# IPOR Fusion Alpha Drops | #3

> Decentralized Ethena — beyond passive funding rate farming on CEXs.

Source: https://ipor.io/news/ipor-fusion-alpha-drops-3-3a2111866c37  
Published: 2024-07-29  
Incentives · Konstantinos Tsoulos · 9 min read

A series of sneak peeks into IPOR Fusion use cases ahead of the official release.

### Use case: “Decentralized Ethena” — beyond passive funding rate farming on CEXs

> Background

The impressive growth of Ethena’s synthetic dollar ([USDe](https://ethena-labs.gitbook.io/ethena-labs)) has drawn a lot of attention to one of the historically **most popular market-neutral strategies** in the digital assets space:

> A delta-neutral position of long spot perfectly offset by short perps position, earning the typically positive funding rate.

![Ethena’s yield-bearing synthetic dollar USDe: a tokenized cash & carry trade. Source: Coinmonks](https://ipor.io/_astro/image-01.Zgu3yzCI_Z22LsUl.webp)

_Ethena’s yield-bearing synthetic dollar USDe: a tokenized cash & carry trade. Source: Coinmonks_

Notwithstanding legitimate concerns about the project’s transparency and associated regulatory, operational, and market [risks](https://ethena-labs.gitbook.io/ethena-labs/solution-overview/risks) (read depeg risk), as well as the strategy’s inherent scalability limitations, Ethena recently surpassed $ 3.5bn and expanded beyond ETH into BTC collateral without evident signs of structural pressure on funding rates to date. Recent [announcements](https://www.theblock.co/amp/post/300845/bitget-to-use-ethenas-usde-as-collateral-for-perpetual-futures-as-part-of-earn-product-and-for-spot-pairs) about USDe achieving collateral eligibility status on established trading venues may suggest that the funding rate farming trade still has legs.

![Illustration from “IPOR Fusion Alpha Drops | #3”](https://ipor.io/_astro/image-02.CC6vGsdL_2wjCdL.webp)

![The impressive growth of USDe (left) and funding rate levels have remained encouragingly resilient so far (right). Source: Coinmonks](https://ipor.io/_astro/image-03.DdE0A-cK_Z278Uus.webp)

_The impressive growth of USDe (left) and funding rate levels have remained encouragingly resilient so far (right). Source: Coinmonks_

In this piece, we explore a more sophisticated variation of the ‘Ethena trade’ that can deliver attractive returns with increased transparency and capital efficiency thanks to the combination of centralized and decentralized venue interactions.

> Liquidity permitting, the strategy will be able to farm funding rates on DEXеs and trade the spread across venues. It will be able to utilize DeFi credit markets to generate yield for idle collateral and intermittently create synthetic positions by looping in credit markets.

We highlight the benefits of implementing the proposed strategy leveraging IPOR Fusion capabilities.

![USDe minting workflow for ETH collateral. Source: Coinmonks](https://ipor.io/_astro/image-04.DCVvQ9e6_Z1TJVbA.webp)

_USDe minting workflow for ETH collateral. Source: Coinmonks_

## Building a smart funding rate farming vault with IPOR Fusion

### Step 1: Vault creation

Vault creation and configuration will be possible with just a few clicks.

![Fusion Vault creation UI.](https://ipor.io/_astro/image-05.D3B7AoU6_Z25JCWT.webp)

_Fusion Vault creation UI._

### Step 2: Fuse selection - Which perp DEX to run the strategy on? Credit market selection for synthetic position implementation.

In spite of the proliferation of perp DEXes with different fee levels, supported assets, margin calculations, and allowed leverage, the decisive factor for including a DEX to the list of accessible venues is **liquidity**. Slippage on perp DEXеs can be detrimental to strategy PnL and overall scalability.

![Perp DEXes — too many options?](https://ipor.io/_astro/image-06.BWWZstrA_Z2hje7K.webp)

_Perp DEXes — too many options?_

![Illustration from “IPOR Fusion Alpha Drops | #3”](https://ipor.io/_astro/image-07.C2m6t5nA_1cUV7h.webp)

![Perp-DEX leader dYdX volumes are still nowhere near top-tier CEX. Source: Dune dashboard on the left by @Shogun.](https://ipor.io/_astro/image-08.BER8rmvh_ZuW2YV.webp)

_Perp-DEX leader dYdX volumes are still nowhere near top-tier CEX. Source: Dune dashboard on the left by @Shogun._

![Liquidity considerations can help narrow down the list of candidate fuses. Source: Dune dashboard by @Shogun.](https://ipor.io/_astro/image-09.CxrjD-TM_49zKX.webp)

_Liquidity considerations can help narrow down the list of candidate fuses. Source: Dune dashboard by @Shogun._

Applying the common rule of thumb of estimating „slippage“ by

![Illustration from “IPOR Fusion Alpha Drops | #3”](https://ipor.io/_astro/image-10.BRM6_YL0_TO6zt.webp)

significantly narrows down the list of [Fuse](https://x.com/ipor_io/status/1814927305317171309) candidates. At the time of writing, dYdX, Synthetix (Kwenta), Hyperliquid, Vertex and GMX seem to be reasonable choices based on this metric for the top 10 coins in terms of market cap.

> Fusion will also allow Atomists to conveniently add and remove fuses during the lifetime of a vault, thus staying up-to-date with the latest developments in liquidity, new features and incentive programs.

> A lot of the complexity of the different DEXes will also be abstracted away thanks to the [Fuses](https://x.com/ipor_io/status/1814927305317171309) implementing common core operations.

![Illustration from “IPOR Fusion Alpha Drops | #3”](https://ipor.io/_astro/image-11.4vSMEyNl_Z1WkWOG.webp)

Deploying capital across both centralized and decentralized exchanges will be possible with Fusion, whereby CEX access should typically be included exclusively for “restricted” access vaults.

### Step 3: Additional restrictions

> Limiting the amount of (margin) capital deployed with a specific trading venue is key to reducing smart contract risk (DEX) and custodial risk (CEX) concentration.

This can be achieved both by introducing maximum capital allocation limits per Fuse, but also specifying the maximum leverage allowed per venue.

Allowing for leverage introduces liquidation risk and, with that, the need for more sophisticated collateral and PnL management (see Step 4). Historical analysis of the spot vs. futures price relationship suggests that dislocation between the two markets, even for the liquid majors on some of the biggest exchanges, can intermittently reach extreme levels.

![Illustration from “IPOR Fusion Alpha Drops | #3”](https://ipor.io/_astro/image-12.BkUwI2kz_13WdIS.webp)

![Temporary basis dislocations could still be significant. Source: Binance](https://ipor.io/_astro/image-13.DE0bo8b2_PTYmn.webp)

_Temporary basis dislocations could still be significant. Source: Binance_

Dislocations are typically rectified over longer time windows but can still trigger liquidations. Such extreme moves may also intermittently generate strong positive PnL and, therefore, the need for “smart” Alpha logic.

While the margining mechanism of each protocol/exchange is the key factor to consider when configuring leverage limits, 2–3x leverage seems to be a reasonable target range, with more conservative max leverage levels appropriate for altcoins. Maintaining an idle capital buffer of 10% of AUM for emergency situations is also a good practice.

![Liquidation risk significantly higher for alts — Source: Binance](https://ipor.io/_astro/image-14.bM3uAa9z_6apcr.webp)

_Liquidation risk significantly higher for alts — Source: Binance_

The whitelisting of CEX wallet addresses will also be possible in this step, ensuring that assets can only leave the vault for specific destinations in a CeFi/DeFi interaction context.

### Step 4: The “secret sauce”

Funding rate farmers are essentially willing to take jump-to-default (smart contract and custodial) and liquidation risk in exchange for a high Sharpe ratio and close to market-neutral returns.

> The funding rate landscape on DEXes is still a lot more challenging; thin liquidity, volatile funding rates, more frequent and violent basis dislocation but also a rich opportunity set for alpha generation for nimble traders and risk managers.

IPOR Fusion’s [architecture](https://ipor.io/blog/what-is-ipor-fusion-a-technical-overview-114ccd67dfcf.md) is designed precisely with the goal of facilitating the tail end of sophistication among funding rate strategies thanks to its support for automation, real-time monitoring, and trading signal implementation.

![DEX funding rates are volatile even for majors. Dune dashboard by @crypto_surfer](https://ipor.io/_astro/image-15.CCl0r51D_Z1t7NsN.webp)

_DEX funding rates are volatile even for majors. Dune dashboard by @crypto_surfer_

### Feature I: Margin monitoring and collateral management

> Managing collateral allocations across venues lies at the core of the strategy, contributing to jump-to-default risk reduction and capital efficiency improvement.

IPOR Fusion Alpha\* serves as the “command center,” monitoring the health factor of margin positions and liquidity status of different exchanges. Fuses abstract the complexity of protocol-specific intricacies. Assuming a 3x leverage rule across the board and a 10% idle capital buffer means that, on average, 70% of assets remain at the vault (or are partially supplied to blue-chip credit markets or liquid staking protocols to generate additional income), while only 30% is used as margin and being topped-up for every 10% balance draw (due to negative PnL or depegs in the case of staked assets).

Margin will also be automatically adjusted through PnL and position management, described below.

_\*”Alphas” are the off-chain agents or bots responsible for maintaining the strategy operations of a specific vault. They run off-chain automated software to optimize asset allocation by calling functions on Fuses. An excellent technical overview of IPOR Fusion is available in the IPOR_ [_blog._](https://ipor.io/blog/what-is-ipor-fusion-a-technical-overview-114ccd67dfcf.md)

### Feature II: PnL management

> While the aggregate spot vs perp or long/short perp position is market neutral, the individual legs are constantly generating (almost perfectly offsetting) PnL.

The management of the individual legs PnL is a strategy in itself with implications for the overall return profile and strategy style.

For vaults seeking to replicate the synthetic dollar strategy concept, maintaining constant TVL (notional exposure) is a requirement that can be ensured by frequent rebalancing of positions through the netting out of PnL. This approach can also help reduce liquidation risk.

![Frequent rebalancing ensures stable gross exposure and reduced liquidation risk.](https://ipor.io/_astro/image-16.BS3gOPKR_ZBzgbC.webp)

_Frequent rebalancing ensures stable gross exposure and reduced liquidation risk._

Rebalancing every 8 hours should have little performance impact in terms of transaction costs for CEX strategies as the costs are applied to position turnover size. Daily or weekly rebalancing is more appropriate for Ethereum mainnet vaults, as gas costs can be punitive.

> Leveraging the optimization capabilities of IPOR Fusion quant libraries can be quite powerful in this context, essentially triggering the rebalancing of PnL when gas costs are attractive and/or DEX liquidity (read slippage) supportive.

![Transaction costs on CEX for a $10m vault are negligible.](https://ipor.io/_astro/image-17.BAg-ABws_Z29bKBQ.webp)

_Transaction costs on CEX for a $10m vault are negligible._

If maintaining fixed notional exposure is not a prerequisite, Strategists (AKA Atomists) might decide not to rebalance frequently and simply manage collateral to avoid liquidations. Reducing leverage is more prudent for this approach overall. The result is gross notional exposure increasing when prices rise and shrinking when prices drop. Strategy PnL follows the same pattern and is in fact exacerbated by the fact that funding rate levels tend to be strongly correlated with market sentiment.

![‘Set and forget’ with no leverage works well in the bull market.](https://ipor.io/_astro/image-18.Cxt6jdC3_a2Lo8.webp)

_‘Set and forget’ with no leverage works well in the bull market._

Our proposed PnL management strategy is, in fact, a hybrid, sentiment-driven approach. The Alpha lets notional grow when prices increase (simply managing margin limits) and rebalances more frequently (optimizing for costs) when prices drop. In the latter case, positive PnL of the short leg is used to buy back more of the long and the short leg is adjusted accordingly to maintain delta neutrality. This way gross notional exposure is maintained at higher levels and total income from funding rate (which typically drops with price) is also overall boosted.

### Feature III: Smart position management and trading signal support

> The biggest challenge and point of criticism of the passive funding rate farming strategy is its dependency on the stage of the market cycle (i.e. it only works in a bull market).

Funding rates collapse with sustained negative sentiment while funding rates of lower market cap altcoins might stay negative for prolonged periods in a bear market.

![Illustration from “IPOR Fusion Alpha Drops | #3”](https://ipor.io/_astro/image-19.BSqyno_d_HIh1B.webp)

![Funding rates remained negative for prolonged periods in the last bear market, even for ETH on Binance (left). Negative funding rates are even more pronounced for alts (right). Source: Binance](https://ipor.io/_astro/image-20.l5GzoMpp_weump.webp)

_Funding rates remained negative for prolonged periods in the last bear market, even for ETH on Binance (left). Negative funding rates are even more pronounced for alts (right). Source: Binance_

> An Atomist equipped with a signal for funding rates and access to DeFi money markets (Fusion‘s bread & butter) can navigate cycles switching their long/short positioning, intermittently utilizing synthetic positions by “looping” in the credit markets.

Identifying a regime shift for funding in a bear market, for instance, can allow the Alpha to go long perps and synthetically short by looping (supply stables and borrow risky assets), while getting paid on both legs!

![Illustration from “IPOR Fusion Alpha Drops | #3”](https://ipor.io/_astro/image-21.BVxZdYVY_6cQT9.webp)

![Funding rates exhibit decent autocorrelation (left). Market cycle agnostic funding rate farming is possible by utilizing synthetic shorts (right). Source: Binance](https://ipor.io/_astro/image-22.OXIP337o_Z2qk7rl.webp)

_Funding rates exhibit decent autocorrelation (left). Market cycle agnostic funding rate farming is possible by utilizing synthetic shorts (right). Source: Binance_

Beyond “regime detection”, funding rate “prediction” is essential for a successful funding rate strategy. The Alpha needs to maintain metadata about the duration and timing of funding rate intervals (typically varying from continuous to 1, 4 or 8 hours), the calculation methodology, as well as the time window for funding rate payment eligibility.

![“Knowing your venue” is essential to running a sophisticated strategy. To access “Details,” use this Google Doc.](https://ipor.io/_astro/image-23.CPVWli1m_Z1vllmf.webp)

_“Knowing your venue” is essential to running a sophisticated strategy. To access “Details,” use this Google Doc._

Funding rate prediction allows Alphas to adjust their position in a timely manner. The main challenge for a more tactical approach, whereby arbitrage between venues (big funding rate spread between long & short) is the most attractive scenario, is the transaction costs incurred. (slippage & gas).

![Cross venue spreads compelling?](https://ipor.io/_astro/image-24.CHjCziKp_ZJM2q8.webp)

_Cross venue spreads compelling?_

Essentially, the vault strategist deals with portfolio construction challenges similar to the ones covered in our previous Alpha Drops [articles](https://ipor.io/news/ipor-fusion-alpha-drops-b23f237e8504.md). Funding rate reset times serve as fixed rebalancing intervals, while trading signals (cross-venue spreads and regime detection signals) can be used as additional rebalancing triggers.

> The quant library capabilities for portfolio construction can certainly be powerful to this end.

### Feature IV: Risk monitoring

Running an active funding rate farming strategy and deploying capital across markets and venues requires real-time monitoring of aggregate and individual exposure (per market and exchange).

> In the case of significant deterioration in liquidity for a given venue, auto-deleveraging, protocol exploits, or depegging of collateral assets, the total exposure is automatically updated, and positions can be adjusted to ensure delta-neutrality. Atomists will also be able to intervene manually and in a discretionary manner should they need to adjust positions or reduce risk.

## ⚛️ IPOR Fusion is coming!

Funding rate farming and arbitrage are great applications of the powerful IPOR Fusion capabilities and architecture. Atomists will soon be able to deploy on-chain ‘Ethena-like’ variations with superior features:

- Increased transparency, auditability, and capital efficiency.
- Market cycle agnostic funding rate farming thanks to synthetic positions.
- Combining CeFi liquidity with DeFi opportunities as a “kicker.” Organically increasing exposure to perp DEXs as liquidity improves.
- Vault composability supporting the creation of “fund-like” vehicles that allocate to different “sub-strategies” (e.g. BTC yield generating vault).

In future Alpha Drops, we will explore the wonderful world of leveraged looping in depth.

Access the two previous Alpha Drops:

🧠 [IPOR Fusion Alpha Drops | #1](https://ipor.io/news/ipor-fusion-alpha-drops-b23f237e8504.md) — Optimized supply of stablecoins in credit markets

🧠 [IPOR Fusion Alpha Drops | #2](https://ipor.io/news/ipor-fusion-alpha-drops-2-09b604d0ad31.md) — Liquidity fragmentation as an arbitrage opportunity