and to do that, I need to minimize the number of other cups. To me, it's all about making the ILV today, and hoping those ILV are worth something more later.
What are the key factors to predict value over time?
The biggest challenge of doing predictions are the unknowns. The biggest unknown is pool participation over time, i.e. the number of “cups” on a given day. For the SLP, daily added “cups” have ranged from +0.1% to +3.0% from August 5 through September 3, meaning every day in this period, there were more cups added. As I write this on 9/4/2021, we are experiencing the first day in a month where the number of "cups" decreased, with more SLP being withdrawn than added. The average daily change was +1.07% over this period. For the ILV pool, things are more complicated, since all claimed rewards end up in that pool as they vest for a year. Over the past month, the average daily growth of the ILV pool was just under +1% per day. This means over time, daily ILV rewards have decreased with 1% more "cups" being added daily. The challenge is projecting the rate at which pool participation will continue to change moving forward.
The number of daily rewards (i.e. water in the pitcher) is quite easy to calculate, as we know the planned decay curve of rewards since yield farming started at the end of June. At least one piece of the equation is easy.
The last challenge and arguably the most important aspect in projecting long term value of the project is estimating the future ILV price. I’ll admit, as much as I try to look for past examples, Illuvium really is setting it’s own path, so there are no good comparisons, so good luck. ILV price will ultimately be the critical factor to determine if you managed to acquire a bunch of rocks, or if those rocks end up to be diamonds.
As always, I hope this was helpful to understand how Illuvium staking and rewards are calculated, and why I’m actually anti-APY. Your feedback is always welcome, and please let me know what I missed or messed up in my analysis. Thanks for reading and for your support!
Disclaimer: I am a long term holder of ILV. All of this is for education and entertainment purposes only, and is not financial advice. Never invest more than you can afford to lose. Do your own research.