cmDeFi #005 A Comprehensive Study of the Frax Stablecoin Ecosystem

Holy Grail

Decentralized stablecoins face an impossible trilemma between capital efficiency, decentralization, and price stability. Striking a balance among these three aspects remains an elusive yet desirable goal.

USDT and USDC are particularly outstanding in terms of capital utilization and price stability. They have also created huge market capitalization and application scenarios with this. However, they exhibit a high degree of centralization.

DAI, as the longest-standing decentralized stablecoin, initially boasted exceptional decentralization. It mainly uses ETH as collateral to over-collateralize to mint stablecoins. However, although the ultra-high collateral ratio can stabilize the price, it sacrifices capital utilization, leading to comparatively limited market cap and application scenarios compared to centralized stablecoins. Eventually, DAI started accepting centralized assets as collateral, sacrificing decentralization for a gradually increasing market cap.

UST, a rather controversial decentralized stablecoin, achieves utmost capital utilization while maintaining decentralization. It once reached a market capitalization second only to USDT and USDC. However, its aggressive strategies have caused the stablecoin price to enter a death spiral in extreme situations.

So until today, there has not been a “flawless” decentralized stablecoin. This may be the “Holy Grail” that builders are tirelessly chasing.

Background

Frax Finance is a full-stack protocol centered around decentralized stablecoins. It began with a partially collateralized algorithmic stablecoin and gradually transitioned to full collateralization, maximizing capital efficiency while expanding horizontally into multiple domains. Eventually, it evolved into a matrix-style full-stack DeFi protocol driven by stablecoins. It’s the longest-surviving partially collateralized stablecoin.

Its products include:

• FRAX stablecoin: Decentralized USD-pegged stablecoin ★
• FPI: Flatcoin pegged to a basket of goods ★
• frxETH：LSD ★
• Fraxlend: Lending ★
• Fraxswap: Time-weighted decentralized exchange ★
• Fraxferry: Cross-chain transfer ★
• FXS & veFXS: Governance module ☆
• AMO: Algorithmic Market Operations Controller ★
• Frax Bond - Bond (v3 coming soon) ☆
• RWA - Real World Assets (v3 coming soon) ☆
• Frax Chain - Layer2 (not yet launched) ☆

Frax has evolved through three versions since its inception: v1, v2, and v3. Unlike many protocols on the market, each version of Frax represents not just functional upgrades but also significant strategic adjustments. In essence, skipping a specific version could lead to a vastly different understanding of Frax.

• Frax v1: It was launched with the goal of becoming an algorithmic stablecoin, using a “fractional algorithm” to gradually reduce the collateral ratio, thereby maximizing capital efficiency.
• Frax v2: Strategically abandons the approach of gradually reducing the collateral ratio of algorithmic stablecoins, instead increasing the collateral ratio to get fully collateralized; introduces the idea of the “Algorithmic Market Operations Controller” (AMO) to participate in the Curve War for on-chain liquidity governance resources; and develops frxETH to enter the Ethereum liquidity staking track LSD.
• Frax v3: Introduces real-world assets (RWA) and continues to use AMO for on-chain and off-chain liquidity.

Business Analysis

This article delves into the forthcoming latest version of Frax, v3, providing an in-depth analysis and breakdown of Frax Finance’s full-stack products, unraveling the entirety of the ecosystem.

Frax Finance v3

Frax v3 is an upcoming version that revolves around RWA, while continuing to use the AMO in v2 to gradually make FRAX a fully exogenously collateralized, decentralized stablecoin that captures both on-chain and off-chain assets. Its core business features include:

1. Full exogenous collateralization
2. RWA
3. IORB Oracle
4. frxGov governance module
5. FraxBond (FXB)

✹ Full Exogenous Collateralization

According to the FRAX Balance Sheet , the FRAX collateral ratio (CR) of the current version is 91.85%.

CR = (Owned assets+Lent assets) / Liabilities
CR = (615,357,001+65,654,459) / 741,400,658 = 91.85%

Starting from the Frax v3 version, the protocol will introduce real world assets (RWA) to increase CR until it is >= 100%, eventually achieving 100% exogenous collateral for FRAX. In fact, in February 2023, the FIP188 stopped the progression of FRAX’s algorithmic stablecoin and began to use AMO1 And the protocol income to gradually increase CR:

The FIP188 proposal holds significant importance for Frax. After FIP188, Frax will completely stop the “fractional algorithm” and “decollateralization” mechanisms, transitioning from partially collateralized algorithmic stablecoins to fully collateralization. Below are some key points of the proposal:

1. The initial version of Frax featured a “fractional algorithm,” or variable collateral ratio, that adjusted based on market demand for FRAX, effectively letting the market decide how much exogenous collateral and FXS would be needed to make FRAX = $1.
2. The reason for discontinuing the “fractional algorithm” is that, judging from the market environment, the costs of being slightly undercollateralized far outweigh the benefits it brings. The market’s concern about insufficient collateral at 1% is far greater than the demand for 10% additional returns.
3. Over time, growth, asset appreciation, and protocol benefits will increase CR to 100%. It is important to note that the proposal does not rely on minting any additional FXS to achieve 100% CR.
4. Retain protocol earnings to increase CR and suspend FXS buybacks.

FRAX Balance Sheet Oct. 10, 2023

FIP 188 approved

✹ RWA

As one of the important means to increase CR to >=100% in Frax v3, Frax’s upcoming frxGov governance module will approve real-world entities to purchase and hold real-world assets controlled by AMO, such as U.S. Treasury bonds.

Users holding FRAX can deposit into the specified smart contract and obtain sFRAX. This principle is similar to the relationship between DAI and sDAI. Let’s compare the difference between sFRAX and sDAI:

• One reason why sDAI can obtain a slightly higher average return on bonds (currently 5%, with a maximum of 8%) is that not all holders of DAI have deposited DAI into the DSR contract, and Maker’s return on investing in RWA only needs to be distributed to those who deposit DAI into DSR to obtain sDAI, so it is equivalent to some people sharing all the RWA income.
• sFRAX also meets this condition, but since Frax accumulated a large number of Curve and Convex tokens in the v2 version and obtained substantial voting power through lock-up, it can control a portion of on-chain CRV and CVX rewards. These on-chain earnings will increase the overall income of sFRAX. Additionally, when returns on one side, either on-chain or off-chain, are subpar or risk increases, you can quickly switch to the other end.

✹ IORB Oracle

FRAX v3 smart contract adopts the Federal Reserve Interest on Reserve Balances (IORB) rate for certain protocol functions such as sFRAX staking yield.

• As the IORB oracle rate increases, the Frax Protocol’s AMO strategies will heavily collateralize FRAX with treasury bills, reverse repurchase contracts, and dollars deposited at Federal Reserve Banks that pay the IORB rate.
• As the IORB oracle rate drops, the AMO strategies will begin to rebalance FRAX collateral with on-chain, decentralized assets and overcollateralized loans in Fraxlend.

Simply put, FRAX v3 adjusts its investment strategy based on the Federal Reserve Interest on Reserve Balances (IORB). When off-chain returns are high, funds are sent to treasury bills, treasury bonds, etc.; when on-chain returns are high, funds are sent to on-chain lending, such as Fraxlend, ensuring maximum returns and stability of stablecoins.

✹ frxGov Governance Module

Frax v3 will remove multi-signature trust assumptions and implement governance entirely through smart contracts using the frxGov module (veFXS). This is an important step towards decentralized governance for Frax.

✹ FraxBond (FXB)

Both sFRAX and FXB introduce treasury bond yields into Frax, but they differ:3

sFRAX represents the zero-term portion of the yield curve, while FXB denotes the forward-term segment. Together, they form an on-chain comprehensive stablecoin yield curve.

• If 50 million FRAX is staked as sFRAX, then ~50 million USDC (assuming CR=100%) in the corresponding treasury can be sent off-chain to purchase 50 million worth of short-term bonds.
• If 100 million FXB with a maturity of 1 year is sold for 95 million USDC, it means that off-chain entities can buy 1-year government bonds with the acquired 95 million USD.

Furthermore, FXB is a transferable ERC-20 token that can build its own liquidity and circulate freely in the secondary market, providing users with stablecoin investments offering various terms, yields, risk levels. It also facilitates the construction of new combinations.

Frax Finance v1

Frax v1 introduced the concept of fractional algorithmic stablecoins, where a portion of its supply is backed by exogenous collateral (USDC) and the rest is backed algorithmically using endogenous collateral FXS.

For example, at an 85% CR, every redeemed FRAX gives the user $0.85 USDC and $0.15 of minted FXS.

Minting $FRAX using USDC and FXS in Frax v1

In Frax v1, AMO exists in its simplest form, where it is called the fractional algorithm. It is mainly used to adjust the CR when minting FRAX according to market conditions, initially set to adjust at fixed intervals (for example, every 1 hour).

During the initial state of Frax v1, FRAX was minted with CR of 100%, meaning 1 FRAX = 1 USDC. This stage is called the “integer stage”. After that, at fixed intervals, AMO will adjust the CR based on market conditions to enter the “fractional stage”.

• If FRAX >1, which is above the peg and needs to be expanded, CR decreases to mint more FRAX with less collateral.
• If FRAX <1, where the price falls below the peg, CR increases to raise the collateral backing each FRAX to restore confidence in the system.

Although the fractional algorithm can influence the CR when newly minting FRAX, this method is relatively slow to affect the CR of the entire system. Hence, Frax v1 introduced two additional functions – Decollateralization⁴and recollateralization⁵ – to facilitate dynamic CR changes alongside the fractional algorithm to achieve the protocol’s required accuracy.

1. Recollateralization: When the fractional algorithm increases the collateral ratio, in order to match the actual collateral ratio to the system’s level, the amount of USDC in the system must be increased. FRAX sets an incentive: anyone can add USDC to the system and exchange more FXS. For example, a user can add $1 worth of USDC to the system in exchange for $1.2 worth of FXS.
2. Decollateralization (buyback): When the system’s collateral ratio is reduced, users can exchange FXS for USDC of the same value to the system at any time, and then FXS will be destroyed. There are no incentives in the buyback mechanism.

Decollateralization (buyback) and recollateralization operations

When Frax v1 was launched, the DeFi market was dominated by the algorithmic stablecoin track. The stablecoin projects launched during the same period of time included Basis cash, Empty Set Dollar (ESD), etc. Based on the development trend of the market at that time, Frax was the most conservative algorithmic stablecoin project. As the market craze faded, only Frax survived. In the subsequent Frax v2, it changed direction by supplementing collateral ratios and utilizing treasury funds.

Frax Finance v2

Frax v2 is the most dynamic version. In this version, the fractional algorithm was stopped, AMO was launched for treasury fund management, and earnings were gradually used to fill the CR. Additionally, new features such as Fraxlend and frxETH were also launched. Frax participated in the Curve war and became the winner of on-chain liquidity governance.

In Frax v2, core features include:

1. AMO
2. Fraxlend
3. Fraxswap
4. FPI (Frax Price Index)
5. frxETH

✹ AMO（Algorithmic Market Operations Controller）

AMO functions similarly to the Federal Reserve in executing monetary policies. Its operational mechanism allows for formulating any FRAX monetary policy as long as it doesn’t reduce the collateral ratio and alters the FRAX price. It involves currency issuance, burning, and fund allocation within the pre-defined algorithmic strategy. This means that AMO controllers can perform open market operations algorithmically (this is how the name of AMO originated), but they cannot simply mint FRAX out of thin air to break the peg.

Frax currently runs 4 AMOs, with Curve AMO has the largest amount of funds. With the operation of AMO, the protocol will use idle assets in the treasury (mainly USDC) and a certain amount of algorithmically controlled FRAX to be injected into other DeFi protocols:

1. Maximize treasury fund utilization to earn additional income. For example, if the treasury holds 1 million USDC and AMO prints 1 million FRAX, forming a USDC-FRAX liquidity pool for mining, the actual yield from mining amounts to 2 million in funds.
2. Since the ownership of money creation in AMO (algorithm-controlled FRAX) is held by the protocol and can be withdrawn and destroyed in AMO strategies, without circulating to users, it does not significantly impact FRAX’s peg.
3. Increases FRAX’s market cap without actually adding new collateral.

Let’s dissect this concept taking Curve AMO strategy as an example:

• Decollateralize - Deposits idle collateral and AMO’s newly minted FRAX into the Curve Pool.
• Recollateralize - Withdraw FRAX-USDC LP from the pool, destroy the excess (once newly minted and controlled by the protocol) FRAX, and return USDC to increase CR.
• Benefits to Protocol - Accues transaction fees, CRV rewards, and regular rebalances the pool. Deposit LP tokens into platforms such as Yearn, Stake DAO and Convex Finance to earn additional yields.

Let’s analyze AMO’s critical money creation ability.

The core of AMO’s money creation strategy can be summarized as:

When AMO adds treasury funds USDC to the Curve Pool, adding a large amount of USDC alone will affect the proportion of USDC in the pool and further impact the price. Therefore, USDC is paired with a proportionate amount of minted FRAX to form LP, and added to the pool with minimal slippage. The LP is held and controlled by AMO.

Moreover, if you want to maximize money creation, there is another scenario:

Assume a pre-minted FRAX supply of Y, and the market’s tolerance for FRAX falling below $1 is X%.

If all Y were sold at once into a Curve Pool with Z TVL and A amplification factor, it would have an impact of less than X% on the price of FRAX. This proves that it is acceptable for the additional minted amount of Y FRAX to circulate in the open market.

In other words, Curve AMO can put FRAX+USDC into its own Curve pool and control TVL. When FRAX falls by X%, it can withdraw and destroy the excess FRAX through the AMO recollateralization, raising CR to restore the peg. The more LP controlled by AMO, the stronger this ability.

Therefore, before FRAX falls by X%, based on AMO’s ability to control LP, we can calculate an amount of FRAX that is allowed to be sold into the Curve pool in one go without having a sufficient impact on the price to cause CR to move. This amount is the maximal “minting”.

For example, a 330 million TVL FRAX3Pool can support a minimum of $39.2 million FRAX sell order without moving the price by more than 1 cent. If X=1%, then the protocol should have at least 39.2 million algorithmic FRAX in the open market at minimum.

The above strategy is an extremely powerful market operation that will mathematically create a circulating algorithmic FRAX floor without posing any risk of breaking the peg.

✹ Fraxlend

Fraxlend is a lending platform that provides a market for borrowing and lending between ERC-20 assets. Unlike the mixed lending pool of Aave v2, each lending pair in Fraxlend is an isolated market. When you choose to deposit a certain collateral for borrowers to borrow, it indicates that you fully recognize and accept the value and risk of this collateral. The design of this isolated pool has two features:

1. Any issues related to collateral or bad loans are limited to individual pairs and do not affect other lending pools;
2. Collateral cannot be lent.

1/ Fraxlend Mechanism Characteristics - Interest Rate Model

Fraxlend provides 3 interest rate models (models 2 and 3 are utilized in practical applications)

1. Linear rate
2. Time-weighted variable rate
3. Variable rate V2

Unlike most lending protocols, all of Fraxlend’s interest rate calculators automatically adjust based on market dynamics, without the need for governance intervention. The Frax team believes it is better to let the market determine interest rates rather than having the team make governance proposals during each market fluctuation (as this approach is slower).

• Linear Rate
  When the utilization rate is greater than the vertex utilization, the rate curve begins to steepen. Most lending protocols adopt this basic rate growth model to ensure that when the funds in the pool are excessively borrowed, the rate is increased to encourage lenders to deposit and borrowers to repay.

• Time-weighted Variable Rate
  Time-weighted variable rate adjusts current rate over time. It controls the interest rate through 3 parameters:
  1. Utilization rate: Adjusts the rate based on the capital utilization.
  2. Interest rate half-life: It determines the speed at which the interest rate adjusts. In layman’s terms, rates increase using a multiplier when utilization is high and decrease when utilization is low.
  3. Target utilization range: No interest rate adjustments will be made within this range, which is considered to be in line with market expectations.
• In the currently available rate calculator, the interest rate half-life is 12 hours. If the utilization rate is 0%, the rate halves (decreases by 50%) every half-life. If the utilization rate is 100%, the rate doubles (increases by 100%) every half-life.

This interest rate model played a key role in Curve founder Mich’s CRV liquidation event. During a 0-day attack on the Vyper compiler affecting Curve, Mich’s on-chain CRV borrowing position was under pressure, leading to significant lender withdrawals and a surge in utilization rates to nearly 80%-100%. Fraxlend adopted the time-weighted variable rate in the CRV market, wherein when the utilization rate approaches 100%, with a 12-hour half-life, the interest rate for CRV collateral loans doubles every 12 hours. This forced Mich to repay borrowings from Fraxlend first; if failure to do so, the interest rate will double every 12 hours and Mich will be the first to be liquidated.

Interest rate adjustment multiplier with 85%-100% utilization rate

The chart below illustrates how interest rates change when the half-life is 4 hours⁶ and target utilization range is between 75% and 85%:

• Variable Rate V2 Interest Rate
  • The variable rate V2 interest rate combines the concepts from the linear interest rate and the time-weighted variable interest rate. Specifically, it utilizes the linear function from the linear interest rate to determine the current rate, but adjusts the vertex and max rate utilizing the formula from the time-weighted variable interest rate. It is characterized by the fact that the interest rate will respond immediately to changes in utilization rate on the linear interest rate curve while adapting to long-term market conditions by adjusting the slope of the linear interest rate curve.
  • Just like the time-weighted variable rate, variable rate V2 uses half-life and target utilization parameters. When utilization is low, the vertex and max rates will decrease. If utilization is high, the vertex and max rates will increase.
  • The decrease/increase in rates are determined by utilization and half-life. If utilization is 0%, the vertex and max rates will reduce by 50% each half-life. If the utilization is 100%, the increase will be 100% per half-life.

2/ Features of Fraxlend Mechanism - Dynamic Debt Restructuring

In a typical lending market, liquidators can close a borrower’s position once the LTV exceeds the maximum LTV (usually 75%). However, in cases of severe volatility, liquidators may not be able to close the unhealthy positions before the LTV exceeds 100%. In this case, bad debt is accumulated, and those withdrawing funds last will suffer the greatest loss.

In Fraxlend, when a bad debt occurs, the pool will immediately “socialize” the losses and distribute them to all lenders. This helps keep the market liquid and does not immediately dry up the lending market even after a bad debt occurs.

3/ Fraxlend AMO

The Fraxlend AMO allows FRAX to be minted into the Fraxlend lending market, allowing anyone to borrow FRAX by paying interest instead of the base minting mechanism.

FRAX minted into the money market will not enter circulation unless borrowers overcollateralize through the money market. Hence, this AMO will not reduce the direct collateral ratio. It will help expand the scale of FRAX, creating a new way for FRAX to start circulating.

Strategy:

• Decollateralize - Mint FRAX into money markets. Minted FRAX will not directly lower CR as all borrowed FRAX is over-collateralized.
• Recollateralize - Withdraw minted FRAX from money markets.
• Benefits to the protocol - Fees generated by borrowed FRAX.

In addition, because Fraxlend AMO has the ability to “mint” and “burn”, it can lower rates by minting more FRAX or increase rates by burning FRAX. This rate adjustment ability is a powerful economic lever as it changes the cost for all borrowers borrowing FRAX.

In theory, if Frax wishes and and is determined in its future direction, it can mint enough FRAX stablecoins into Fraxlend to attract users to lend FRAX at rates lower than any other stablecoin on the market. This would create optimal lending rates while subsequently increasing rates through Fraxlend AMO when needed to respond to the market. It is difficult for stablecoin projects to control their lending rates.

✹ Fraxswap

Fraxswap uses a time-weighted average market maker (TWAMM) for conducting large trades over long periods of time trustlessly. It is completely permissionless and the core AMM is based on Uniswap V2. For an in-depth explanation of TWAMM, you can refer to our other article.

TWAMM (Time-weighted Average Market Maker)

Chen Mo CMDEFI.IO

✹ FPI (Frax Price Index)

1/ Definition

FPI is the first flatcoin pegged to a basket of real-world consumer goods defined by the U.S. CPI-U average. The FPI stablecoin aims to maintain its purchasing power by keeping its price constant with all items in the CPI basket through an on-chain stability mechanism. Like the FRAX stablecoin, all FPI assets and market operations are on-chain and use AMO contracts.

FPI uses the unadjusted 12-month inflation rate of the U.S. CPI-U reported by the federal government. This data is then submitted on-chain by a dedicated Chainlink oracle immediately upon public release. The reported inflation rate is applied to the redemption price of FPI stablecoins in the system contract. This redemption price grows on-chain every second (or falls in the rare case of deflation).

2/ FPIS

FPIS is the governance token of the system and is also entitled to seigniorage from the protocol. Excess earnings will be transferred directly from the treasury to FPIS holders, similar to the FXS structure.

When the FPI treasury does not create enough yield to maintain the increased backing per FPI due to inflation, new FPIS may be minted and sold to increase the treasury.

3/ FPI Stabilization Mechanism

FPI uses AMO similar to FRAX stablecoin, but its model always maintains a 100% collateral ratio (CR). This means that in order to keep the CR at 100%, the protocol’s balance sheet growth aligns at least with the CPI inflation rate. Therefore, the AMO strategy contract must earn returns proportional to CPI, otherwise the CR will drop below 100%. During periods when AMO earnings are below the CPI rate, a TWAMM AMO will sell FPIS tokens in exchange for FRAX stablecoins to ensure that the CR is always 100%. When CR returns to 100%, FPIS TWAMM will be deleted.

✹ frxETH - Ether Staking Derivative

Frax ETH currently ranks 4th overall on the LSD track, with a TVL of $427.64M and a market share of 2.42%. However, as of the time of writing, it offers a yield of up to 3.88%, ranking 1st in provided returns. The reason why Frax ETH can offer returns above market average lies in its control over on-chain liquidity management resources.

LSD data source: defillama

Frax ETH includes:

• frxETH (Frax Ether)
  frxETH is a stablecoin pegged to ETH, making that 1 frxETH always represent 1 ETH, similar to Lido’s stETH, but holding frxETH alone will not be rebased and will not receive Ethereum staking benefits.
• sfrxETH (Staked Frax Ether)
  sfrxETH is an ERC-4626 vault designed to accrue the staking yield of the Frax ETH validators. At any time, frxETH can be exchanged for sfrxETH by depositing it into the sfrxETH vault, allowing users to earn staking yield on their frxETH. Over time, as validators accumulate staking yield, an equivalent amount of frxETH is minted and added to the vault, allowing users to redeem their sfrxETH for more frxETH than they deposited. Therefore, in theory, the exchange rate of frxETH per sfrxETH increases over time. By holding sfrxETH, users can hold a % claim on an increasing amount of the frxETH in the vault. It is similar to Aave’s aDAI.

So how did Frax ETH push interest rates above the market average?

Frax has accrued a large amount of CRV and CVX governance resources in the market through AMO, and built frxETH Pool in Curve and Convex, so that frxETH can obtain incentives in the third-party liquidity market without issuing additional FXS tokens. All staking income of Ethereum will be covered by sfrxETH.

We assume that of the 270,000 ETH staked in Frax ETH, 100,000 are not staked to sfrxETH, but form a liquidity pool with other Ethereum assets, such as WETH, stETH, etc., and the other 170,000 ETH are staked to sfrxETH. Then the incentives obtained respectively are:

• 100,000 frxETH in Curve, Convex, and other liquidity pools receive CRV, CVX incentives.
• 170,000 frxETH staked in sfrxETH earns staking rewards from the entire 270,000 ETH.

Therefore, Frax ETH uses the liquidity governance resources on-chain to introduce external incentives to frxETH, enhancing the overall returns and indirectly increasing the market rate for LSD (sfrxETH).

frxETH Pool (Source: Convex)

crvUSD already supports sfrxETH as collateral

Tokenomics

This section analyzes the funding rounds and token distribution about Frax Finance’s governance token, FXS, as well as the tokenomics about veToken.

Funding Rounds

Frax Finance has undergone two funding rounds in July and August 2021 respectively. The funding tokens accounted for 12% of the total amount, but the funding amount and valuation were not disclosed.

Participating investors include well-known investment institutions such as Parafi, Dragonfly, Mechanism, and Galaxy digital, alongside notable project founders in the DeFi field such as Stani kulechov from Aave, Robert Leshner from Compound, Kain Warwick from Synthetix, Eyal Herzog from Bancor, etc. Further, Frax Finance also receives investments from CEXs, such as Crypto.com, Balaji Srinivasan (former Coinbase CTO and A16Z partner), etc.

Frax Finance Investors

Governance Token FXS (Frax Shares) Distribution

• 60% – Liquidity Programs / Farming / Community – Via gauges & governance halving naturally every 12 months
• 5% – Project Treasury / Grants / Partnerships / Security-Bug-Bounties – via Team and Community discretion
• 20% – Team / Founders / Early Project Members – 12 months, 6 month cliff
• 3% – Strategic Advisors / Outside Early Contributors – 36 months
• 12% – Accredited Private Investors – 2% unlocked at launch, 5% vested over the first 6 months, 5% vested over 1 year with a 6 month cliff

Currently, the circulating supply of FXS is 74.57 million out of a total of 100 million tokens. The parts distributed to team, advisors, and outside investors are all fully unlocked, and all uncirculated parts belong to community parts (liquidity plan/treasury).

FXS market cap and circulating supply data

FXS unlocking data (Source: TokenUnlocks)

veFXS Tokenomics

1/ veToken model

This is a vesting and yield system based on Curve’s veCRV mechanism. Users can lock up their FXS for up to 4 years to receive veFXS. veFXS is not a transferable token nor does it trade on liquid markets.

Currently, 36.15 million FXS has been locked in veFXS, accounting for 48.48% of the circulating supply.

The veFXS balance decreases linearly as tokens approach their lock expiry, approaching 1 veFXS per 1 FXS when the remaining lock time hits zero. This encourages long-term staking and an active community.

Each veFXS has 1 vote in governance proposals. Staking 1 FXS for a maximum period of time (4 years) will generate 4 veFXS. This veFXS balance itself will slowly decay down to 1 veFXS after 4 years, at which time users can redeem the veFXS back for FXS.

2/ Gauge

Similar to veCRV’s power in the Curve system, veFXS can vote to determine the emission of incentives in the liquidity pools supported by Frax.

Gauge

3/ Buyback

The primary cash flow distribution mechanism of the Frax protocol is to veFXS holders. Cash flow earned from AMOs, Fraxlend loans, and Fraxswap fees are typically used to buy back FXS from the market and then distributed to veFXS stakers as proceeds.

However, with the strategic adjustments in Frax v2 ​​and v3, the protocol will prioritize increasing CR to 100%, so buybacks may be suspended or restricted. When CR is increased to 100%, veFXS will have the opportunity to capture all of the protocol revenue.

Investment Opinions

This section will summarize investment opinions based on Frax Finance’s real collateral ratio analysis, profitability, CR impact, etc.

1. Analysis of Real Collateral Ratio

We have reorganized Frax’s balance sheet (as of Oct. 10, 2023), and the assets held by the protocol total 616.8 million, where:

• The total amount of FRAX held by the protocol is 450.1 million
• US dollars and other assets total 166.7 million

In addition, there are 65.6 million of FRAX lent in Fraxlend (over-collateralized). The total supply (total circulation) of FRAX is 741.4 million, and the collateral ratio is 92.05%.

CR= Asset SUM / total FRAX

If the FRAX held by the protocol is removed from both the asset and liability sides, the collateral ratio will decrease, but the absolute value of the collateral ratio gap will not change much. This absolute value is currently about 58.97 million.

We can conclude from above:

1. Through the AMO strategy, Frax used 166.7 million of underlying assets to leverage several times the size of the stablecoin without breaking the peg. (If using the traditional issuance ratio of 1:1, the circulation of FRAX is equal to the value of the underlying asset at 166.7 million)
2. To achieve CR=100%, the protocol needs to generate 58.9 million in revenue to enter the treasury.

2. Frax’s Profitability

Most of Frax’s current profits come from AMO:

1. Curve, Convex AMO yields: 2%-8%
2. Fraxlend AMO yields: 2%-6%
3. RWA yields: 5.5%
4. sDAI yields: 5%

Convex AMO APY

To estimate how long it will take for the protocol to reach CR=100% from two perspectives, taking the average AMO profit level at 5% APY:

1. If all AMO control assets are used to their maximum extent \
   680M*5%=34M
2. If most of AMO’s minted funds are recovered (current status) \
   200M*5%=10M

In other words, under the current market environment, it will take about 2-6 years to achieve CR=100% by relying on AMO yields. Of course, since most of the income in AMO is CRV and CVX tokens, if the market situation improves, the increase in CRV and CXV tokens will accelerate this process.

3. Evaluate the Impact of Increases in CRV and CVX on CR

Frax currently holds 8 million CRV (~$3.4 million) and 3.7 million CVX (~$9.8 million)

If the prices of CRV and CVX increase 4 times compared with the current price, CR can directly rise to close to 100%

CRV $0.44 → $1.76

CVX $2.68 → $10.72

4. Influence of RWA on CR

sFRAX was launched in Frax v3 to capture the returns of real-world assets. This stands out as a promising avenue in DeFi during bearish markets. Currently, sFRAX’s returns are calculated by tracking IORB rates, with 50K FRAX pre-deposited each Wednesday to pay the current sFRAX returns. The total income of sFRAX in one year is 50K*52=2.6M. Calculated based on RWA’s actual annualized income of 5.5%, Frax will deploy at least 2.6M / 5.5% = 47M USD assets to RWA. (This data is estimated based on current earnings and may change with IORB fluctuations in the future)

When the deposit in the sFRAX contract is less than 26M, the annualized return of sFRAX will be 10%, which will gradually decrease as more FRAX is deposited.

From Sam, founder of Frax

At present, the potential revenue of the Frax Finance protocol itself in the RWA business is to deploy AMO funds here to get yields. Additionally, there’s a possibility that Frax might levy charges or offer protocol dividends on these RWA returns in the future. Once Frax’s RWA business scales up, alongside the protocol charging fees or providing dividends on these profits, this could significantly expedite the process towards CR = 100%.

5. Influence of Frax ETH on CR

The current income of Frax ETH is $1.31 million per year, compared with Lido’s $55.46 million per year. Currently, Frax ETH’s income has a relatively minor impact on improving CR. However, the LSD track has substantial growth potential. Should Lido’s dominant position waver, other protocols would witness significant improvements.

Frax ETH data from Tokenterminal

Lido data from Tokenterminal

6. Summary of Investment Opinions

Overall, a conservative estimate suggests it would take 2-6 years to raise CR to 100% given the current scenario. There’s significant variability, primarily reliant on how Frax utilizes its AMO.

Optimistically, an increase in CRV and CVX could vastly accelerate the rate of CR improvement. However, Frax will also face the dilemma of whether to sell these voting rights to ensure CR. Holding and locking up CRV and CVX will grant on-chain liquidity governance resources. Selling would immediately boost CR but forfeit on-chain incentive measures.

In terms of business potential, the current growth of RWA is a key factor in propelling CR improvement. MakerDAO has absorbed a large amount of US dollar liquidity through sDAI. If sFRAX gradually gains market acceptance, its growth potential will be far greater than other businesses. If Frax chooses to allocate part of the RWA income to the treasury to continue to improve CR, then the process towards CR=100% will be greatly improved.

Hence, from an investment standpoint, we should pay attention to the following indicators:

1. Utilization and profitability of all AMOs
2. CRV and CVX token prices
3. The growth of RWA and whether the protocol’s treasury will receive dividends

Frax has built a large full-stack stablecoin system. We can see that both Fraxswap and Fraxlend, in addition to being launched on the open market, are serving Frax Finance. This is similar to the subDAO in the MakerDAO endgame plan:

• Both MakerDAO and Frax are planning to expand horizontally around their core (stablecoin) and build a full-stack product.
• The difference between the two is that MakerDAO decided to outsource these functions to other subDAOs, while Frax is governed by frxGov.

The advantage of Frax is that it has captured almost all the appropriate demands in the DeFi market, with a higher potential ceiling and forward-looking mechanisms in its design. However, evidently, a potential issue arises concerning a comprehensive system encompassing stablecoins, trading, lending, cross-chain, LSD, and potentially the forthcoming Frax Chain Layer2. Such a system necessitates an exceedingly efficient and robust governance module. Additionally, the risk isolation between various functionalities becomes particularly crucial, which tests the stability of future protocol functionalities and on-chain governance.”

Risk Warning

The crypto market carries an extremely high level of risk. The opinions in this article does not constitute investment advice. This article delivers independent opinions without any sponsorship.

Follow cmdefi.io 👏

• Crypto Research
• Crypto Alpha Aggregation
• DeFi strategies, insights, and trends
• Metaverse
• NFT
• 🐦 My Twitter twitter.com/cmdefi
• 🙋 Telegram https://t.me/cmdefi

Disclaimer：

1. This article is reprinted from [cmdefi]. All copyrights belong to the original author [陈默 CMDEFI.IO]. If there are objections to this reprint, please contact the Gate Learn team, and they will handle it promptly.
2. Liability Disclaimer: The views and opinions expressed in this article are solely those of the author and do not constitute any investment advice.
3. Translations of the article into other languages are done by the Gate Learn team. Unless mentioned, copying, distributing, or plagiarizing the translated articles is prohibited.