Yield Compression Challenges: How DeFi Lending Markets Evolved in Q1 2025

DeFi Lending Markets in Q1 2025: Yield Compression and Innovation

Despite a significant decline in yields across major DeFi lending platforms, the sector continues to evolve, with innovation at the edges driving its maturation, according to Ryan Rodenbaugh, CEO of Wallfacer Labs, the team behind vaults.fyi.

The Great Yield Compression

The first quarter of 2025 has seen a sharp contraction in DeFi yields across key lending platforms:

• The vaults.fyi USD benchmark has fallen to 3.1%, dropping below the U.S. 1-month Treasury bill yield of ~4.3% for the first time since late 2023. This marks a significant decrease from 14% in late 2024.
• Spark has implemented four consecutive rate cuts in 2025, reducing yields from 12.5% at the start of the year to 4.5%.
• Aave’s stablecoin yields on mainnet are now at ~3% for USDC and USDT, levels that would have been considered unattractive just months ago.

This decline reflects a cooling market compared to the exuberance seen in late 2024, with borrowing demand showing clear signs of slowdown.

The TVL Paradox: Growth Despite Lower Yields

Despite shrinking yields, total value locked (TVL) in DeFi lending platforms has grown significantly:

• Aave, Sky, Ethena, and Compound have collectively quadrupled in size over the past year, increasing from $4 billion to $15 billion in supply-side deposits.
• Spark’s TVL has tripled since the start of 2025, even as its rates declined.

This paradox suggests a shift in perception, with DeFi now seen as legitimate financial infrastructure rather than just a speculative market.

The Rise of Curators: DeFi’s New Asset Managers

A major trend in DeFi lending is the rise of curators, who actively manage lending vaults. Platforms like Morpho and Euler have introduced these curators to optimize capital allocation and maximize returns.

Curators serve as a new class of asset managers, handling:

• Risk management (setting loan-to-value ratios, selecting collateral assets)
• Yield optimization (balancing exposure across lending markets)
• Capital deployment strategies

Firms like Gauntlet, which previously provided advisory services to platforms like Aave and Compound, now directly manage nearly $750 million in TVL across DeFi protocols. With performance fees ranging from 0-15%, this sector is evolving into a lucrative industry.

Market Stratification: The Two-Tier DeFi Lending Landscape

The DeFi lending market has structured itself into two key layers:

1. Blue-Chip Infrastructure (Aave, Compound, Sky)
   • Operate like traditional money market funds
   • Offer lower but stable yields (2.4-6.5%)
   • Capture the bulk of TVL growth
2. Infrastructure Optimizers & Strategy Providers
   • Base Layer Optimizers (Morpho, Euler) improve capital efficiency
   • Strategy Providers (MEV Capital, Steakhouse, Gauntlet) design yield-maximizing strategies, offering returns up to 12% on stablecoins

This stratification creates a dynamic landscape where protocols and strategy providers collaborate to optimize capital efficiency and yield generation.

Where Are the Yields Now?

Ethereum remains the dominant chain for DeFi lending, maintaining higher yields than alternative Layer 1s and Layer 2s. However, Base has emerged as a notable secondary hub, attracting capital due to its increasing role in on-chain financial services.

• Ethereum mainnet continues to offer the best yield opportunities, despite the proliferation of L2s.
• Newer chains like Berachain and Sonic provide higher yields, but sustainability remains uncertain as incentive programs diminish.

The DeFi Mullet: FinTech in the Front, DeFi in the Back

Coinbase’s Bitcoin-backed loans on Morpho via its Base L2 network illustrate the “DeFi Mullet” concept—where FinTech interfaces operate in the front while DeFi infrastructure runs in the background.

• Users post BTC collateral to mint cbBTC, Coinbase’s wrapped Bitcoin on Base.
• They then borrow USDC on Morpho, a Coinbase-backed lending protocol.
• This full-circle integration allows millions of retail users to access DeFi without needing to interact with complex smart contracts.

Future Catalysts for DeFi Lending

Several factors could reshape DeFi lending in 2025:

1. AI-driven curation – Could AI-powered strategies democratize access to custom lending strategies?
2. RWA integration – The addition of real-world assets (RWAs) may introduce stable, non-crypto-correlated yield opportunities.
3. Institutional adoption – More traditional finance players entering DeFi could shift market dynamics significantly.
4. Specialized lending markets – The emergence of niche lending sectors could create new opportunities beyond simple yield farming.

Conclusion

DeFi lending is entering a new phase of maturation, defined by lower but sustainable yields, increasing institutional trust, and sophisticated capital optimization strategies. The platforms that thrive will be those that balance risk management, capital efficiency, and adaptive yield strategies, ensuring DeFi’s continued evolution as a core financial infrastructure.