Frax Finance: Building a decentralised central bank, starting with a stablecoin
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May 28th, 2022

Anyone who has dabbled in decentralised finance (DeFi) for even a short while would be aware of the importance of stablecoins – cryptocurrencies whose value is pegged to another asset, often fiat currency such as the US dollar. In a market like crypto where large price swings are the norm, stablecoins provide some semblance of sanity for market participants, serving as a relatively stable medium of exchange for other volatile crypto assets, or as an on-chain store of value, especially during risk-off periods.

If you ask most DeFi participants about which stablecoins they use or have heard of, chances are you will hear a few common names – USDT, USDC, BUSD and DAI – that are currently part of the top four stablecoins by market capitalisation. There is also UST, which was the third largest stablecoin by market capitalisation before its spectacular collapse in May 2022. Sitting below these established names is Frax Finance’s FRAX stablecoin, which has received much less attention even though it is now the fifth largest stablecoin by market capitalisation.

Top five stablecoins by market capitalisation as of 28 May 2022 as shown on CoinGecko.
Top five stablecoins by market capitalisation as of 28 May 2022 as shown on CoinGecko.

I believe Frax Finance remains an under-the-radar DeFi protocol that bears watching because it is not just trying to build a more well-designed stablecoin (i.e. FRAX), but leveraging it to acquire an outsized influence in the rapidly-growing DeFi space. In fact, in my previous essay on Olympus DAO, I characterised the protocol as a ”community-owned central bank”. But after learning about Frax Finance, I think the latter comes much closer to building DeFi’s version of a central bank, and it is doing this from ground up, starting with its FRAX stablecoin.

A summary of this essay for the time-starved individual.
A summary of this essay for the time-starved individual.

(1) The case for a partially-collateralised stablecoin

To understand how FRAX works, it is useful to situate it among the other stablecoins in existence, most of which fall squarely within two camps:

  • Fully-collateralised stablecoins: These stablecoins are backed by an equivalent amount of assets or more. In other words, to mint 1 USD worth of such stablecoins, at least 1 USD worth of collateral must be parked in a reserve to back them. Examples of such stablecoins include USDT (or so its creator claims), USDC (which is fully backed by USD cash and short-duration US government treasuries), and DAI (which is in fact overcollateralised, since its collateral includes more volatile crypto assets such as ETH).
  • Non-collateralised stablecoins: These stablecoins do not have any collateral to back them, but instead utilise various algorithmic mechanisms to maintain their peg. Terra protocol, whose UST stablecoin was the largest non-collateralised stablecoin by market capitalisation before its collapse, used an associated token, LUNA (now called LUNC), to absorb the price volatility of UST and maintain its peg. When UST fell below 1 USD, Terra incentivised users to burn their UST to mint LUNA, thereby reducing the UST supply and increasing its price back towards 1 USD. Conversely, when UST rose above 1 USD, Terra incentivised users to burn their LUNA to mint UST, increasing the supply and thus reducing the price of UST.

Both types of stablecoins come with their own set of limitations. Fully-collateralised stablecoins have to contend with custodial risk (are its collateral held in a secure place?) and face constraints regarding capital efficiency (their growth is limited by the availability of collateral). On the other hand, non-collateralised stablecoins tend not to inspire much confidence from market participants since they are largely unbacked, and therefore face a significant risk of a bank run that can completely obliterate their value, as shown in the case of Iron Finance’s IRON stablecoin, and most recently, Terra’s UST stablecoin.

Frax Finance took a middle-of-the-road approach with FRAX, by designing it to be a partially-collateralised stablecoin. This does not eradicate the limitations above, but it does moderate them. As a partially-collateralised stablecoin, FRAX is more capital efficient than fully-collateralised or overcollateralised stablecoins – it requires less collateral to maintain its peg. At the same time, by being partially backed (on top of other mechanisms which will be explained in the next section), market participants will feel more assured when using FRAX as compared to other non-collateralised stablecoins, resulting in a lower risk of a bank run.

(2) How does the FRAX stablecoin work?

The name of the FRAX stablecoin is derived from the term “fractional-algorithmic”, which reflects the mechanism by which FRAX maintains its peg to the US dollar, i.e. 1 FRAX = 1 USD.

FRAX is essentially an attempt to incorporate the principles of both fully-collateralised and non-collateralised stablecoins – a part of FRAX’s value is backed by collateral (predominantly USDC for now), while the remaining part is algorithmically stabilised with the help of another token (i.e. FXS, which is Frax Finance’s governance and utility token).

As Frax Finance’s website clearly states, FRAX is partially backed bycollateral and partially stabilised algorithmically.
As Frax Finance’s website clearly states, FRAX is partially backed bycollateral and partially stabilised algorithmically.

Maintaining the peg

Like other stablecoins, FRAX maintains its peg to USD by allowing for arbitrage via expanding and contracting the supply of FRAX and FXS:

  • When the price of each FRAX falls below 1 USD: Users can purchase FRAX on the open market, and then make a profit after redeeming each FRAX for 1 USD of value from the protocol. At the current collateral ratio of around 89%, every FRAX can be redeemed for 0.89 USD of collateral (i.e. USDC) and 0.11 USD worth of newly-minted FXS. In doing so, the supply of FRAX is reduced, and the price of FRAX should trend upwards 1 USD.
  • When the price of each FRAX rises above 1 USD: Users can mint new FRAX by depositing 1 USD of value into the protocol, and profit from selling the minted FRAX for over 1 USD each on the open market. At the current collateral ratio of around 89%, the user must deposit 0.89 USDC and 0.11 USD worth of FXS (which will be burned) to mint each new FRAX. In doing so, the supply of FRAX will increase, and the price of FRAX should trend downwards towards 1 USD.
How Frax Finance allows arbitrageurs to maintain the peg of FRAX.
How Frax Finance allows arbitrageurs to maintain the peg of FRAX.

Determining the collateral ratio

What sets FRAX apart from other stablecoins is the fact that it is not only partially collateralised, but that it also allows for a dynamic collateral ratio that is determined by the market. The protocol itself makes no assumption about what this collateral ratio should be, and simply keeps the ratio at whatever the market demands to ensure that each FRAX is priced at 1 USD. In a way, the collateral ratio at any given point in time reflects the extent of the market’s confidence in a non-collateralised stablecoin.

Sam Kazemian, the founder of Frax Finance, explains how the collateral ratio for FRAX is determined by the market.
Sam Kazemian, the founder of Frax Finance, explains how the collateral ratio for FRAX is determined by the market.

When FRAX was first launched in December 2020, the collateral ratio was set at 100%, and the protocol adjusted it once every hour in steps of 0.25%:

  • When the price of each FRAX fell below 1 USD: The protocol increased the collateral ratio by one step per hour, to help restore confidence in FRAX by increasing its backing. This meant that if the price of FRAX was below 1 USD a majority of the time within a certain time period, the collateral ratio would trend upwards towards 100%.
  • When the price of each FRAX rose above 1 USD: The protocol decreased the collateral ratio by one step per hour, which would facilitate the minting of new FRAX to bring the price back down towards 1 USD. In other words, if the price of FRAX was above 1 USD a majority of the time within a certain time period, the collateral ratio would trend downwards.

In February 2021, Frax Finance updated its mechanism to determine the collateral ratio, incorporating a metric called the “growth ratio”, which measures the amount of FXS available as liquidity on decentralised exchanges (DEXs) against the total supply of FRAX. Using this growth ratio helps the protocol to ensure that any reduction in the collateral ratio can be supported by the relative supply of FXS and FRAX.

After all, a larger supply of FRAX is harder to stabilise algorithmically. Hence, the protocol should only reduce the collateral ratio when there is sufficient liquidity for FXS (as reflected by a higher growth ratio) to support doing so. Otherwise, in the case of insufficient FXS liquidity (as reflected by a lower growth ratio), reducing the collateral ratio would mean that while users who redeemed their FRAX would get more newly-minted FXS, they would also face greater price slippage when selling these FXS. This may lead to undesirable negative feedback loops, such as a price collapse for FXS over time.

Formula for the growth ratio.
Formula for the growth ratio.

Buybacks and recollateralisation

Due to FRAX’s dynamic collateral ratio, there are periods of time when the protocol has either too much or too little collateral. To correct for such surpluses or deficits, the protocol has built in two swap functions to rebalance the amount of collateral it has: buybacks and recollateralisations.

When the value of the collateral in the protocol dips below the current collateral ratio, a user can call the “recollateralise” function to check whether this is the case. If so, the user will be allowed to add collateral up to the amount needed to reach the target collateral ratio. In return, the user will get newly-minted FXS at a discount rate, which is set at 0.20%. This provides an incentive for arbitragers to recollateralise the protocol whenever there is a deficit in collateral.

On the other hand, when the value of the collateral in the protocol rises above the current collateral ratio, a user can call the “buyback” function to verify whether this is the case. If so, the protocol will use the excess collateral to swap for FXS and then burn it. This reduction in FXS supply will benefit all FXS holders, akin to how share buybacks work in the stock market.

(3) What is the value of holding FXS?

Now that you understand how FRAX works as a stablecoin, it is time to look at how the protocol is able to accrue value for itself, and by extension, FXS holders.

Fundamentally, the value of FXS is tied to the demand and adoption of FRAX:

  • If you recall, when demand for FRAX decreases (thereby pushing the price below 1 USD), users are incentivised to redeem FRAX for the underlying collateral and some newly-minted FXS. The supply of FXS will therefore be inflationary if there is poor demand for FRAX.
  • In contrast, when demand for FRAX increases (thereby pushing the price above 1 USD), users are incentivised to mint new FRAX by depositing collateral and burning FXS. The supply of FXS will therefore be deflationary if there is strong demand for FRAX.

Enabling demand for FRAX

The key to increasing the value of FXS is therefore to ensure strong demand for FRAX.

There are a few common things that DeFi protocols do to build demand for their tokens, and not surprisingly, Frax Finance has been pursuing these as well:

  • Incentivising liquidity: A critical enabling factor of demand for any DeFi protocol’s token is liquidity, without which users will not have the confidence to transact with the token, given the risk of price slippage. This is why DeFi protocols have typically devoted substantial resources to incentivise users to provide liquidity for their tokens. Frax Finance is no different, and it has allocated 60% of FXS’ total supply (capped at 100 million FXS tokens) for liquidity incentives. In other words, if users provide liquidity for FRAX in an eligible liquidity pool on a DEX, they will be able to get additional FXS rewards (see here for the list of active FRAX liquidity pools that receive liquidity incentives in FXS and other tokens). Nevertheless, liquidity incentives are often not sustainable, and should only be used primarily when a protocol has just started out to bootstrap liquidity from nothing. In the case of Frax Finance, the emissions schedule of FXS for liquidity incentives will halve every year based on current parameters. This should help to pare down the dilution in FXS supply from liquidity incentives and resultant selling pressure.
  • Partnering other protocols: While critical, liquidity alone will not guarantee demand, especially as liquidity incentives decrease over time. Frax Finance has to build up organic demand for FRAX, and this is best achieved when other DeFi protocols find it useful to transact or hold FRAX. Partnerships with other protocols are therefore something that Frax Finance has been focused on, to develop use cases for FRAX. For instance, Frax Finance and Olympus DAO, which I previously wrote about, partnered to launch a dual-incentivised FRAX-OHM pool on Uniswap, and have undertaken a DAO-to-DAO swap to accumulate each other’s tokens in their respective treasuries, among other collaborations.
  • Going multi-chain: Expanding FRAX beyond its native chain, i.e. Ethereum, has also helped to increase the total addressable market for Frax Finance, in terms of users and protocols it can partner with. To date, both FRAX and FXS are deployed on 14 blockchains. Frax Finance has a bridge mechanism to maintain a consistent global state for FRAX and FXS, and ensure that the FRAX peg is kept tight across all blockchains that it is deployed on.

While the market capitalisation of FRAX still pales that of the top four stablecoins, it has been steadily growing since FRAX was launched in December 2020. At the same time, much of the growth in FRAX’s market capitalisation occurred between October 2021 and the start of this year, just before the cooldown in DeFi markets that began in end-January and the much sharper downturn in May following Terra’s collapse.

Chart of FRAX's market capitalisation as of 28 May 2022 from Frax Finance's website.
Chart of FRAX's market capitalisation as of 28 May 2022 from Frax Finance's website.

This suggests that besides Frax Finance’s ongoing demand generating efforts as mentioned above, there may be other factors at play behind that sudden spurt of demand for FRAX in Q4 2021. Here, we turn to another of Frax Finance’s innovations, “Algorithmic Market Operations”, which started taking off around the same time period.

Chart of Frax Finance's accrued profits from its Algorithmic Market Operations (AMOs) as of 28 May 2022 from Frax Finance's website.
Chart of Frax Finance's accrued profits from its Algorithmic Market Operations (AMOs) as of 28 May 2022 from Frax Finance's website.

Algorithmic Market Operations (AMOs)

The concept of AMOs was first introduced by Frax Finance as part of its upgrade to Frax v2, announced in March 2021. These AMOs are enacted by smart contracts, which Frax Finance calls “AMO controllers”. They essentially enable Frax Finance to autonomously pursue market operations in ways that can drive greater value to the protocol, without jeopardising the peg and stability of FRAX, which is central to what Frax Finance is about.

As Sam Kazemian, the founder of Frax Finance, explained in his Medium post announcing Frax v2:

Simply put, an AMO controller is an autonomous contract that enacts arbitrary FRAX monetary policy so long as it does not lower the collateral ratio and change the FRAX price. This means that AMO controllers can perform open market operations algorithmically (that’s where they get their name), but they cannot simply mint FRAX out of thin air and break the peg. This keeps FRAX’s base layer stability mechanism pure and untouched which has been the core of what makes our protocol special and has inspired other smaller projects. It also keeps AMO controllers economically disciplined knowing that there is a ceiling for the amount of FRAX that can be unbacked which stops the protocol from unrestrained money printing of classical central banks.

Each AMO can be seen as a module that operates on top of Frax Finance’s base “fractional-algorithmic” mechanism. While each AMO can run different market operations and thus achieve different objectives for the protocol, they all share the following four functions which builds on the base mechanism:

  • Equilibrium: Under the base mechanism, the protocol will not do anything when it is at equilibrium, i.e. the price of FRAX is at its peg of 1 USD. For an AMO, this is the primary space in which it will run its market operations.
  • Decollateralise: If the price of FRAX exceeds 1 USD, the base mechanism will aim to increase the supply of FRAX by essentially reducing the collateral ratio to encourage the minting of new FRAX. An AMO likewise has to include a similar “decollateralise” function to reduce the collateral ratio and help bring the protocol backs towards equilibrium when the price of FRAX exceeds 1 USD.
  • Recollateralise: Conversely, if the price of FRAX falls below 1 USD, the base mechanism will aim to increase confidence and demand for FRAX by essentially increasing the collateral ratio. An AMO likewise has to include a similar “recollateralise” function to increase the collateral ratio and help bring the protocol backs towards equilibrium when the price of FRAX goes below 1 USD.
  • FXS1559: This is a function, named in homage to EIP1559, that builds on the “buyback” function in the base mechanism and ensures that every AMO is able to accrue value to FXS when the protocol has excess collateral. The FXS1559 function can calculate the value of the excess collateral above the protocol’s collateral ratio at a given time interval, and mint an equivalent amount of new FRAX at the collateral ratio. It then uses the newly-minted FRAX to buy FXS from the open market and burn it, thus reducing the supply of FXS and accruing value to FXS holders. Unlike the “buyback” function in the base mechanism which uses the excess collateral to directly swap for FXS and burn it, the FXS1559 function has the added step of using the excess collateral to mint new FRAX first, which will help to also expand the supply of FRAX.

Frax Finance has designed Frax v2 to incorporate multiple AMO controllers, with anyone able to propose, build and deploy AMOs, subject to the protocol’s governance process. Currently, the protocol has several AMOs in operation, with the key ones outlined below:

  • Collateral Investor AMO: This AMO enables the protocol to tap on its idle collateral (currently only USDC) and move them to selected DeFi protocols (e.g. Aave, Compound and Yearn) to generate yield. Collateral that is invested with the option for immediate withdrawals do not count as lowering the collateral ratio. Revenue generated from the yield that places the value of the protocol’s collateral above the collateral ratio can be used to mint FRAX and burn FXS via the FXS1559 function to accrue value to FXS holders.
  • Curve AMO: This AMO allows the protocol to deploy its idle USDC collateral or mint new FRAX (to the extent that it will not change the collateral ratio) into its FRAX3CRV liquidity pool on Curve. This helps to increase liquidity for FRAX and tighten its peg, while simultaneously allowing the protocol to earn revenue and CRV rewards from providing liquidity on Curve.
  • Lending AMO: This AMO enables the protocol to mint FRAX directly to lending/borrowing protocols such as Aave and Compound, from which users can obtain FRAX by borrowing, instead of minting it via the base mechanism, i.e. by depositing collateral and FXS. The protocol earns revenue from the interest paid by borrowers. In addition, as lending/borrowing protocols require borrowers to overcollateralise their positions, the operations of the lending AMO do not lower the collateral ratio. This effectively allows the protocol to mint new FRAX at will as long as FRAX does not lose its peg. Given this low cost of money creation, Frax Finance claims that it can offer more competitive interest rates for lending FRAX as compared to other stablecoins. Ultimately, the lending AMO allows Frax Finance to influence the interest rate for FRAX by minting or removing FRAX accordingly – a powerful lever that allows it to retain significant influence over market demand for FRAX.

What is noteworthy about the impact of these AMOs was that since October 2021, the large amount of new FRAX that were minted seemed to have been through the AMOs, rather than the base mechanism. According to the FXS dashboard on Frax Finance’s website, there have not been much FXS burned since October 2021.

Chart of FXS burned as of 28 May 2022 from Frax Finance's website.
Chart of FXS burned as of 28 May 2022 from Frax Finance's website.

This seems counter-intuitive. After all, even if much of the new FRAX was minted by the AMOs (in particular the Curve AMO), shouldn’t the FXS1559 function work to buyback and burn FXS using the profits from the AMOs? This was how the AMOs were supposed to accrue value to FXS holders.

Staking FXS

It turns out that the FXS1559 function is not the only way to do so. In fact, Frax Finance has also directly channelled its AMO profits to FXS holders who stake their FXS. Initially, 50% of the profit from the AMOs (i.e. yield that forms the protocol’s excess collateral) was used to buy and burn FXS via the FXS1559 function, while the other 50% was used to buy FXS and distribute them to those who stake their FXS as veFXS.

However, following a governance vote in October 2021, 100% of AMO profits have since been channelled to the latter, i.e. veFXS stakers. This was why there was not much burning of FXS since then. As outlined in the governance proposal, this move was to encourage the long-term holding of FXS, by increasing the yield from staking FXS as veFXS.

veFXS stands for vote-escrowed FXS. It is based off the vesting system pioneered by Curve Finance for its CRV token, which can be locked as veCRV. Essentially, users can lock up their FXS tokens and receive veFXS tokens in return, at a rate that depends on the duration of lock-up. Those that stake their FXS for the maximum time period of four years will receive 4 veFXS for every FXS locked, while those who do so for shorter time periods will receive fewer veFXS proportionally. The veFXS tokens are non-transferrable and a user’s veFXS balance will vest linearly, decreasing to 1 veFXS per 1 FXS at zero lock time remaining.

The intent of such a vesting system is to encourage long-term holding of FXS, since users receive more veFXS the longer they lock their tokens for. The utility of holding veFXS, to encourage users to even want to lock up their FXS in the first place, can be summed up by the following:

  • Greater voting power: Each veFXS gives the user one vote in governance proposals. If a user wants to have more say in the governance of Frax Finance, then he or she needs to acquire more FXS and lock them for the maximum time period of four years – a long time in the world of crypto.
  • Boost in liquidity incentives: Holding veFXS also gives users a greater share of the protocol’s liquidity incentives if they provide liquidity to eligible liquidity pools. veFXS holders also have the ability to vote on where the protocol’s liquidity incentives go through the gauge system, and this can be valuable because users can vote to direct more incentives towards the liquidity pools that they are participating in.
  • Yield: Holding veFXS entitles users to receive the protocol’s AMO profits in the form of additional FXS. At the moment, 100% of the AMO profits are distributed to veFXS holders. The annual yield works out to an annual percentage rate (APR) of around 8% at the time of writing, but it can range from about 3% to as high as 20% depending on market conditions, as Sam shared on this Bankless podcast.

Valuing FXS

Having gone through the main ways in which Frax Finance is able to accrue value to FXS holders, the next important question for any potential FXS holder is how should one value FXS?

Since Frax Finance is a revenue-generating protocol (primarily through its AMOs), one way is to use the ratio of FXS’ market capitalisation and the protocol’s annualised earnings to get what is essentially the price-to-earnings (PE) ratio for the protocol. This ratio can serve as a rough measure of Frax Finance’s valuation when compared with other revenue-generating entities.

Given the rather significant price movements over the past month following Terra’s collapse, I thought to calculate Frax Finance’s PE ratio before and after that unfortunate incident, using two arbitrary dates: 1 May and 28 May.

On its website, Frax Finance discloses its accrued profits from its AMOssince 8 June 2021. Nevertheless, the annualised figures in the chart above are
On its website, Frax Finance discloses its accrued profits from its AMOssince 8 June 2021. Nevertheless, the annualised figures in the chart above are

Frax Finance’s trailing PE ratio (based on earnings in the past 12 months) is around 18.96 on 1 May 2022 and 11.80 on 28 May 2022. This is actually significantly lower than the trailing PE ratio for the S&P 500 and Nasdaq 100 as reflected below, but bear in mind that this is an apples-to-oranges comparison. In fact, if I were to narrow down the comparison to real-world companies that are most similar to Frax Finance, i.e. traditional banks, the protocol’s valuation is still higher.

28 May 2022 is a Saturday, when stock markets are not open. Hence, Iused the trailing PE ratios as of 27 May 2022 for comparison.
28 May 2022 is a Saturday, when stock markets are not open. Hence, Iused the trailing PE ratios as of 27 May 2022 for comparison.

In any case, comparing against other DeFi protocols will be more instructive, but likewise, the limitation is that each protocol is designed differently and there nothing quite like Frax Finance and its AMOs on the market now. A decent comparison could be with MakerDAO, which is a decentralised autonomous organisation (DAO) managing the DAI stablecoin, and earns revenue from fees paid by users for borrowing DAI. Between May 2021 and April 2022, MakerDAO reported a net protocol income of USD 130.9 million. As of 1 May 2022, its market capitalisation was USD 1.31 billion based on its MKR token, which translated to a trailing PE ratio of around 10.01. As of 28 May 2022, assuming MakerDAO’s profits in the past 12 months remain constant, its trailing PE ratio based on the market capitalisation of MKR then would be around 8.01.

From this, you can see that Frax Finance has a more demanding valuation than MakerDAO. That said, another perspective is that Frax Finance probably has a higher growth potential, given that the partially-collateralised FRAX is more capital-efficient than the over-collateralised DAI. Furthermore, the market capitalisation of FRAX is still only about one-quarter that of DAI – if the supply of FRAX continues to grow, chances are that much more value can further accrue to Frax Finance.

Of course, there are many more ways to assess the valuation of a potential investment, and to do so more rigorously. But my primary aim to use the PE ratios was to simply show that the valuation of Frax Finance is not crazy. FXS could even be considered under-valued when compared against growth stocks, given that the current trailing PE ratio for the Nasdaq 100 is at 25.43. Moreover, unlike many of these companies which are not even profitable in the first place, Frax Finance already has a sustainable source of income through its AMOs that it can further grow as it works to expand the use of FRAX across DeFi.

(4) What is the end-game for Frax Finance?

Ultimately, investing is more than just assessing financial statements and valuations. It is also about making calculated (and optimistic) bets on the future, which often may not have a quantifiable basis. So the most salient question for me when looking at Frax Finance is more than just whether it is fairly-valued today, but whether it has a compelling and achievable long-term vision – an end-game that it can works towards and bring into reality.

Achieving the “holy trinity”

Sam has been clear about Frax Finance’s end-game – to achieve what he calls the “holy trinity” of DeFi, in which a protocol is able to have its own stablecoin, liquidity ecosystem, as well as lending market. This essentially allows the protocol to not only issue its own currency (its stablecoin), but also control the supply and demand of its currency (via its liquidity ecosystem and lending market). This is very much like how actual central banks work, which buy and sell securities on the open market to influence money supply in their respective jurisdictions.

Frax Finance has been building towards this “holy trinity” systematically:

  • Stablecoin: Frax Finance’s core product is its FRAX stablecoin, which has done its job remarkably well – it has never gone off its peg since its launch, even during the recent turmoil caused by Terra’s collapse. The distinctive feature of FRAX is not only that it is partially collateralised and partially algorithmically-stabilised, but that its collateral ratio is also dynamic. This adds what Sam has called “an anti-bank run mechanism” to FRAX, in that if market confidence in FRAX falls for whatever reason, the collateral ratio will increase to help restore confidence in FRAX. All in all, it is clear that a lot of thought has gone into the design of FRAX to ensure that it is fundamentally sound.
  • Liquidity ecosystem: Frax Finance has built a specialised automated market maker (AMM) called Fraxswap. Unlike generalised AMMs or DEXs like Uniswap or Curve, Fraxswap is envisioned to be targeted at DAOs. Its aim is to allow these DAOs to rebalance large amounts of tokens efficiently via a mechanism called the time-weighted average market maker (TWAMM), which breaks a large order into “infinitely many infinitely small sub-orders” to ensure smooth execution over time with minimal price slippage and gas costs. Ultimately, by creating and controlling its own liquidity ecosystem, Frax Finance can expand the reach of FRAX as a source of liquidity for many other assets.
  • Lending market: Frax Finance has also indicated that it is working to build its own lending market called Fraxlend. This would be similar to the Lending AMO, except that instead of minting new FRAX on other lending/borrowing protocols for users to loan, Frax Finance can do this on its own platform, i.e. Fraxlend. In doing so, Frax Finance will be able to better control its own interest rates, which will ensure that it retains significant influence over market demand for FRAX. At the same time, Fraxlend may also signal a shift in FRAX’s model – from being a stablecoin that is only partially backed by collateral, to one that is also backed by credit. This would strengthen the resilience of FRAX, as the portion of FRAX that is algorithmically stabilised by FXS would then also be backed by on-chain loans, reducing the reflexive risk that had brought down UST and LUNA.

Besides working towards the “holy trinity”, it is also worth noting that Frax Finance is building another innovative product – the Frax Price Index (FPI) stablecoin whose value tracks the 12-month Consumer Price Index in the US. In other words, FPI is designed to be an inflation-adjusted stablecoin that can serve as a true store of value. It is meant to track inflation through the yield generated from the FRAX used to mint FPI. As the detailed documentation for FPI is still being worked on, the exact mechanisms by which this yield would be generated is not yet clear.

Nevertheless, if Frax Finance can ensure that FPI is able to generate sustainable yield to track inflation over the long term, it would serve as yet another way to entrench the protocol across various use cases in DeFi: transactions (with FRAX), trading (with Fraxswap), borrowing/lending (with Fraxlend), and capital preservation (with FPI).

Risks

Of course, like virtually all projects in the nascent and largely experimental DeFi space, Frax Finance still faces significant risks. These would include:

  • Smart contract risk. Like other DeFi protocols, Frax Finance is built on smart contracts. Any flaw or loopholes in their code could therefore lead to exploits or hacks, resulting in compromised or stolen assets. While Frax Finance’s smart contracts are not immune to this risk, the fact that they have been audited by third-parties should provide some assurance. That said, as its latest audit report by Trail of Bits in December 2021 stated, “every exchange or sidechain that the protocol interacts with adds to the attack surface”. With Frax Finance linked to many other DeFi protocols through its AMOs, it is also exposed to the smart contract risk of these protocols.
  • Custodial and regulatory risk. The entirety of FRAX’s collateral is currently in one centralised stablecoin, i.e. USDC. This means that if USDC fails, the value of FRAX would be at risk. Likewise, if Centre (the joint venture between Coinbase and Circle to create the USDC stablecoin) is forced by regulators to block Frax Finance from using USDC, FRAX will also be impacted. Nevertheless, Sam has clarified that most of FRAX’s supply lies in smart contracts in other DeFi protocols due to its AMOs; hence, regulators are unable to blacklist FRAX fully unless they blacklist these other protocols that use FRAX. He added that Centre would also have no incentive to allow this to happen, as it would effectively destroy most of USDC’s use cases.
  • Execution risk. Much of Frax Finance’s potential depends on Sam and his team’s ability to continue executing their vision. If anything happens to them or their ability to work on the protocol, there is a chance that the protocol may not live up to its potential. Similarly, like central banks in the real world, the success of Frax Finance will also hinge on sound monetary policy – its AMOs have to work, if not the protocol will not be able to expand the supply of FRAX and accrue value to FXS holders. This will certainly not be easy, given the nascence and volatility of crypto markets as we have seen this year, especially since Terra’s collapse. There will certainly be more headwinds in the future, and Sam and his team will have their work cut out as they steer Frax Finance through these challenges.

At the end of the day, as Sam has acknowledged, Frax Finance is “highly experimental and risky”. There is every chance that the protocol can fail, from the risks stated above and beyond. With that in mind, it is imperative that one should not be going all in on FRAX or FXS. Even if the potential rewards seem attractive, always be sure to diversify your investments. After all, nothing is ever certain in this world.

(5) Concluding thoughts

I was only able to write this essay in fits and starts over the course of more than two months due to my full-time work commitments. During this time, I have witnessed both ends of the hope-fear spectrum regarding Frax Finance:

  • The former occurred when Terra partnered with Frax Finance to launch a new stablecoin liquidity pool on Curve, called the “4pool” comprising of UST, FRAX, USDC and USDT. Given that UST and FRAX were the leading non-collateralised algorithmic stablecoins in the market then, many expected that their partnership would help anchor market confidence in both stablecoins, and push the adoption of algorithmic stablecoins further. If you look at the price of FXS, it spiked significantly when the 4pool was announced in early April.
  • Unfortunately, the latter occurred shortly after. No long after the 4pool launched, UST failed. Its collapse in early May predictably impacted perceptions of FRAX, since both were algorithmic stablecoins. As a result, the price of FXS has fallen significantly since then.
Price of FXS over the past three months as of 28 May 2022 from CoinGecko.
Price of FXS over the past three months as of 28 May 2022 from CoinGecko.

That said, regardless of market sentiments, what I have seen from Sam and his team have been a steadfast commitment to continue building, and to make the protocol as solid as it can be. In fact, Sam has written that he wants “FRAX to be as safe as the best”, and that “just because FRAX is and has been at peg always doesn’t mean we can’t make it better”. As a holder of a small amount of FXS, this growth mindset is reassuring to me.

Protocols that will survive the current bear market will be those that are built to last. From what I can see, Frax Finance fits into this mold. While it is impossible to predict the movement of markets over the short term, I still remain optimistic about the value proposition of DeFi, and Frax Finance’s potential to occupy a strong position in this nascent yet fast-evolving space over the long term. The design of FRAX seems fundamentally sound, and the protocol’s AMOs appear to be well-placed to expand the supply of FRAX and generate revenue for FXS holders sustainably.

My hope is that Sam and his team can continue building on their good work so far, and see through their vision of creating DeFi’s equivalent of a modern central bank – one that will keep on chugging away to make sure that our future on-chain economies remain stable as much as possible, with ample liquidity and sustainable credit facilities.

Disclaimer: Nothing in this essay constitutes financial advice. Please do your own research and be mindful of your own investment objectives before investing into any cryptocurrencies, DeFi protocols or NFTs.

Cover image by Pixabay from Pexels.

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