Presto OriginalMar 4, 2025

DeFi Interest Rates: Challenges, Innovations, and the Path to Stability

Summary

  • DeFi yield comes from borrowing fees, staking rewards, and other financial activities. While some yields are organic, many protocols still rely on inflationary token incentives. The challenge is transitioning toward more predictable and sustainable yield mechanisms.

  • Unlike TradFi, DeFi lacks a standardized benchmark interest rate, leading to inconsistent borrowing and lending rates across platforms. Many protocols depend on short-term liquidity incentives, and the absence of robust hedging instruments and price discovery makes risk management difficult for institutional investors.

  • New protocols like Pendle’s yield stripping, Term Finance’s auction-based lending, and Ethena’s market-driven funding fees are addressing these inefficiencies. These innovations improve price discovery, introduce fixed-rate lending, and reduce reliance on speculative APYs, paving the way for a more stable DeFi yield market.

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1. Introduction

DeFi has revolutionized the way capital is deployed and borrowed, offering yield opportunities that TradFi cannot match in terms of accessibility and composability. However, despite the explosive growth of DeFi yield markets, fundamental questions remain: Where does the yield come from? How sustainable are current models? And what innovations are shaping the future of DeFi interest rates?

Unlike TradFi, where interest rates are influenced by central banks, credit risk, and macroeconomic conditions, DeFi yields are largely dictated by protocol incentives, supply-demand imbalances, and market inefficiencies. This essay explores the mechanics of yield generation in DeFi, the structural limitations of its interest rate system, and the emerging innovations that could transform DeFi into a more stable and institution-friendly market.

2. Where Does the Yield Come From?

Every yield paid to a lender, staker, or liquidity provider must be funded by some form of economic activity. The sustainability of this yield depends on whether it is generated organically (through real market demand) or artificially (through inflationary incentives). Below are the primary sources of yield in DeFi today:

2.1. Borrowing Fees: The Core of Organic Yield

The most fundamental source of DeFi yield comes from lending markets, where borrowers pay interest on loans, and lenders earn a share of this interest. Platforms like Aave, Compound, and Morpho operate similarly to traditional banks, where users deposit capital into liquidity pools, and borrowers take out loans against collateral.

  • The borrow APY (Annual Percentage Yield) is higher than the supply APY, with the protocol capturing the spread as revenue.

  • Borrowing demand fluctuates based on market conditions, leverage appetite, and the availability of crypto assets.

  • The more demand for leverage (e.g., borrowing stablecoins to buy more ETH), the higher the interest rates lenders can earn.

For instance, during bull markets, stablecoin borrowing rates on Aave and Compound can exceed 10% APY, while supply rates remain slightly lower, around 8% APY. In contrast, bear markets see lending APYs drop significantly due to reduced borrowing activity. This natural fluctuation mirrors TradFi’s credit cycles, making lending-based yield one of the most sustainable sources in DeFi.

Figure 1: The Supply & Borrow structure most closely resembles the TradFi lending market.
Source: AAVE

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2.2. Protocol Incentives and Subsidized Yield

Many DeFi protocols distribute staking rewards and liquidity incentives via their native token treasuries. While this attracts liquidity, it often leads to inflationary and unsustainable yield models.

  • Protocols issue governance tokens to LPs or stakers, increasing circulating supply.

  • Once token incentives dry up or lose value, APYs collapse, leading to capital outflows.

  • This model was prevalent during DeFi Summer 2020, when protocols offered triple-digit APYs, only for rewards to become worthless as token prices dropped.

2.3. Transaction Fees: Staking Yield from Blockchain Activity

Proof-of-Stake (PoS) blockchains like Ethereum, Solana, and Avalanche offer staking yield sourced from transaction fees and block rewards. Validators and delegators secure the network and receive rewards in return.

  • When blockchain activity is high (e.g., during NFT mints or market volatility), staking APYs increase due to higher gas fees.

  • During bear markets or periods of low transaction volume, staking rewards decline.

For example, Ethereum’s staking yield fluctuates between 3-5%, with a portion coming from priority fees paid by users. This makes staking-based yield more stable than incentive-driven APYs but still subject to network congestion and block demand.

2.4. Alternative Yield Models: Funding Fees and Market Making

Newer DeFi platforms are innovating on yield generation by tapping into funding fees and market-making rewards. 

  • Funding Fees in Perpetual Markets: Platforms like Ethena generate yield through perp funding rates, where traders in long positions pay fees to short traders (in most market conditions.)

  • Market-Making Vaults: HyperLiquid’s HLP vault performs automated market-making and earns a share of trading fees and liquidation profits. Currently, HLP generates 15-20% APR from these activities.

Figure 2: The yield from Hyperliquid vaults comes from profit sharing, resembling an investment in a fund in the TradFi market.
Source: Hyperliquid

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These models create more market-driven and sustainable yield mechanisms than pure token emissions, aligning DeFi yield closer to TradFi’s structured finance products or funds.

3. Structural Limitations of DeFi Interest Rates

Despite its innovation, DeFi’s yield markets face significant inefficiencies that prevent them from functioning as a stable alternative to TradFi’s fixed-income instruments.

3.1. Absence of a Standardized Benchmark Interest Rate in DeFi

A key challenge faced by the DeFi sector is the absence of a universally accepted benchmark interest rate. In conventional financial systems, there’s a clear distinction between the benchmark and market rates. The benchmark rate, set by central institutions like the Federal Reserve, accounts for macroeconomic conditions. This established rate acts as a consistent point of reference for all market participants. The market rate, on the other hand, evolves based on this benchmark, factoring in elements such as risk, typically framed as “benchmark rate + basis points (BP)”.

This structural clarity is missing in the DeFi space. Without a consistent benchmark, there’s notable disparity in interest rates across various platforms or blockchains, even for the same cryptocurrency. The decentralized nature of DeFi means there’s no centralized entity to enforce or suggest standardized rates, and there’s a lack of uniformity in how participants perceive and set interest rates. This environment naturally enhances market volatility where it’s not rare to witness sizable interest rate discrepancies on the same platform, often without clear justification. As a result, DeFi interest rates presently struggle to reflect genuine value and often play a more promotional role for projects rather than mostly being an intrinsic component like in traditional finance.

Figure 3: The APY calculation is arbitrary, unlike in the TradFi market, where even within the same pool and chain, APYs can vary drastically between projects without clear risk-based justifications.
Source: DefiLIama, Presto Research

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3.2. Over-Reliance on Inflationary Token Incentives

Many DeFi yields are driven by governance token emissions, which dilute value over time. Unlike TradFi yields that are derived from economic productivity, DeFi’s yield farming models often rely on token issuance, leading to:

  • Temporary liquidity influxes that dissipate once rewards decrease.

  • A cycle of unsustainable APYs that discourage long-term capital allocation.

3.3. Absence of Interest Rate Hedging Instruments

In conventional financial systems, the interest rate market isn’t just about borrowing and lending; it has a robust derivatives segment. For perspective, the global over-the-counter (OTC) interest rate derivatives market is valued at an impressive $573.7 trillion, dwarfing the $120 trillion foreign exchange OTC market. This derivatives market offers investors tools to protect against interest rate changes, as well as avenues for generating returns.

In contrast, the DeFi landscape is predominantly focused on lending and borrowing, and these services often only provide floating rates. This restricts investors from effectively gauging the true value of interest rates since they lack hedging tools to counter the inherent market volatility. Furthermore, the range of products centered on interest rate investments in DeFi is quite limited. Such constraints deter institutions that seek dependable returns, including pension funds and insurance companies, from entering the DeFi space.

4. Emerging Yield Protocols in DeFi to Solve Problems

To address DeFi’s current interest rate limitations—such as the lack of a benchmark rate, reliance on native token emissions, and weak price discovery—several innovative protocols have emerged. These projects aim to create structured yield markets that function more like fixed-income instruments in TradFi, enabling price discovery, risk management, and institutional adoption.

4.1. Early Yield Models in DeFi

Before today’s more sophisticated approaches, the first structured DeFi yield products borrowed ideas from traditional fixed-income markets. Two notable models were:

4.1.1  Zero-Coupon Bonds (Ex, UMA)

Zero-coupon bonds are a well-established concept in traditional finance, and DeFi protocols have begun experimenting with similar instruments to provide structured yield opportunities. Unlike traditional bonds that pay periodic interest (coupons), zero-coupon bonds are issued at a discount and redeemed at full face value upon maturity, offering a predetermined return.

  • Investors purchase discounted yield-bearing tokens that mature into full-value assets.

  • Instead of receiving continuous interest payments, investors are rewarded at the bond’s maturity date.

  • This allows for predictable returns (fixed-rate return), reducing exposure to fluctuating APYs seen in conventional DeFi lending.

4.2.2. Junior and Senior Tranches (Ex, Centrifuge)

Tranche-based structures divide a lending pool into different risk tiers, catering to investors with varying risk appetites. This model, borrowed from structured credit markets, has gained traction in DeFi as protocols seek to attract both risk-averse and risk-seeking capital.

  • Senior Tranche: Receives priority payouts with lower risk but also lower yields.

  • Junior Tranche: Accepts higher risk in exchange for potentially higher returns.

  • The yield from lending or staking first covers the senior tranche, with any excess going to the junior tranche.

4.2. Today’s Advanced Yield Protocols

While early models laid the groundwork, recent developments have introduced more sophisticated mechanisms for price discovery, structured interest rates, and leverage trading in DeFi.

4.2.1. Yield Stripping (Ex, Pendle)

Pendle Finance introduced Yield Stripping, a method that separates the principal from the yield of an asset, creating two distinct tradable tokens:

  • Principal Token (PT): Represents the underlying asset and guarantees a return to its face value at maturity.

  • Yield Token (YT): Represents the interest portion, which fluctuates based on market demand and supply.

Example: Suppose you own stETH (staked Ethereum), which earns yield over time. Pendle allows you to tokenize it into:

  • PT-stETH – The base staked ETH, redeemable at full value upon maturity.

  • YT-stETH – The variable interest earnings, which traders can speculate on.

Investors can then trade, hedge, or speculate on these yield components separately.

  • Anticipating Rising Rates: If you believe interest rates will go up, you can sell your PT and reallocate those funds to purchase more YT.

  • Anticipating Falling Rates: Conversely, if you predict a decline in rates, it would be wise to sell off YT and use those proceeds to buy more PT.

Why it matters: Yield stripping allows for price discovery of DeFi interest rates, enabling the creation of a yield derivatives market that resembles TradFi’s fixed-income sector. It also provides a way to lock in fixed returns while allowing others to speculate on interest rate movements.

Figure 4: Example of how yield-bearing tokens are stripped and traded.
Source: Pendle, Presto Research

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4.2.2. Yield Auctions (Ex, Term Finance)

Term Finance introduces auction-based lending, similar to how U.S. Treasury bond auctions set interest rates in TradFi.

  • Borrowers submit bids indicating the maximum interest rate they’re willing to pay.

  • Lenders submit offers specifying the minimum rate they require to lend funds.

  • The protocol clears the market by determining a uniform interest rate based on overlapping demand.

Why it matters: This system improves fixed-rate lending in DeFi, making yields more predictable and reducing reliance on speculative APYs. It also mirrors traditional bond markets, making DeFi lending more appealing to institutional capital.

4.2.3. Actual Yield Market (Ex, Ethena)

Ethena has introduced a structured market for yield farming and funding rates that aligns DeFi yields with real market forces rather than token emissions.

  • If demand for long positions is high, funding fees become positive, meaning short traders receive payments.

  • Ethena captures these funding fees (Long Spot + Short Futures) and distributes them to investors, creating a sustainable, non-inflationary yield source.

Figure 5: Ethena generates yield by earning funding payments in the perps market while maintaining a delta-neutral position by being short futures and long spot.
Source: Ethena

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4.2.4 Leverage Yield Trading (Ex, RateX)

RateX introduces a leverage yield trading market, allowing users to amplify exposure to interest rate fluctuations and hedge DeFi borrowing and lending risks.

  • Users borrow against yield-bearing assets (e.g., stETH, USDC deposits) to increase their exposure to changing interest rates.

  • Traders can take long or short positions on DeFi yields, speculating on whether rates will rise or fall.

Why it matters: RateX introduces a structured yield speculation market, allowing for better risk management and hedging in DeFi. This deepens liquidity and enhances interest rate price discovery, making DeFi yields more predictable and tradable.

Figure 6: The yield market enables price discovery on yields, making it a more efficient market.
Source: RateX

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Overall, these innovations are transforming DeFi yield markets by enhancing price discovery and enabling fixed-rate returns, making them more predictable and attractive for adoption. By introducing mechanisms that separate principal from yield and implementing auction-based interest rate setting, DeFi is moving toward structured, transparent pricing models. The ability to lock in fixed returns reduces volatility, provides stability for long-term investors, and encourages institutional participation.

5. Conclusion

DeFi’s yield markets are evolving toward greater stability, structure, and sustainability. The early reliance on token incentives is gradually being replaced by more organic and market-driven yield mechanisms, bringing DeFi closer to TradFi’s fixed-income markets. However, challenges remain—without standardized benchmark rates, effective hedging instruments, and predictable yield structures, DeFi still struggles to attract long-term institutional capital.

Emerging innovations, such as yield stripping, auction-based lending, and market-driven funding fees, are paving the way for a more transparent and efficient interest rate system. These developments enable better price discovery, reduce reliance on speculative APYs, and introduce fixed-rate returns, making DeFi yields more predictable and investable.

As the sector matures, the next phase of growth will depend on integrating on-chain reference rates, structured yield products, and deep liquidity for interest rate derivatives. If DeFi can successfully address these limitations, it has the potential to become a true alternative to TradFi’s bond markets—offering transparent, scalable, and risk-adjusted returns for both retail and institutional investors.

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