Frax Finance - Part 1: An Intro Guide to the Stablecoin Revolution

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TLDR;

• Frax Finance is a stablecoin issuer with a focus on stability, innovation, and adaptability.

• Its flagship product, FRAX, is a semi-algorithmic stablecoin pegged to the US dollar and has survived and thrived through a difficult market cycle.

• Frax Finance also offers FPI, a stablecoin pegged to CPI, and frxETH, a stablecoin backed by Ethereum.

• Frax Finance's two-token model enables its stablecoin to maintain a one-to-one peg with the US dollar without the need for yield incentives.

• Frax Finance is setting a new standard for stablecoins in the DeFi space, and its impact on the crypto industry is poised to endure.

Introduction

Our two-part series introduces Frax Finance, a pioneering stablecoin protocol. This article will introduce the protocol as a whole, followed by an investment thesis for the FXS token, considering current narratives and valuation models.

In a landscape where stability is key, Frax Finance stands out as a game-changer. They have engineered the only algorithmic stablecoin, $FRAX, that weathered the storm (and thrived) throughout the tumultuous year of 2022.

While other giants in the stablecoin arena, such as UST, crumbled to the brink of extinction, FRAX not only retained its peg but emerged as a symbol of resilience and innovation. We will reveal how Frax Finance has revolutionized a combination of security and stability for stablecoins.

What is Frax Finance?

Frax Finance specializes in the creation of stablecoins. One of its flagship offerings is FRAX, a stablecoin backed by the US dollar, that acts as a ‘safe haven’ crypto asset. In addition to FRAX, Frax Finance also offers FPI, a stablecoin pegged to the Consumer Price Index (CPI), and frxETH, a stablecoin backed by Ethereum. To support and expand its stablecoin ecosystem, Frax Finance has developed a range of innovative products and applications, including Fraxlend, Fraxswap, and Fraxferry. These tools not only facilitate the stability of their stablecoins but also aim to establish Frax Finance as a leading force in the pursuit of creating the best stablecoins in the cryptocurrency market at scale.

Who is behind Frax Finance?

In 2019, Sam Kazemian, Travis Moore, and Jason Huan came together to establish Frax Finance with the aim of developing a decentralized stablecoin that would operate independently from the price fluctuations of Bitcoin. Prior to this venture, Sam and Travis had collaborated on Everipedia, a blockchain-based knowledge platform resembling an on-chain encyclopedia.

What went wrong in 2022 for the stablecoin market?

The persistent hiking of interest rates meant that several crypto exchanges and projects collapsed. It has been made apparent that many protocols cannot succeed in a high interest-rate environment. Users who were once attracted to DeFi/CeFi platforms due to lucrative yields fled to safety, causing liquidity drains, whilst Frax Finance continued to generate revenue and consistently implement new features into its ecosystem.

What is Frax Finance’s Mission?

Frax Finance's mission is to emulate the role of a central bank by becoming issuers of a currency that embodies stability at scale. Despite their diverse product offerings, Frax maintains an efficient team of just eight individuals, driven by the singular objective of building the best stablecoins in the market. This streamlined approach enables them to operate with agility and precision, thanks to a cohesive framework, a well-defined roadmap, and a clear vision for the future. It's important to note that all of Frax's applications, from Fraxlend to Fraxswap and Fraxferry, are not standalone entities; rather, they form integral components of a larger mechanism that facilitates the issuance of top-tier stablecoins.

The goal is to issue currency that people will hold without expecting an interest rate to be paid, which is known as the monetary premium. Frax founder Sam Kazemian believes that without this monetary premium in place, Frax’s stablecoins will not be able to scale to the trillion-dollar market value that they are aiming for.

Some of the metrics we can look at to determine the monetary premium for stablecoins include:

• Spot liquidity

• Proven USD peg over time

• Support in several DeFi protocols

• Growing usage in the real world

What is FRAX?

FRAX is a semi-algorithmic stablecoin designed to maintain a one-to-one peg with the US dollar. It was introduced as the first asset by the Frax Finance team in December 2020.

During the inception of FRAX, the stablecoin landscape faced limitations, with existing options often characterized by inefficiency or speculation. DAI, the primary stablecoin at the time, was over-collateralized by ETH, requiring $1.50 in collateral for every $1 of DAI issued in order to add an extra layer of stability. This system was constrained by the availability of ETH and couldn't expand beyond its value. Meanwhile, various projects attempted to create algorithmic stablecoins with entirely endogenous collateral (meaning all the value is confined within the token itself) but they struggled to maintain their pegs.

There was a clear dilemma of stability vs scalability. Sam Kazemian decided to blend ideas from the two approaches mentioned above, leading to the birth of Frax v1. FRAX is the first stablecoin that combines principles from fully collateralized and fully algorithmic stablecoins. It is backed by USDC and FXS (the protocol’s native governance token).

It operates on a 2 fundamental principles:

• 1 FRAX can always be redeemed for $1 worth of USDC and FXS

• The ratio of collateralized (USDC) to algorithmic (FXS), the Collateralisation Ratio, depends on the market’s pricing of the FRAX stablecoin.

The concept is straightforward: when the market price of FRAX exceeded $1, individuals could mint FRAX with $1 worth of collateral and sell it for a profit. Conversely, when the market price dropped below $1, arbitrageurs could purchase FRAX for less than $1 and redeem it for $1 worth of collateral, also earning a profit. In times of higher demand for FRAX, the algorithm decreases the Collateralisation Ratio (CR). This is because the market is signalling trust in the internal collateral backing FRAX (FXS), so less USDC is needed to facilitate growth. This, in turn, increases the value of FXS, as more FXS is needed to be burned to mint new FRAX tokens. However, when demand for FRAX decreases, the CR increases in order to retain market confidence with more USDC backing the stablecoin.

Ultimately, the CR reaches a level determined by market forces and investor comfort.

How did the Frax V2 upgrade contribute to the Frax Finance ecosystem?

Frax V1 implemented the use of Algorithmic Market Operations (AMOs) in order to adjust the FRAX Collateral Ratio, as mentioned by the mechanism above.

Frax V2, however, introduced several other AMOs that worked in tandem with and complemented, FRAX’s stability mechanism. These AMOs are outlined below:

• Collateral Investor AMO – idle USDC collateral from the FRAX treasury is put to work in DeFi protocols such as Aave, Compound, and Yearn. As the collateral ratio is lowered due to higher FRAX demand, this AMO will send more idle USDC to DeFi protocols in order to generate yield for FXS holders.

• Curve AMO – idle USDC and/or new FRAX is sent to Curve, Convex and StakeDAO. The trading fees and LP rewards are rewarded to FXS holders.

• Liquidity AMO – FRAX and idle USDC is added to FRAX-based pairs on Uniswap/other AMMs. The trading fees generated are rewarded to FXS holders.

• Lending AMO – FRAX is minted into money markets like Aave, so someone can borrow FRAX by paying interest.

The above AMOs allow the protocol to adapt to its market conditions and therefore remain stable in crises like May 2022 when UST lost its peg. Nonetheless, Frax relies on other DeFi protocols so the stablecoin does not have full control over its monetary policy, such as yield rates and fee structures. Frax built Fraxswap and Fraxlend in order to gain control over the liquidity and lending markets that FRAX interacts with.

FXS tokenomics

FXS is the governance and incentive token of the Frax protocol. It plays a crucial role in maintaining the stability of FRAX and governing the protocol. FXS holders have two main responsibilities and benefits:

• Governance: FXS holders can participate in on-chain governance decisions. They can propose and vote on changes to the protocol, including adjustments to collateral ratios and other parameters that affect FRAX stability.

• Seigniorage: FXS holders receive seigniorage rewards when the Frax protocol generates excess collateral value. Seigniorage is the difference between the value of the collateral backing FRAX and the outstanding supply of FRAX. This seigniorage is distributed to FXS holders as an incentive.

veFXS

veFXS is a non-transferable locked FXS variant that offers several advantages. Users have the option to lock their FXS tokens for a maximum of 4 years, yielding four times the amount of veFXS (for instance, locking 100 FXS for 4 years results in 400 veFXS). Unlike traditional tokens, veFXS cannot be traded on public markets. The primary mechanism for cash flow distribution within the Frax Protocol is directed towards veFXS holders. Typically, cash flow generated from activities such as AMOs, Fraxlend loans, and Fraxswap fees is employed to repurchase FXS tokens from the market, subsequently disbursing these repurchased tokens as yield to veFXS stakers.

Fraxswap

Fraxswap is Frax Finance’s native decentralized exchange. Fraxswap is the first automated market maker to use an advanced and technical function called time-weighted average market maker orders (TWAMMs). The TWAMM allows for a better average price with less slippage, due to congregating orders over a period of time instead of all at once. Frax uses this application to rebalance collateral as well as mint or redeem new FRAX tokens.

Fraxlend

Fraxlend allows stablecoin lending to occur in the Frax Finance economy, as collateral assets are onboarded. FRAX can be minted into lending protocols like Aave to allow users to borrow FRAX and pay interest.

Fraxferry

Fraxferry allows for natively issued Frax Protocol tokens to be transferred across many blockchains, hence supporting Frax’s multichain efforts. Fraxferry does not rely on bridges, which could result in hacks, or third-party applications.

What stablecoins have Frax Finance built aside from FRAX?

Frax Ether (frxETH)

frxETH is an ETH-pegged stablecoin. It is backed by ETH that is either staked in validators or residing in AMOs that manage the protocol liquidity. Most of the ETH backing the frxETH is staked in a validator, as this is the closest you can get to a risk-free rate of interest paid out by the Ethereum protocol. The rest is liquid in the Curve AMO, where you can stake your frxETH into a Curve LP to receive CRV, CVX and FXS as rewards.

This means that frxETH gets no interest, and is very similar to wETH, but you can stake frxETH in the sfrxETH vault to get all the validator rewards that the staked ETH is earning. The sfrxETH token marked Frax's entry into the LSD space, competing with market leaders such as Lido and Rocket Pool.

As shown above, the earnings for 1000 ETH staked YTD has been over 50% more lucrative for sfrxETH compared to that of RocketPool’s rETH, and over 30% more rewarding than Lido’s stETH.

Although frxETH was launched in October 2022, it rapidly became one of the protocol's crucial offerings, especially amongst the rapid growth of the Liquid Staking Derivative (LSD) market this year.

Sam Kazemian actually has a positive sum outlook on the LSD market and other LSD products, meaning his aim is centered around the whole LSD market growth as opposed to taking away market share from competitors. Sam has even mentioned in interviews that he aspires for frxETH to be partially backed with wrETH and stETH in the future, so as frxETH grows, so do these other protocols.

The big question - Why is frxETH necessary if it earns no yield?

Firstly, splitting up the Frax LSD into the principle token (frxETH) and the yield token (sfrxETH), allows for two options for users to get yield – either from the Curve LP or getting a (close to) risk-free rate in the POS vault. Having alternative options for frxETH holders other than staking means that sfrxETH yields are higher than its competitors, as not all of the frxETH is being used for staking, so the rewards are going to a smaller group of people.

You can see via the chart below, provided by DeFiLlama, that Frax’s sfrxETH remains the most lucrative option out of the major LSDs.

The core reason why Sam Kazemian has chosen the two-token model is the inherent ability to enable the token that receives no yield to gain a monetary premium. In the context of stablecoin issuance, this model is particularly advantageous. For stablecoin issuers, the primary goal is to establish their currency as a widely accepted medium of exchange. Users should hold it in spot transactions or use it for payments without the expectation of earning interest. When users opt for another stablecoin without seeking yield, issuers are compelled to offer interest rates to attract them, which can be an ongoing financial burden. This is where the two-token model excels.

Consider DAI, which has garnered a substantial monetary premium; many users and projects simply hold DAI as a decentralized currency. In times of economic crises, stablecoins should function as a safe haven of last resort, not as assets that require yield incentives for users to retain them. The two-token model facilitates this by allowing one token to maintain stability and liquidity while the other token captures the monetary premium, ensuring the stability and viability of the stablecoin system.

Frax Price Index (FPI)

FPI is pegged to a basket of real-world consumer items – the Consumer Price Index (CPI). Buying FPI, allows holders to take the position that the rate of CPI inflation rate of the US dollar is growing faster than another asset such as BTC or ETH.

FPI has a governance token that works like FXS does to FRAX, called FPIS.

How is the FPI token pegged to the rate of CPI?

FPI maintains a 100% collateral ratio (CR) of FRAX tokens at all times, which means that the protocol balance sheet must be growing at least at the rate of CPI inflation. For this to occur, the AMO strategy contracts must earn a yield proportional to CPI by investing in DeFi protocols and LPing on Curve. If the AMO yield is under the CPI rate, the AMO will mint FPIS tokens and sell them for FRAX stablecoins to ensure that 100% CR is maintained.

If the yield generated is more than CPI, this excess yield is directed toward veFPIS holders. Similar to veFXS, users may lock their FPIS for up to 4 years for four times the amount of veFPIS. So, for every FPIS locked for 4 years, you get 4 veFPIS. (e.g. 100 FPIS locked for 4 years returns 400 veFPIS). Since the protocol is launched from within the Frax ecosystem, the FPIS token will also direct a variable part of its revenue to FXS holders.

FPI has a great use case, as it provides the ability to get a cost-of-living adjustment on your checking/savings account whilst retaining liquidity. This means that it becomes significantly easier to maintain real wealth as you compound at the CPI rate. In addition, this inflation-adjusted dollar could become a medium of exchange, aligning with Satoshi’s goal of creating a peer-to-peer currency that is independent of government policy.

Wrapping Up

Frax Finance's journey is marked by a relentless pursuit of stability, innovation, and adaptability. As they continue on their mission to build the best stablecoins in the market, their vision of creating a widely accepted medium of exchange, free from the need for yield incentives, brings us closer to a decentralized financial future where stability reigns supreme. In the world of DeFi, Frax Finance has set a new standard for stablecoins, and their impact on the crypto space is poised to endure.

Keep a lookout for our next piece on Frax that dives into our investment thesis for the FXS token, taking into account narratives and valuation models.

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