Frax Finance, a Sweet Spot for Stablecoins, is the focus of the DeFi Project.

Frax Finance, a Sweet Spot for Stablecoins, is the focus of the DeFi Project.

Frax Finance is a distributed protocol that operates as a fractional-algorithm stablecoin named FRAX and is essentially a fully autonomous on-chain central bank. FRAX is the first decentralised stablecoin that uses a constantly modifying collateral ratio to successfully preserve peg stability. It is found in the sweet spot between completely collateralized and uncollateralized stablecoins.

Where We Are Now With Stablecoins

Frax is a flagship fractional-algorithm stablecoin managed via a decentralised, fully autonomous on-chain protocol backed by both external and internally generated collateral.

Having a general understanding of the existing stablecoin ecosystem is essential before delving into Frax’s value proposition and where it stands in comparison to other stablecoins. Stablecoins are digital assets that are linked to a fiat currency, usually the U.S. dollar, in some form. They can be broken down even further into two major groups: centralised and decentralised. Centralized stablecoins are digital assets that are issued and managed by a single organisation, or “custodian,” and are fully backed by fiat currency. These have the lion’s share of the market and include USDT from Tether, USDC from Circle, and BUSD from Binance.

StableCoin
StableCoin

The asset class’s simplest form is centralised stablecoins. They are issued by centralised issuers in exchange for dollars and redeemed for dollars at a one-to-one exchange rate. To meet redemptions, issuers must be relied upon to maintain an adequate level of cash or other highly liquid, low-risk assets such as commercial paper or treasuries. Although centralised stablecoins are seen as safer by the market, there are still significant dangers of custodial and censorship abuse.

On the other side, there are two main types of decentralised stablecoins: those that are over-collateralized and those that are not. The Maker protocol is the most well-known example of the former, as it enables users to mint the DAI stablecoin by locking external crypto collateral in smart contracts as collateralized debt positions. For the CDPs to function properly, they must be over-collateralized, meaning that the value of the assets locked up in Maker is greater than the total value of all DAI in circulation at all times. Since DAI’s growth is limited to the demand for leverage, while this makes it a secure and trustworthy investment in terms of peg resilience, it also makes it capital-inefficient and difficult to scale.

Many have tried to develop more scalable and capital-efficient stablecoins, but the recent failure of Terraform Labs’ UST stands out. Shortly before its demise, UST had a market valuation of roughly $18.6 billion, making it the third largest stablecoin. As a “algorithmic” stablecoin that did not rely on collateral, UST was able to sustain its value through a system of arbitrage swaps with LUNA, Terra’s native governance token. When the value of the UST fell below $1, arbitragers may benefit by exchanging it for LUNA at the rate of $1 per UST. Similarly, when its price rose over $1, arbitrageurs might create new coins by exchanging $1 in LUNA for new ones, selling them on the open market for a profit. This would increase the supply of the currency and eventually drive the price down to $1.

Although initially successful, UST eventually collapsed due to a $40 billion death spiral event that engulfed Terra’s whole ecology. The system was extremely sensitive to the possibility of a bank run because it relied solely on collateral generated in-house using LUNA. Like all other attempts at creating a stable cryptocurrency based on algorithmic principles, it ultimately failed and was abandoned.

There appears to be a happy medium that takes advantage of the best features of both over-collateralized stablecoins like DAI and non-collateralized or entirely algorithmic stablecoins like UST. Sam Kazemian, founder of Frax Finance, spoke with Crypto Briefing about the protocol and claimed that since its inception in December 2020, FRAX has occupied this niche. Many people are beginning to see that we have the best of both worlds, as I have pointed out. “I also believe FRAX is a significant breakthrough; we appear to have created a more capital-efficient yet just as safe stablecoin as Maker. Currently, we’re the only ones still here to hold our own alongside them.

Explanation of Frax Financials

This paper introduces Frax Finance, a permissionless, open-source, and fully on-chain stablecoin technology that provides and autonomously administers a highly scalable decentralised stablecoin named FRAX. The protocol uses a fractional-algorithmic approach to keep its peg to the U.S. dollar, hence the name FRAX.

A percentage of the stablecoin is backed by external collateral, most often USDC, and another portion is backed algorithmically with the protocol’s native governance token, FXS, which earns fees, seigniorage revenue, and profits from the protocol’s open market activities. A PID controller, which adjusts the collateral ratio in response to demand for the FRAX stablecoin and external market conditions, is used by the protocol to determine the exact ratio between the external and internal backing. The technique itself is relatively straightforward, despite the apparent complexity of the preceding sentence.

The protocol uses a PID Controller to automatically change, based on market data, the amount of external collateral required to mint or redeem FRAX. The collateral ratio is lowered by the protocol during sustained periods of FRAX growth, requiring less external collateral and more FXS to issue or redeem the stablecoin. The logic behind this is that while the economy is growing, the market sends a signal of confidence in the internal collateral supporting FRAX, suggesting that the protocol reduce the collateral ratio to reflect this confidence and make growth more manageable.

If the price of FRAX rises over the $1 objective, the protocol reduces the collateral ratio such that less USDC and more FXS back the currency. When the price of FRAX drops below $1, however, the protocol increases the collateral ratio in order to restore faith in FRAX by providing greater backing from a “more sound” external source. Because of the importance of open communication, the collateral ratio is always shown prominently on Frax Finance’s homepage. At present, the collateral ratio stands at 89.50%, which means that in order to mint 100 FRAX, you must first deposit $89.5 USDC and then burn $10.50 in FXS.

To clarify, a collateral ratio of 0% would indicate that investors have full faith in FRAX’s internal FXS backing and have no plans to redeem their holdings for another asset. Having FRAX backed by collateral of equal or greater value, such as USDC, would indicate that the market has no faith in the internal collateral and instead desires that FRAX be fully backed by such collateral.

When compared to a system like Maker, which uses a fixed collateralization ratio of 150% for volatile assets like Ethereum, Frax’s ability to dynamically alter the collateral ratio based on real-time market conditions provides it a considerable edge in scalability and capital efficiency. Kazemian made an insightful observation regarding the meaning of “capital efficiency” as he elaborated on this distinctive aspect of FRAX:

Typically, this means that “acquiring” or “minting” the stablecoin is less of a hassle. More than only overcollateralized loans can bring it into existence. In addition to depositing USDC, depositing a large amount of Ethereum is one of the primary and only ways to mint DAI. For example, if you invest $1 in Ethereum into Frax’s protocol-controlled liquidity pool, you will receive $1 in FRAX.

Kazemian emphasised that “in Maker,” DAI is the users’ debt and not the protocol’s. But under a fractional reserve system like Frax, FRAX is the protocol’s debt because it is the protocol’s responsibility to ensure that there is always enough collateral to cover redemptions. To create stablecoins in the over-collateralized model, users must take on loans or incur debt, but in the fractional approach, the protocol can simply issue money like the Federal Reserve.

According to Kazemian, the other crucial aspect of Frax’s capital efficiency advantage is that the protocol is much more profitable due to its ability to print money. More specifically, he elaborated as follows:

With a $2.6 billion supply, Frax still generates around $150 million in annual revenue, while Maker, with a much larger supply, generates only around $80 million. One of the biggest problems of printing money is that FRAX has more risk than DAI. The Fed has inflation, and we have the risk of breaking the peg, but we also make more money.

When discussing potential threats to a stable peg, it is important to note that one of the primary ways stablecoin protocols guarantee the strength of their peg is by guaranteeing substantial liquidity for their stablecoin on a number of decentralised exchanges like DeFi. Because of this early realisation, Frax implemented a number of techniques to assist it efficiently find and secure liquidity across decentralised exchanges.

For example, as of this writing, 16.7% of all CVX governance tokens issued by Convex are held by Frax. This grants it extensive sway over Convex’s governance, which in turn is a stand-in for command over Curve’s CRV payouts on the leading decentralised market for stablecoins. Highly efficient trading between FRAX and DAI, USDC, and USDT is made possible by the FRAX3CRV liquidity pool, which currently has about $1.46 billion in liquidity.

Thanks to its partnership with OlympusDAO, Frax has bought and is in control of a portion of its liquidity, eliminating the need to pay out large incentives backed by dilution of its own governance token in order to rent liquidity from third-party mercenary liquidity providers. Moreover, Frax can put idle collateral to work by providing liquidity on Uniswap V3 using its so-called Liquidity AMO. It has the ability to automatically enter any position on Uniswap and mint FRAX against it, so securing deep liquidity and profiting from trading costs.

Automated Markets

Frax introduced its Algorithmic Market Operations controllers in the first quarter of 2021, taking another step toward its goal of becoming a decentralised central bank. These “AMOs” stand in for smart contracts that carry out a variety of open market activities algorithmically to make money and strengthen the security and reliability of the protocol by investing collateral.

Frax has access to a large quantity of external collateral thanks to FRAX minting, and as a result, the AMOs create enormous profit for the protocol. This profit is redistributed to the FXS holders through buybacks and token burns. To paraphrase Frax, an AMO is like a “central bank money lego” with these four characteristics:

The process of reducing the collateral to loan ratio is called “decollateralization.”

Operations in the Market that maintain stability and do not alter the collateral to risk ratio
Increasing the amount of collateral used is called recollateralizing.
FXS1559: a codified accounting of the AMO’s balance sheet that specifies how much FXS may be purchased and burned using earnings in excess of the intended collateral ratio.
Currently, Frax uses four AMOs: Investor, Curve, Lending, and Liquidity.

The Investor AMO uses proven yield aggregator protocols and money markets like Yearn, Aave, Compound, and OlympusDAO to invest the protocol’s collateral and produce yield. For the sake of flexibility in meeting FRAX redemptions, this AMO never commits funds to strategies or vaults with withdrawal waiting periods.

The Curve AMO invests unused USDC and freshly created FRAX into the Curve exchange’s FRAX3CRV pool. This AMO not only helps the protocol deepen FRAX liquidity to buttress its peg, it also generates revenue for Frax through trading, administrative fees, and CRV incentives (which Frax may influence through its considerable shares of Convex).

Instead of using the traditional minting mechanism, users can purchase FRAX through over-collateralized borrowing thanks to the Lending AMO, which mints FRAX straight into pools on money markets like Compound and CREAM. This AMO makes FRAX more accessible to users, who may now mint it by posting collateral like they would when minting DAI on Maker, and generates money through interest payments on the loans.

Last but not least, the Liquidity AMO leverages FRAX and some of the protocol’s collateral by trading it for other stablecoins on Uniswap V3 in exchange for a fee. In order for the protocol to increase its supply, it has an AMO that can buy any position on the exchange and mint FRAX against it. That means Uniswap customers can now buy FRAX with Ethereum, wBTC, and other stablecoins.

Concluding Remarks

Although the Terra debacle may have tarnished the reputation of all algorithmic stablecoins, including fractional-algorithmic stablecoins, it is important to remember that not all stablecoins are the same, despite their shared features. Therefore, it is important to note that the price of FRAX has been consistently constant, with no major fluctuations over 1% of its desired peg, since its inception over 16 months ago. This suggests that the novel collateralization process is sufficiently robust to survive large-scale systemic shocks, such as the Terra collapse.

However, it’s also true that Frax has its share of flaws. One issue is that it relies too heavily on USDC, which is not the best paradigm for a protocol that aspires to be really decentralised and censorship-resistant because it uses a centralised stablecoin to mint and back a “decentralised” one.

Kazemian concedes that Frax has a problem with its dependency on USDC, but he stresses that no one in the crypto industry has created a “holy grail decentralised solution with no relationship to fiat money.” Kazemian acknowledges that the current levels of exposure to USDC for both Frax and Maker are high. Nonetheless, at present it is essential to guarantee adequate stability for both stablecoins. “We will not diversify out of fiat currency for fun and depeg like Terra,” he emphasised, “unless there is a strong regulatory need to do that.”

Frax uses a simple and elegant approach that appears to be the sweet spot in stablecoin architecture, with its decentralized, scalable, safe, and trustworthy protocol.

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