# IPOR Fusion Alpha Drops | #2 > Liquidity fragmentation as an arbitrage opportunity. Source: https://ipor.io/news/ipor-fusion-alpha-drops-2-09b604d0ad31 Published: 2024-07-23 Incentives · slevin_ipor · 6 min read A series of sneak peeks into IPOR Fusion use cases ahead of the official release. ## Use case: Transform liquidity fragmentation into superior risk-adjusted returns ### Part II: Liquidity fragmentation as an arbitrage opportunity After learning in [Part I of the IPOR Fusion Alpha Drops](https://ipor.io/news/ipor-fusion-alpha-drops-b23f237e8504.md) how to optimize the supply of stablecoins in credit markets, we want to raise the stakes in this article a bit. Liquidity fragmentation, as is well known, exists not only within a single blockchain but also among the rapidly growing number of L1s, L2s (and soon perhaps L3s). However, the old saying applies here: one man’s trash is another man’s treasure. ![Illustration from “IPOR Fusion Alpha Drops | #2”](https://ipor.io/_astro/image-01.Dqv9spLd_Z1gdtY4.webp) ## Example 1: USDC cross-chain lending optimization Circle’s USDC is the most widely used stablecoin in DeFi. It is present in all major money markets. However, the interest rates can vary significantly, even within two blue-chip protocols like Aave v3 and Compound v3. The 30-day average in the following screenshot from ranges from 6.27% (AAVE v3 Optimism) to 11.38% (AAVE v3 Arbitrum). ![defillama.com, June 14, 2024](https://ipor.io/_astro/image-02.DoeN5feU_ZrvgK0.webp) _defillama.com, June 14, 2024_ > This significant spread indicates an inefficient market. IPOR Fusion will enable the automatic arbitrage of this spread. A particular advantage of the stablecoin USDC is that, thanks to Circle’s CCTP, it can be moved in large amounts between different blockchains very cheaply and quickly. For instance, bridging 1 million USDC costs only 40 cents. ![Illustration from “IPOR Fusion Alpha Drops | #2”](https://ipor.io/_astro/image-03.BwBZZ1X0_27jIQG.webp) Thanks to EIP-4844 (Proto-Danksharding), Ethereum L2s now have low transaction fees, which enables allocation optimization to be performed multiple times a day. > The quants in the IPOR Labs team have already created simulations showing that an optimized USDC cross-chain strategy can significantly outperform the market average. In the following backtest, two strategies were compared: 1. **Market Portfolio**: Allocation is rebalanced hourly, weighted by each market’s supply. 2. **Optimized**: Allocation is rebalanced hourly to the pool with the highest yield. The following 8 markets were used: - Compound v3 Polygon - Compound v3 Base - Compound v3 Arbitrum - Aave v3 Polygon - Aave v3 Base - Aave v3 Arbitrum - Aave v3 Optimism - Aave v3 Avalanche The historical USDC lending rates for these markets are as follows: ![Illustration from “IPOR Fusion Alpha Drops | #2”](https://ipor.io/_astro/image-04.inMhqVG8_ZyFioc.webp) ![Illustration from “IPOR Fusion Alpha Drops | #2”](https://ipor.io/_astro/image-05.D2leQ7WF_Z21GViY.webp) The backtest for the period from June 2023 to June 2024 yielded the following performance: - **Market Portfolio**: 6.74% APR - **Optimized**: 9.46% APR > This means an outperformance of **40%**! For simplicity, slippage, transaction, and bridging costs were not considered, which would slightly reduce the real achievable return (optimization and slippage also depend on portfolio size). However, the return could theoretically be increased by expanding the strategy to include additional markets and chains (such as Morpho Blue, Fluid, or Gearbox). In this article, the primary focus is to demonstrate the potential of such a strategy within an IPOR Fusion Plasma Vault. ## Example 2: Rates arbitrage with blue chip collateral Even though borrowing interest rates in most DeFi protocols currently do not depend on the quality of the collateral but mainly on the LTV (loan to value), it is already foreseeable that this will likely change. Isolated lending markets are gaining market share (e.g., Morpho Blue). Additionally, with AAVE v4, “liquidity premiums” will be introduced: > “Riskier collaterals (either because of centralization dependencies or market risk) should be priced accordingly, while with the current iteration of Aave V3 this is not possible.” [\[TEMP CHECK\] Aave Protocol V4 Development Proposal](https://governance.aave.com/t/temp-check-aave-protocol-v4-development-proposal/17541) But even now, there are opportunities to take out a loan against high-quality collateral and lend it elsewhere at higher interest rates. These opportunities could expand further due to the dynamics described above. ### crvUSD CDP-Lend-Arbitrage For example, an IPOR Fusion WBTC vault could [mint crvUSD against wBTC collateral](https://crvusd.curve.fi/#/ethereum/markets/wbtc/create) and deposit it into a crvUSD yield optimizer vault, earning the spread between borrowing rates and lending rates. An Alpha could ensure automatic health factor management, minting crvUSD when the WBTC price rises and repaying crvUSD when it falls. The [LLAMMA soft liquidation mechanism](https://docs.curve.fi/crvUSD/amm/) introduced by Curve Finance also allows for very high capital efficiency. ### Stablecoin cross-market arbitrage fund IPOR Fusion will also enable the creation of the first fully automated stablecoin fund. It could invest in selected blue chip stablecoins and deposit them to the highest available (risk-adjusted) yields, even borrowing other assets to deposit them in another market to earn an additional spread (arbitrage). The key to such a strategy is to understand every possible investment combination as a representation of interest rate in some way, shape, or form. For example, if AAVE v3 offers 8% APR on USDC and charges 9% borrowing APR on DAI, and this DAI can be deposited at 12% APR on Morpho Blue, the effective APR on the initial USDC investment would be 11% (LTV disregarded for simplification). The stablecoin fund’s returns could be further increased if fluctuations in the stablecoins’ pegs can be capitalized. Allocation restrictions ensure risk-adjusted returns (for example: deposit a maximum of 20% of the total vault assets in Gearbox). > The IPOR Labs quant team has already conducted simulations for this strategy, showing that stablecoin arbitrage can indeed generate additional yields. In the following backtest, several strategies were compared: **1. Market Portfolio: Allocation is rebalanced hourly, weighted by each market’s supply.** a) Compound v2/v3, Aave v2/v3 b) Compound v2/v3, Aave v2/v3, Gearbox, Morpho Blue, Fluid **2. Optimized: Allocation is rebalanced hourly to the pool with the highest yield.** a) Compound v2/v3, Aave v2/v3 b) Compound v2/v3, Aave v2/v3, Gearbox, Morpho Blue, Fluid \3. **Arbitrage: Allocation is rebalanced to the highest yield route. The starting point is always Aave or Compound.** The historical APRs of all possible permutations of the arbitrage strategy are as follows: ![Illustration from “IPOR Fusion Alpha Drops | #2”](https://ipor.io/_astro/image-06.DKWnmcsh_1WAUvE.webp) > The backtest has shown that stablecoin arbitrage can lead to significant outperformance. The following chart shows that the outperformance sharply increases starting in April 2024. This could be due to the opening of new markets. ![Illustration from “IPOR Fusion Alpha Drops | #2”](https://ipor.io/_astro/image-07.V48JMBGa_jKexr.webp) In this backtest, slippage, transaction costs, and bridging costs were also disregarded for simplification. ## Example 3: Fund of funds > IPOR Fusion will also allow the creation of a fund of funds, thanks to the composability of the ERC-4626 vaults. The composition and weighting can be determined as desired. The allocation of such a fund of funds stablecoin vault could look like this: 1. 55% optimized blue chip / low-risk vault (Aave + Compound only) 2. 40% medium-risk stablecoin arbitrage vault 3. 5% high-risk optimized emerging markets vault Such a portfolio would have achieved the following returns from January to July 2024 compared to the market portfolio and pure blue-chip vault strategies: 1. Market Portfolio: 6.74% 2. Optimized (Aave/Compound only): 9.2% 3. FoF Portfolio: 16.8% ![Illustration from “IPOR Fusion Alpha Drops | #2”](https://ipor.io/_astro/image-08.BFWYM3mN_ZbJKSi.webp) ## From fragmentation to opportunity and beyond As the article above illustrates, DeFi’s growth, while exciting, can lead to inefficiencies. When properly analyzed, these can be transformed into opportunistic gains. Remember, no strategy is without risk, and the above analysis is for illustrative purposes only. However, it highlights the use of data intelligence and strategy automation as a key to optimizing a DeFi portfolio. The Fusion Alpha Drops series has focused on various optimizations around stablecoin allocation for optimal returns. In future articles, the strategies will be expanded to include leverage, derivatives, and collateral management, as well as a diversified set of assets such as ETH and WBTC. With increasing sophistication, risk management becomes a critical factor for success and navigating negative outcomes. Stay tuned.