DeFi enters a "winter of yields": liquidity stagnation, leverage contraction, and the disappearance of arbitrage opportunities

Author: Jae, PANews

The end of a cycle often begins with the smallest indicators.
Since September 2025, the DeFi (Decentralized Finance) market has entered a “interest rate winter.” The average annual percentage yield (APY) for mainstream stablecoins in top lending protocols has fallen to its lowest level since June 2023.
On Ethereum’s Aave V3, USDC and USDT deposit rates have dropped below 2%. Meanwhile, the U.S. 10-year Treasury yield has risen back to 4.24%. For DeFi players who experienced the DeFi Summer and are accustomed to high APYs, this is not just a numbers decline but a warning bell signaling the end of a cycle.
Is this simply cyclical fluctuation, or is the market undergoing a structural transformation?

Supply and demand mismatch, liquidity overload triggers rate collapse
Over the past six months, the interest rate curves of mainstream lending protocols have been steadily declining, reflecting a “surplus supply” that causes yield compression.

Interest rates are the price of capital. The physical basis for setting this price is the supply of capital.
Since 2024, the stablecoin sector has experienced an unprecedented “expansion wave,” with total market cap soaring from under $130 billion to over $310 billion, with a compound annual growth rate of about 55%.

The problem is that the surge in supply has not been matched by a proportional increase in on-chain demand.
When the supply of a certain asset (liquidity of stablecoins) increases significantly while demand remains weak, its price (interest rate) must fall. This is a fundamental economic principle, and DeFi is no exception.
Taking Aave, the leading lending platform, as an example, its stablecoin utilization rate is declining sharply. As of March 12, Aave’s total value locked (TVL) reached $42.5 billion.
Examining the fund structure reveals an alarming figure: active loans amount to only $16.3 billion. Over 60% of deposited assets are idle. This supply-demand imbalance directly causes rapid interest rate declines.
This means funds are only deposited but not borrowed, leading to severe liquidity stagnation. Protocol algorithms are forced to automatically lower the interest rate curve to attract more borrowers.
However, these efforts have yielded limited results. On Aave V3, the baseline rates for USDC and USDT on Ethereum have already fallen below 2%, starkly contrasting with double-digit returns during the bull market.
The stablecoin market has fallen into a “liquidity trap.” When the market is flooded with low-cost capital but lacks high-yield investment opportunities, these funds accumulate in lending pools.

Funding rate collapse, cyclical borrowing cooling, and leverage stall
The prosperity of stablecoin interest rates in DeFi is fundamentally driven by “leverage.” When arbitrage activity in the perpetual futures market cools, the borrowing demand for stablecoins rapidly shrinks, causing rates to plummet.
In a bullish market, high long sentiment leads to positive and high funding rates. Arbitrageurs use a delta-neutral strategy—borrowing stablecoins to buy spot and selling perpetual contracts—to earn funding fees. In this process, stablecoins serve as fuel.
However, recent performance in derivatives markets has been sluggish. On major centralized exchanges (CEX), BTC and ETH funding rates have repeatedly turned negative or remained very low positive. This indicates that bearish forces dominate or that bullish sentiment is extremely cautious.
Either way, the result is the same: a lack of arbitrage motivation.
When annualized funding rates drop significantly, considering borrowing costs and transaction fees, net arbitrage profits are greatly reduced. Consequently, borrowing demand for stablecoins collapses.
Another major source of stablecoin borrowing demand is cyclic borrowing. This profit-enhancing strategy involves depositing yield-bearing assets like sUSDe in Aave, borrowing USDC, then swapping the borrowed USDC for more sUSDe and depositing again.
This strategy was once popular because USDe yields reached 30%, while borrowing costs were around 10%, leaving a 20 percentage point arbitrage margin.
However, after the “1011” event, the interest spread narrowed catastrophically, and USDe faced a scalability ceiling, shrinking from nearly $15 billion to the current $6 billion.
USDe yields are highly dependent on the size of short positions in the market. Since the total open interest in perpetual markets is limited, as USDe scales up, the hedge required from short positions reduces overall market funding rates, further suppressing sUSDe yields.
For ordinary traders, declining sUSDe yields reduce their strategy margins. Their decreased demand for leveraged positions further diminishes their need for stablecoin collateral.
This creates a self-reinforcing negative cycle: demand shrinks → rates fall → demand shrinks further.

Market risk appetite shifts toward certainty
A significant factor behind the declining stablecoin rates is the overall reduction in risk appetite in the crypto market.
In the past month, the Crypto Fear & Greed Index has frequently hit “extreme fear” levels, even when BTC prices remain around $70,000, with no sustained improvement in sentiment.

Data from CoinDesk shows that in February, total trading volume on CEXs fell 2.41%, down to $5.61 trillion, the lowest since October 2024.
Decreased risk appetite prompts investors to move toward more certain market segments.
Since January 2024, the Federal Reserve’s effective federal funds rate has remained above 3.6%. Although markets expect a mild rate cut in the future, current actual rates remain relatively high.
This macro environment also exerts a profound downward pressure on DeFi stablecoin interest rates. When risk-free U.S. Treasury yields surpass DeFi deposit rates, rational investors tend to withdraw funds from on-chain protocols or shift to RWA (Real World Asset)-backed protocols, which offer higher yields.
During this interest rate winter, not all protocols are shrinking. Sky (formerly MakerDAO) has built a unique “yield moat.”
Compared to Aave, which relies heavily on on-chain lending demand, Sky’s yields also come from $1.5 billion in mature RWA assets, including U.S. Treasuries and AAA corporate bonds. These assets are unaffected by crypto market volatility and provide stable cash flows.
This model of converting RWAs into collateral has driven USDS supply to grow by 68% annually each month, with a market cap approaching $8 billion.
Currently, sUSDS yields around 3.75%, serving as a “de facto floor” for on-chain yields. In USDC and USDT treasuries, deposit rates can exceed 5%.
This positions Sky as a sort of “benchmark rate platform.” In comparison, similar assets on Aave offer rates that are hardly competitive.
Thus, Sky is transforming from a simple stablecoin protocol into a “fixed income asset management” protocol, leveraging its large RWA portfolio to hedge against crypto market downturns. When DeFi demand wanes internally, it can seek yields from external (traditional finance) markets.
For investors, learning to analyze whether yield is derived from government bond dividends or from volatility premiums in futures markets will be a crucial skill in this cycle. Strategies should shift from “chasing APY” to “seeking differentiated risk exposure.”
The “interest rate winter” is not only a cyclical fluctuation but also an inevitable pain point in DeFi’s “bubble deflation.”
Perhaps, just as the lows of 2023 laid the groundwork for the prosperity of 2024, this rate bottoming could also be DeFi’s way of accumulating energy for the next leap.