DeFi Yield Winter: Liquidity Stagnation, Leverage Shrinkage, and Lack of Arbitrage Opportunities

Author: Jae, PANews

The end of a cycle often begins with the smallest, most subtle indicator.

Since September 2025, the DeFi (decentralized finance) market has entered an "interest rate winter." The average annualized yield (APY) of mainstream stablecoins on leading lending protocols has hit its lowest level since June 2023.

On Ethereum's Aave V3 mainnet, the deposit rates for USDC and USDT have fallen below 2%. Meanwhile, the yield on 10-year US Treasury bonds has rebounded to 4.24%. For DeFi players who experienced the DeFi Summer and are accustomed to high APYs, this is not just a decline in numbers, but more like the death knell of a cycle.

Is this simply a cyclical fluctuation, or is the market undergoing a structural reshaping?

Supply-demand mismatch and excess liquidity trigger interest rate collapse

Over the past six months, the yield curves of mainstream lending agreements have shown a downward trend, and their interest rate models are experiencing a yield collapse caused by "oversupply".

Interest rates are the price of capital. And the physical basis that determines prices is the supply of capital.

Since 2024, the stablecoin sector has experienced an unprecedented "expansion wave," with its total market capitalization surging from less than $130 billion to over $310 billion, representing a compound annual growth rate of approximately 55%.

The problem is that the surge in supply has not been accompanied by a proportional expansion in on-chain demand .

When the supply of a certain commodity (stablecoin liquidity) increases significantly while demand weakens, its price (interest rate) will inevitably fall. This is a basic principle of economics, and DeFi is no exception.

Take Aave, a leading player in the lending sector, as an example; its stablecoin utilization rate is declining significantly. As of March 12, Aave's total value locked (TVL) had reached a staggering $42.5 billion.

A closer look at the funding structure reveals a disturbing figure: active lending is only $16.3 billion. More than 60% of deposited assets are idle, and this supply-demand imbalance has directly led to a rapid decline in interest rates.

This means that funds are only deposited and not lent out, resulting in a severe liquidity stagnation. The protocol algorithm has to automatically lower the interest rate curve in an attempt to attract more borrowers.

However, these efforts have yielded little result. The benchmark interest rates for USDC and USDT on the Ethereum mainnet on Aave V3 have fallen below 2%, a stark contrast to the double-digit returns that were common during the bull market.

The stablecoin market has fallen into a "liquidity trap." When the market is flooded with low-cost funds but lacks high-return investment opportunities, these funds accumulate in pools of lending protocols.

The collapse of funding rates and the cooling of revolving lending led to a loss of leverage.

The boom in DeFi stablecoin interest rates is essentially driven by leverage. When arbitrage activity in the perpetual contract market cools down, the demand for lending stablecoins shrinks rapidly, causing interest rates to plummet.

In a bull market, heightened bullish sentiment leads to positive and high funding rates. Arbitrageurs use a Delta-neutral strategy—borrowing stablecoins to buy spot and selling perpetual contracts—to hedge risk-free and earn funding fees. In this process, stablecoins are the fuel.

However, the derivatives market has been sluggish recently. On major centralized exchanges (CEXs), funding rates for BTC and ETH have repeatedly turned negative or reached extremely low positive values. This reflects either the dominance of short sellers or extreme caution among long positions.

Regardless of the explanation, they all point to the same conclusion: a lack of motivation for arbitrageurs .

With the annualized funding rate declining sharply, arbitrageurs' net profits will be significantly reduced, taking into account borrowing costs and transaction fees. Their demand for lending stablecoins will subsequently plummet.

Another major source of demand for stablecoin lending is revolving lending. A typical path for this yield-enhancing strategy is to deposit yield-generating assets such as sUSDe into Aave, borrow stablecoins such as USDC, and then exchange the borrowed USDC for more sUSDe and deposit it back.

This strategy was once very popular because USDe yields were as high as 30%, while borrowing costs were only around 10%, leaving a 20 percentage point arbitrage opportunity.

However, after the "1011" incident, the interest rate spread narrowed catastrophically, and USDe also reached the ceiling of "scalability," with its size declining from nearly $15 billion to the current $6 billion.

USDe's yield is highly dependent on the size of short positions in the market. Since the total open interest in the perpetual contract market is limited, when USDe expands to a certain size, the short positions required for hedging will lower the funding rates of the entire market, thereby suppressing sUSDe's yield.

For ordinary traders, the decline in sUSDe yields will lead to a reduction in their strategy spreads. Their decreased demand for leveraged positions will further reduce their need for stablecoin collateral.

This is a self-reinforcing negative cycle: shrinking demand → falling interest rates → further shrinking demand.

Risk appetite is shifting in the crypto market, with funds seeking greater certainty.

The decline in overall risk appetite in the crypto market is another important factor contributing to the lower stablecoin interest rates.

Over the past month, the Fear & Greed Index has frequently touched the "extreme fear" zone, and even when the price of BTC remained at $70,000, sentiment did not show any sustained improvement.

CoinDesk Data also shows that total trading volume on CEXs fell by 2.41% in February to $5.61 trillion, the lowest trading volume since October 2024.

Declining risk appetite has prompted investors to shift towards more certain market segments.

Since January 2024, the effective federal funds rate of the Federal Reserve has consistently remained above 3.6%. Although the market anticipates a gradual path of rate cuts in the future, the current real interest rate remains relatively high.

This macroeconomic environment has also exerted a profound downward pressure on DeFi stablecoin interest rates. When the risk-free yield on US Treasury bonds is higher than the DeFi deposit rate, rational investors will choose to withdraw their funds from on-chain protocols or invest them in protocols backed by RWA (Real-World Assets) without risk premium compensation.

In the midst of an interest rate winter, not all protocols are shrinking. Sky (formerly MakerDAO) has built a unique "yield moat."

Compared to Aave, which relies more on on-chain lending demand, Sky's revenue also comes from $1.5 billion in mature RWA assets. These assets include US Treasury bonds and AAA-rated corporate debt, which are unaffected by crypto market fluctuations and provide a stable underlying cash flow.

This model of converting RWA into underlying collateral has driven USDS supply up 68% year-over-year, bringing its market capitalization close to $8 billion.

As of now, sUSDS's interest rate remains around 3.75%, making it the "fact floor" for on-chain yields. In contrast, deposit rates in USDC and USDT-related vaults can reach over 5%.

This has allowed Sky to assume a role similar to a "benchmark interest rate platform." In contrast, the interest rates for similar assets on Aave are hardly competitive.

This demonstrates that Sky is transforming from a simple stablecoin protocol into a "fixed-income asset management" protocol , leveraging its massive RWA portfolio to hedge against downside risks in the crypto market. When there is a lack of demand within DeFi, it can generate returns from external sources (traditional financial markets).

For investors, learning to examine the underlying asset logic behind yields—whether it stems from government bond dividends or volatility premiums in the futures market—will become an essential lesson in this cycle. Strategies also need to shift from "chasing APY" to "seeking differentiated risk exposures."

The "interest rate winter" is not only a result of cyclical fluctuations, but also an inevitable growing pain of DeFi's "bubble dehydration".

Perhaps just as the trough in 2023 gave birth to the boom in 2024, this bottoming out of interest rates may be DeFi accumulating energy for its next leap.