Conclusion

Frax Finance is a full-stack DeFi protocol centered around decentralized stablecoins, spanning various sectors such as RWA, lending, LSD, and more. In 2024, it established its own Layer2 and raised the collateral ratio of its stablecoin to 100%, achieving full collateralization. The protocol's goal is to integrate the FRAX stablecoin throughout the entire ecosystem and expand outward through its comprehensive DeFi offerings. In terms of business potential, the growth of RWA business supports protocol liquidity during bear markets, while AMO plays a pivotal role during bull markets. Layer2 is a key factor in increasing the overall project valuation of Frax.

Holy Grail

Decentralized stablecoins face the impossible trilemma of capital efficiency, decentralization, and price stability, constantly seeking a balance among these three factors, which is an elusive yet desirable goal.

USDT and USDC excel particularly in capital efficiency and price stability, leading to their massive market capitalization and widespread adoption. However, they are highly centralized in terms of decentralization.

DAI, as the oldest decentralized stablecoin, initially excelled in decentralization by primarily collateralizing with ETH and over-collateralizing to mint stablecoins. However, the excessively high collateralization ratio sacrifices capital efficiency, resulting in less adoption and a smaller market capitalization compared to centralized stablecoins. Later, DAI gradually accepted centralized assets as collateral, sacrificing decentralization for a growing market capitalization.

UST is the most controversial decentralized stablecoin, achieving utmost capital efficiency while retaining decentralization. It once reached a market capitalization second only to USDT and USDC. However, its aggressive strategies sometimes led to extreme situations, causing the stablecoin's price to spiral out of control.

Therefore, to this day, a "perfect" decentralized stablecoin has yet to emerge, making it the "Holy Grail" that builders tirelessly pursue.

Background Analysis

Frax Finance is a full-stack protocol centered around decentralized stablecoins. It started with a partially collateralized algorithmic stablecoin and gradually transitioned to complete collateralization while maximizing the utilization of capital efficiency. It expanded horizontally into multiple domains, ultimately forming a matrix-like full-stack DeFi protocol driven by stablecoins. It is also the longest surviving partially collateralized stablecoin.

Its flagship products include:

• FRAX stablecoin：A decentralized dollar-pegged stablecoin.

• FPI：A stablecoin resistant to inflation, marked against a basket of commodities.

• frxETH：LSD

• Fraxlend：Borrowing and lending platform.

• Fraxswap：Time-weighted decentralized exchange.

• Fraxferry：Cross-chain transfers.

• FXS & veFXS：Governance module.

• AMO：Algorithmic Market Operations Controller for open market operations.

• Frax Bond - Bonds

• RWA - Real-world assets

• Frax Chain - Layer2

Frax has undergone three major versions since its inception: v1, v2, and v3. Unlike many other protocols in the market, each version of Frax represents not only functional upgrades but also significant strategic adjustments. Missing out on any one version could lead to a completely 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 collateralization ratio to maximize capital efficiency.

• Frax v2：Strategically abandoned the approach of gradually reducing the collateralization ratio for algorithmic stablecoins and shifted towards increasing the collateralization ratio to full backing. Developed AMO to enter the Curve war to compete for on-chain liquidity governance resources and launched frxETH to enter the Ethereum liquidity staking track LSD.

• Frax v3： Introduced real-world assets (RWA) and continued to utilize AMO to maintain liquidity both on-chain and off-chain.

Business Analysis

This article will start from the upcoming latest version v3 of Frax, analyzing and organizing each product of the Frax Finance stack one by one, revealing the full picture of Frax Finance.

Frax Finance v3

Frax v3 is an upcoming version that will focus on RWA, while continuing to utilize AMO from v2 to gradually transform FRAX into a fully externally collateralized, capturing both on-chain and off-chain assets, multi-dimensional decentralized stablecoin. Its core business features include:

1. Complete External Collateralization

2. RWA

3. IORB Oracle

4. frxGov Governance Module

5. FraxBond (FXB) Bonds

✹ Complete External Collateralization

According to the FRAX balance sheet (as of October 2023), the current version of FRAX has a Collateral Ratio (CR) of 91.85%.

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

📊 As of March 2024, the balance sheet of FRAX shows a 100% Collateralization Ratio (CR), primarily influenced by the appreciation of tokens like CRV and CVX, as well as accumulated income.

Starting from Frax v3, the protocol will introduce Real-World Assets (RWA) to increase the CR until it reaches or exceeds 100%, ultimately achieving 100% external collateralization for FRAX. In fact, in February 2023, the community proposal FIP188 halted the progression of FRAX algorithmic stablecoin and began utilizing AMO and protocol income to gradually increase the collateralization ratio (CR).

FIP188 is a landmark proposal for Frax. From FIP188 onwards, Frax will completely cease the "Fractional Algorithm" and "Decollateralization" functionalities. The key points of this proposal are summarized as follows:

1. Frax's initial versions included a "Fractional Algorithm," allowing for a variable collateralization ratio adjusted based on market demand for FRAX. This effectively allowed the market to determine the combination of external collateral and FXS needed to equal 1.00 USD per FRAX.

2. The reason for discontinuing the "Fractional Algorithm" is that, from a market perspective, the cost of slightly insufficient collateral far outweighs the benefits it brings. Market concerns about even 1% under-collateralization far exceed the demand for obtaining an additional 10% in returns.

3. Over time, growth, asset appreciation, and protocol income will increase the CR to 100%. It should be noted that this proposal does not rely on minting additional FXS to achieve a 100% CR.

4. Protocol income will be retained to provide funds for increasing the CR, while FXS buybacks will be suspended.

✹ RWA

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

Users holding FRAX can deposit it into designated smart contracts and receive sFRAX, a principle similar to the relationship between DAI and sDAI. Let's compare the differences between sFRAX and sDAI:

• One reason sDAI can achieve slightly higher returns than the average Treasury bond yield (currently 5%, maximum 8%) is that not all DAI holders deposit their DAI into the DSR contract. Maker's investment in Real World Assets (RWA) returns only needs to be distributed to those who deposit DAI into the DSR to earn sDAI, effectively meaning that a portion of the returns is shared among those who deposit DAI into the DSR.

• sFRAX also satisfies this condition, but Frax has accumulated a large amount of Curve and Convex tokens during the v2 phase, gaining significant voting power. Consequently, Frax can control a certain amount of CRV and CVX rewards on-chain, which will enhance the overall yield of sFRAX. Moreover, when returns are suboptimal or risks increase on one end, whether on-chain or off-chain, users can swiftly switch to the other end.

✹ IORB Oracle

In FRAX v3 smart contracts, the Interbank Offered Rate for Bank Reserves (IORB) is used to provide data for certain protocol functionalities, such as the equity yield for sFRAX.

• When the IORB rate increases, the Frax protocol's AMO strategies will heavily collateralize FRAX with treasury bills, reverse repurchase agreements, and US dollars deposited in the Federal Reserve Bank paying the IORB rate.

• When the IORB rate decreases, the AMO strategies will begin to rebalance FRAX collateral using decentralized assets on-chain and collateral loans in Fraxlend.

In simple terms, FRAX v3 adjusts its investment strategy based on the Interbank Offered Rate for Bank Reserves (IORB), sending funds to treasury bills, government bonds, etc., when off-chain yields are high, and to on-chain lending platforms like Fraxlend when on-chain yields are high, ensuring maximum returns and stablecoin stability.

✹ frxGov Governance Module

FRAX v3 will remove multisigs and fully implement governance (veFXS) through the frxGov smart contract module. This is an important step for Frax towards decentralized governance.

✹ FraxBond (FXB)

Both sFRAX and FXB introduce government bond yields to Frax, but they differ in their functions:

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

• if 50 million FRAX is pledged as sFRAX, approximately 50 million USDC (assuming a CR of 100%) can be sent to off-chain to purchase short-term government bonds worth 50 million.

• If 100 million FXB with a maturity of 1 year is sold for 95 million USDC, it means off-chain entities can purchase 1-year government bonds worth 95 million US dollars.

Additionally, FXB is a transferable ERC-20 token that can establish its liquidity in secondary markets and circulate freely, providing users with stablecoin investment options with varying terms, yields, and risk levels. It also offers new components for building innovative portfolio structures.

Frax Finance v1

In Frax v1, the concept of a fractional algorithmic stablecoin was introduced, which essentially means that part of its supply is backed by external collateral (USDC), while the rest is unbacked (supported by internal collateral FXS through algorithms).

For example, in a scenario where the collateral ratio (CR) is 85%, each redeemed FRAX would provide users with $0.85 USDC and $0.15 worth of FXS.

In v1, the AMO existed in its simplest form, referred to as the Fractional Algorithm. Its primary function was to adjust the collateralization ratio (CR) when minting FRAX based on market conditions.The most primitive setting involved adjusting the AMO at fixed intervals, for example, every 1 hour.

Initially, in the first state of Frax v1, FRAX was minted with CR = 100%, meaning 1 FRAX = 1 USDC, known as the "integer stage." Subsequently, at fixed intervals, the AMO controlled the CR based on market conditions to transition into the "fractional stage."

• If FRAX > 1, indicating it is over-pegged and needs expansion, the CR is reduced to allow for more FRAX to be minted with less collateral.

• If FRAX < 1, indicating it is under-pegged, the CR is increased to enhance the collateral backing for each FRAX, restoring confidence in the system.

While the Fractional Algorithm could intervene in CR adjustments during new FRAX minting, it was relatively slow to impact the overall system CR. Additionally, two features were introduced in Frax v1 to facilitate dynamic CR changes in coordination with the Fractional Algorithm to achieve the desired CR for the protocol:

Decollateralization and Recollateralization

1. Recollateralization: When the Fractional Algorithm raises the system's collateralization ratio, the actual collateralization ratio must be increased by adding more USDC to the system. Frax implemented an incentive whereby anyone could add USDC to the system and receive more FXS in return; for example, a user could add $1 worth of USDC to the system and receive $1.2 worth of FXS.

2. Decollateralization (Buyback): When the system's collateralization ratio is lowered, users can exchange FXS for an equivalent value of USDC from the system, and the FXS will subsequently be burned. There are no incentive mechanisms in the buyback process.

When Frax v1 was launched, it was amidst the dominance of algorithmic stablecoin projects in the DeFi market. At the same time, other algorithmic stablecoin projects like Basis Cash and Empty Set Dollar (ESD) were also launched. In the context of the market trends at that time, Frax was the most conservative algorithmic stablecoin project. However, as the market frenzy subsided, only Frax survived, and it pivoted in the subsequent Frax v2 version to bolster collateralization ratios and utilize treasury funds.

Frax Finance v2

was the most active version, discontinuing the fractional algorithm and introducing AMO for treasury management. It gradually filled the collateralization ratio (CR) gap with profits. Additionally, new businesses like Fraxlend and frxETH were launched, and Frax participated in the Curve war, emerging as a winner in on-chain liquidity governance.

The core businesses in the v2 version include:

1. AMO

2. Fraxlend

3. Fraxswap

4. FPI (Frax Price Index)

5. frxETH

✹ AMO（Algorithmic Market Operations Controller）

AMO functions as a tool similar to the Federal Reserve for executing monetary policies. Its mechanism allows it to devise any FRAX monetary policy within the constraints of pre-defined algorithmic limitations, as long as it doesn't decrease the collateralization ratio and alter the FRAX price. This means that the AMO controller can conduct algorithmically driven open market operations (hence their name), but they cannot simply mint FRAX out of thin air to break the peg.

Currently, Frax operates four AMOs, with the Curve AMO having the largest pool of funds. Alongside the operation of AMOs, the protocol utilizes idle assets from the treasury (primarily USDC) and pairs them with a certain amount of minted (algorithmically controlled) FRAX to deploy them into other DeFi protocols:

1. Maximize the utilization of treasury funds to earn additional income. For example, if the treasury holds 1 million USDC, the AMO mints 1 million FRAX, and together they form USDC-FRAX LP for yield farming, effectively generating yield farming rewards for a pool with a combined value of 2 million.

2. Since the ownership of minted FRAX (algorithmically controlled) within the AMO belongs to the protocol and can be withdrawn and destroyed according to AMO strategies without circulating to users' hands, it does not significantly impact the peg of FRAX.

3. Increases the market capitalization of FRAX without actually adding new collateral.

Using the Curve AMO strategy as an example:

• Decollateralize: Idle collateral and newly minted FRAX from the AMO are deposited into the Curve Pool.

• Recollateralize: Initially, FRAX-USDC LP tokens are withdrawn from the pool, excess FRAX (previously minted and controlled by the protocol) is destroyed, and USDC is returned to increase the collateralization ratio (CR).

• Protocol revenue: Accumulate trading fees, CRV rewards, and periodically rebalance the pool. The LP tokens are deposited into platforms like Yearn, Stake DAO, and Convex Finance to earn additional yield.

Let's analyze the crucial "minting" ability of the AMO.

The core strategy of the AMO "minting" can be summarized as follows:

When the AMO needs to add USDC from the treasury funds to the Curve Pool, adding a large amount of USDC individually would affect the proportion of USDC in the pool, thereby impacting the price. Therefore, by minting an appropriate amount of FRAX paired with USDC to form LP, the funds can be added to the pool with minimal slippage, with the LP held and controlled by the AMO.

Additionally, there exists another scenario for maximizing "minting":

Suppose there is a pre-minted supply of FRAX, denoted as Y, and the market tolerance for FRAX falling below $1 is X%.

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

In other words, since the Curve AMO can create FRAX+USDC LP and control TVL in its own Curve Pool, when FRAX falls by X%, excess FRAX can be withdrawn and destroyed through the AMO's Recollateralize operation to increase CR and bring the price back to the anchor. The more LP controlled by the AMO, the stronger this ability.

Therefore, before FRAX falls by X%, based on the AMO's control of LP, a certain amount of FRAX can be calculated, which is allowed to be sold into the Curve Pool at once without causing enough price impact to move CR. This amount is the maximum "minting."

For example, a 330 million TVL FRAX3Pool can support at least a $39.2 million FRAX sell order without changing the price by more than 1 cent. If X = 1%, then at least 39.2 million algorithmic FRAX can be "maximally minted" on the open market.

The above strategy is an extremely powerful market operation that mathematically creates a minimum circulating supply of algorithmic FRAX without any risk of breaking the peg.

✹ Fraxlend

Fraxlend is a lending platform that provides a lending market between ERC-20 assets. Unlike Aave v2's blended lending pools, each lending pair in Fraxlend is an isolated market. When you choose to deposit a particular collateral for borrowing by borrowers, you fully acknowledge and accept the value and risks of this collateral. This design of isolated pools has two characteristics:

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 out.

1/ Fraxlend Mechanism Characteristics - Interest Rate Models

Fraxlend offers three interest rate models (actually using the second and third):

1. Linear interest rates

2. Time-weighted floating interest rates

3. Floating interest rates V2

Unlike most lending protocols, all interest rate calculators in Fraxlend automatically adjust based on market dynamics, without the need for governance intervention. The Frax team believes that letting the market determine interest rates is preferable to proposing governance proposals every time the market fluctuates (as this method is slower).

• Linear Interest Rates:

  When the utilization rate exceeds the critical value of the peak utilization rate, the slope of the interest rate increase curve begins to steepen. Most lending protocols use this basic interest rate growth model to ensure that when funds are borrowed too much from the pool, depositors are encouraged to deposit and borrowers are prompted to repay by raising interest rates.

• Time-weighted floating interest rate

  The time-weighted floating interest rate adjusts the current rate over time. It is controlled by three parameters:

  1. Utilization: Adjusts the rate based on the utilization of funds.

  2. Half-life: Determines the speed of rate adjustments. In simple terms, when the utilization is high, the rate will increase with a multiplier, while it will decrease when the utilization is lower.

  3. Target utilization range: No rate adjustments occur within this range, as it is considered to be the expected market value.

  In the current available interest rate calculator, the rate's half-life is set to 12 hours. If the utilization rate is 0%, the rate halves every half-life period, decreasing by 50%. Conversely, if the utilization rate is 100%, the rate doubles every half-life period, increasing by 100%.

This interest rate model played a critical role in the CRV liquidation event involving Curve founder Mich, and in the 0-day vulnerability exploit in the vyper compiler affecting Curve, leading to a squeeze on Mich's CRV borrowing position on-chain. With a significant number of lenders withdrawing funds, the utilization rate skyrocketed to nearly 80%-100%. In the CRV market of Fraxlend, a time-weighted floating interest rate model is adopted, with a half-life of 12 hours when the utilization rate approaches 100%. The interest rate for CRV collateralized borrowing doubles every 12 hours. This prompted Mich to repay the borrowing from Fraxlend first; otherwise, the doubling of the interest rate every 12 hours would have led to the first execution of Mich's liquidation.

The following graph illustrates how the interest rate changes when the half-life of rates is 4 hours, and the target utilization range is between 75% and 85%.

• Floating Rate V2

  • Floating Rate V2 combines the concepts of linear rates and time-weighted floating rates. Specifically, it utilizes the linear function of linear rates to determine the current rate, but adjusts the inflection point and maximum rate using the formula of time-weighted floating rates. Its characteristic is that the rate will immediately respond to changes in utilization along the linear rate curve, while adapting the slope of the linear rate curve to long-term market conditions.

  • Similar to time-weighted floating rates, Floating Rate V2 adopts parameters such as half-life and target utilization range. When utilization is low, the inflection point and maximum rate will decrease. Conversely, if utilization is high, the inflection point and maximum rate will increase.

  • The reduction/increase in rates is determined by utilization and half-life. If utilization is 0%, the inflection point rate and maximum rate will decrease by 50% per half-life. If utilization is 100%, they will increase by 100% per half-life.

2/ Characteristics of Fraxlend Mechanism - Dynamic Debt Restructuring

In typical lending markets, when the Loan-to-Value (LTV) ratio exceeds the maximum LTV (usually 75%), liquidators can close out the borrower's position. However, during extreme volatility, liquidators may not be able to close out unhealthy positions before the LTV exceeds 100%. In such cases, defaults may occur, and those who withdraw funds last will incur the greatest losses, turning it into a "game of chicken."

In Fraxlend, when defaults occur, the losses are immediately "socialized," meaning they are distributed among all lenders. This helps maintain market liquidity, ensuring that the lending market does not immediately dry up even after defaults occur.

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 using the underlying minting mechanism.

FRAX minted into the money market does not enter circulation unless borrowers over-collateralize through the money market, so this AMO does not directly decrease the collateralization ratio (CR). It facilitates the expansion of FRAX's scale, creating a new avenue for FRAX to enter circulation.

Strategies:

1.Decollateralize - Mint FRAX into the money market. The minted FRAX does not directly reduce CR, as all borrowed FRAX is over-collateralized.

2.Recollateralize - Withdraw minted FRAX from the lending market.

3.Protocol earnings - Fees generated by borrowers.

Additionally, because the Fraxlend AMO has the ability to "mint" and "burn," it can lower interest rates by minting more FRAX or raise interest rates by burning FRAX. This interest rate adjustment capability is a powerful economic lever because it changes the cost for all borrowers who borrow FRAX.

In theory, if Frax is willing and confident, it can mint enough FRAX stablecoins to enter Fraxlend, attracting users to lend FRAX at rates lower than any other stablecoin in the market, thereby creating the optimal lending rate. Furthermore, when necessary, it can use the Fraxlend AMO to increase rates in response to market demand. Stablecoin projects typically struggle to control their lending rates.

✹ Fraxswap Fraxswap utilizes a Time-Weighted Average Market Maker (TWAMM) for large trades conducted over extended periods without trust. It is entirely permissionless, and its core AMM is based on Uniswap V2. TWAMM is discussed in detail in another article.

✹ FPI (Frax Price Index)

1/ Definition

FPI is the first anti-inflation stablecoin pegged to a real-world basket of goods defined by the average U.S. CPI-U. The FPI stablecoin aims to maintain its purchasing power by keeping its price constant relative to all items in the CPI basket through on-chain stabilization mechanisms. Similar to the FRAX stablecoin, all FPI assets and market operations are on-chain and utilize the AMO contract.

FPI uses the 12-month non-adjusted inflation rate reported by the U.S. federal government's CPI-U. A dedicated Chainlink oracle submits this data on-chain immediately upon its public release. The inflation rate reported by the oracle is then applied to the redemption exchange price of the FPI stablecoin. This redemption price grows on-chain every second (or decreases in rare cases of deflation).

2/ FPIS

FPIS is the governance token of the system and also has the right to minting fees from the protocol. Any excess earnings are distributed directly from the treasury to FPIS holders, similar to the FXS structure.

When the income generated by FPI is insufficient to maintain the increased support due to inflation, new FPIS tokens may be minted and sold to increase the funding support for FPI.

3/ FPI Stabilization Mechanism:

FPI uses the same type of AMO as the FRAX stablecoin, but its model always maintains a 100% collateralization ratio (CR). This means that to maintain a 100% collateralization ratio, the protocol's balance sheet must grow at least at the rate of CPI inflation. Therefore, AMO strategy contracts must generate earnings proportional to the CPI, or else the CR will fall below 100%. During periods when AMO earnings are lower than the CPI rate, a TWAMM AMO will sell FPIS tokens in exchange for FRAX stablecoins to ensure the CR remains at 100%. When the CR returns to 100%, the FPIS TWAMM will be removed.

✹ frxETH - Ethereum Staking Derivative: Currently ranked 4th overall in the LSD track, Frax ETH has a TVL of $427.64M, with a market share of 2.42%. However, it can achieve yields of up to 3.88%, ranking 1st in terms of provided earnings. The reason Frax ETH can provide above-market-average returns also stems from its control of on-chain liquidity governance resources.

In Frax ETH, there are two main components:

• frxETH (Frax Ether): This is an Ethereum stablecoin pegged to ETH, where 1 frxETH always represents 1 ETH. Similar to Lido's stETH, holding frxETH alone does not undergo rebases, and holders do not receive Ethereum staking rewards.

• sfrxETH (Staked Frax Ether): sfrxETH is an ERC-4626 vault designed to accumulate staking rewards from Frax ETH validators. At any time, frxETH holders can deposit their tokens into the sfrxETH vault to convert them into sfrxETH, allowing users to earn staking rewards on their frxETH holdings. Over time, as validators accrue staking rewards, an equivalent amount of frxETH is minted and added to the vault, allowing users to redeem more frxETH than they initially deposited. Therefore, theoretically, the exchange rate of sfrxETH to frxETH will continuously increase over time. By holding sfrxETH, users have a percentage claim to an increasing amount of frxETH in the vault. This mechanism is similar to the principle behind Aave's aDAI.

How does Frax ETH increase the interest rate above the market average?

Frax ETH increases its interest rate above the market average by leveraging its accumulated CRV and CVX governance resources in the market through AMO. Frax builds the frxETH Pool on platforms like Curve and Convex, allowing frxETH to earn incentives in third-party liquidity markets without issuing its own token, FXS. All Ethereum staking rewards are then directed to sfrxETH.

Let's assume that out of the 270,000 ETH deposited into Frax ETH, 100,000 ETH are not staked as sfrxETH but are instead used in liquidity pools with other Ethereum assets like WETH and stETH on liquidity markets such as Curve and Convex. The remaining 170,000 ETH are staked as sfrxETH. The incentives received are as follows:

• The 100,000 ETH deposited in liquidity pools like Curve and Convex earn CRV and CVX incentives.

• The 170,000 ETH staked as sfrxETH earn Ethereum staking rewards for the entire 270,000 ETH.

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

Tokenomics Analysis

This paragraph analyzes the financing situation, token distribution, and veToken tokenomics mechanisms of Frax Finance's governance token FXS.

The Financing Situation

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

Investors in Frax Finance include well-known investment firms such as Parafi, Dragonfly, Mechanism, and Galaxy Digital, as well as notable founders from the DeFi sector such as Stani Kulechov from Aave, Robert Leshner from Compound, Kain Warwick from Synthetix, and Eyal Herzog from Bancor. Additionally, investments also come from backgrounds in centralized exchanges (CEX), such as Crypto.com, and individuals like Balaji Srinivasan (former Coinbase CTO and A16Z partner).

The distribution of the governance token FXS (Frax Shares) is as follows:

60% allocated to liquidity programs/farming/community - halved naturally every 12 months through governance.

5% allocated to project treasury/grants/partners/security bug bounties - to be decided by the team and community.

20% allocated to team/founders/early project members - vested over 12 months with a 6-month lockup.

3% allocated to strategic advisors/external early contributors - vested over 36 months.

12% allocated to accredited private investors - 2% unlocked at launch, 5% vested within the first 6 months, 5% vested within 1 year with a 6-month lockup.

Currently, the circulating supply of FXS is 74.57 million out of a total supply of 100 million. The team, advisors, and external investors are fully unlocked, with the non-circulating portion held entirely by the community (liquidity programs/treasury).

veFXS Tokenomics

1/ veToken Model

This is a ownership and reward system based on the Curve veCRV mechanism. Users can lock their FXS for up to 4 years to obtain veFXS. veFXS is not a transferable token and is not traded on the open market.

As the tokens approach the expiration of their lockup period, the veFXS balance decreases linearly, approaching a 1:1 ratio of 1 FXS per 1 veFXS when the remaining lockup time reaches zero. This encourages long-term staking and an active community.

Each veFXS holder possesses 1 voting right in governance proposals. Staking 1 FXS for the maximum duration (4 years) will generate 4 veFXS. This veFXS balance itself gradually decays to 1 veFXS after 4 years, at which point users can redeem veFXS back to FXS.

2/ Gauge

Similar to the power of veCRV in the Curve system, veFXS can determine the emissions incentives in the liquidity pools supported by Frax through voting.

3/ Repurchase

The primary cash flow allocation mechanism of the Frax protocol is directed towards veFXS holders. Cash flows generated from AMO, Fraxlend loans, and Fraxswap fees are typically used for repurchasing FXS from the market, which is then distributed as earnings to veFXS stakers.

However, with strategic adjustments in Frax v2 and v3, the protocol will prioritize raising the CR to 100%. Therefore, repurchases may be paused or restricted. Once the CR reaches 100%, veFXS holders will have the opportunity to capture all protocol income.

Data Analysis

This section analyzes and summarizes the treasury data, balance sheet, and real collateralization ratio of Frax Finance at present.

Real Collateralization Ratio Analysis

We have reorganized Frax's balance sheet (as of October 10, 2023). The total assets held by the protocol amount to $616.8 million, including:

• Total amount of FRAX held by the protocol: $450.1 million

• US dollars and other assets: $166.7 million

In addition, there are $65.6 million FRAX lent out in Fraxlend (overcollateralized). The total issuance size (total circulating supply) of FRAX is $741.4 million, with a collateralization ratio (CR) of 92.05%.

CR= Asset SUM / total FRAX

If both FRAX held by the protocol on the asset and liability sides are removed simultaneously, the numerical value of the collateralization ratio will decrease, but the absolute value of the collateralization ratio gap will not change significantly. This absolute value is currently approximately $58.97 million.

From here, we can see that:

1. Frax leveraged $166.7 million of underlying assets through AMO strategies to expand the stablecoin supply several times without breaking the peg. (If following the traditional 1:1 issuance ratio, FRAX's circulating supply equals the value of the underlying assets, $166.7 million.)

2. To achieve a CR of 100%, the protocol needs to earn $58.9 million in profits to enter the treasury.

📊 In March 2024, the Collateralization Ratio (CR) of the FRAX stablecoin reached 100%, taking approximately 5-6 months from the initial publication of the article. This increase was driven by revenue from various sources such as AMO, RWA, and LSD operations. However, the main contributing factor was the bull market, which led to a more than 100% increase in the prices of assets held by Frax, including CRV, CVX, and FXS.

Following this, Frax founder Sam stated in an interview that they plan to reopen the dividend switch for veFXS, which will significantly increase the potential value of the FXS token.

Summary of Investment Views

Overall, we began writing articles in October 2023 when the Collateralization Ratio (CR) was around 92%. At that time, due to being in a bear market, excluding the increase in floating assets held by Frax, we estimated that it would take at least one year to raise the CR to 100%. However, with the arrival of the bull market, Frax achieved this goal six months ahead of schedule. However, the floating assets held in its collateral primarily consist of on-chain governance assets (such as CRV, CVX), which will continue to be a fluctuating factor in Frax's CR. Strictly speaking, Frax remains a hybrid stablecoin partially collateralized by these assets.

In terms of business potential, the growth of Real World Asset (RWA) business supports protocol liquidity in bear markets, while the Automated Market Operations (AMO) function is most effective during bull markets. Layer 2 (L2) is a key factor in raising the overall project valuation ceiling for Frax.

So from an investment perspective, we should focus on the following indicators:

1. Utilization and profitability of all AMO funds.

2. Prices of CRV and CVX tokens.

3. Growth of the RWA business.

4. Development progress of the Layer 2 (L2) ecosystem.

Frax has built a sufficiently large full-stack stablecoin system. We can see that both Fraxswap and Fraxlend, in addition to being launched on public markets, are serving Frax Finance itself. This is similar to MakerDAO's endgame plan with subDAOs:

• The similarity lies in the fact that both MakerDAO and Frax are planning to horizontally expand around their core (stablecoin) to build a full-stack product.

• The difference is that MakerDAO decided to outsource these functionalities to other subDAOs, while Frax is governed uniformly by frxGov.

The advantage is that Frax has captured almost all the correct demands in the DeFi market and currently has forward-thinking mechanism designs. However, it is evident that the potential problem lies in a huge system covering stablecoins, trading systems, lending systems, cross-chain systems, LSD, Layer 2, etc. Such a large system requires a highly efficient and robust governance module, and risk isolation between functionalities is also crucial. This tests the stability of future protocol functionalities and on-chain governance.

Risk Warning

CRYPTO market carries extremely high risks and does not constitute investment advice. This article presents independent opinions and is not sponsored by any party.