Stable-Stablecoins From DeFi’s Decentralized Bank: FXS Alpha Report* - by Søren

Chains: Ethereum, Arbitrum (11 Others)

Launch: May 2019

Category: Stablecoin, DEX (spot), Money Market, Liquid Staking Derivates, Bridge

Overview

Centralized stablecoin issuers and exchanges have recently found themselves in hot water. Their highly profitable business strategy of opaquely distributing yield has landed some in the crosshairs of the Securities and Exchange Commission. BUSD issuance will cease from PAXOS. Paypal halted their stablecoin project. Kraken's staking service is being shutdown. Coinbase is already posturing about a potential court fight. The list will most likely grow.

Centralized institutions are willing to take on this regulatory risk because stablecoins are a potential trillion dollar industry. Tether secured $700 million in net profit during Q4 of 2022 alone. Defi is, in part, about creating financial primitives in a decentralized, non-custodial manner, that allow users - rather than centralized intermediaries - to profit in the process. Circle, Tether, Kraken, Coinbase, and other centralized stablecoin issuers, exchanges, and staking providers, are generally not working towards that decentralized, disintermediated goal. Using low risk, highly liquid investment vehicles, centralized or fiat-backed stablecoin issuers can make 2 -4% APR off their total circulating supply. The profits go to the shareholders (i.e., suits) rather than token users (i.e., retail).

Humble yield farmers and degens alike can get a cut of the profits which accompany the stablecoin and liquid staking business, without becoming entangled with direct exposure to what the SEC potential views as a security.

The Frax team created a suite of censorship resistant, highly liquid, stable-stablecoin products. Even amidst the ongoing stablecoin FUD, their infrastructure creates a flywheel designed to allow FXS (and FPIS) holders to profit from the stablecoin, lending, and liquidity/exchange businesses. This alpha report attempts to provide an overview of the unified, albeit dense, system the Frax team has created, as well as information about their future plans (aka, alpha).

Stablecoins:

• FRAX: Pegged to USD, $1.024 Billion Total Supply

• frxETH: Pegged to ETH, $143.4 Million TVL

• FPI: Pegged to CPI (Consumer Price Index), $87.1 Million Total Supply

Governance:

• FXS: Algorithmic collateral for FRAX (veFXS receives a portion of fees), $792.6 Million Circulating Supply

• FPIS: Algorithmic collateral for FPI, $26.6 Million Circulating Supply

Infrastructure:

• AMOs (Algorithmic Market Operations): Help FRAX keep peg and accrue value for FXS/veFXS holders (more on this later).

• Fraxswap : AMM (with concentrated liquidity on the horizon), $173.04 Million TVL

• Fraxlend: Money Market, $223.01 Million TVL

• Frax Ferry : Bridge for FXS, frxETH, FRAX, sfrxETH from mainnet to L2s (it’s a ferry cause it goes “under” bridges)

• AladdinDAO’s Autocompounder for FXS and frxETH (not built by Frax team)

In Dev:

• frxBTC: Pegged to BTC, would use FraxFerry

• Fed Master Account: Only the Best RWA

• FRAX on Cosmos

• Fraxchain

• veFPIS

• Borrow AMM (BAMM) – Oracle-free mechanism to allow users to borrow FRAX using long-tail (low liquidity) assets.

The DeFi Trinity: Lending, Stablecoins, and Liquidity

A holy trinity.

The basic ingredients for DeFi are swapping, borrowing, and/or holding a token spot while knowing it will keep its pegged value. Money markets, AMMs/DEXes, and stablecoins of various flavors/spot holdings are the necessary ingredients for a DeFi ecosystem. When looking at how dapps have evolved overtime, as Sam Kazemian pointed out in a recent Empire Podcast episode, a pattern of “financial natural selection” towards building out these 3 primitives emerges. The Frax team shipped these def primitives, in-house, before the conclusion of 2022, to support their growing ecosystem of stable-stablecoins and generate profits for FXS/FPIS holders. As developing these in house is a profitable strategy, note how other dapps are doing the same.

The same table can be drawn for centralized exchanges

Structure of FRAX v1: The OG AMO

FRAX is a fractional-algorithmic stablecoin. FXS is the governance token which also earns yield when staked as veFXS. In FRAX v1, USDC was the only collateral. Rumor even has it that FRAX was memeified as wrapped USDC. Given how USDC and FXS are the only collateral for FRAX, it is easy to see how this reputation propagated.

The collateral ratio (CR) is the percentage of FRAX that has FXS as collateral. In Frax V1 the fractional-algorithmic stability mechanism ran like this:

• When FRAX is above $1, the collateral ratio was lowered, as demand exceeded supply (supply expansion, aka, print FRAX or incentivize people to mint it to bring down the peg).

• When FRAX is below $1, the collateral ratio was raised to increase market confidence as supply exceeded demand (supply contraction, aka, buy-back FRAX or incentivize people to utilize supply sinks to bring up the peg).

With this model FRAX had a single mechanism to keep peg which relied heavily on USDC. It is hard to build a suite of stable-stablecoins and be the decentralized bank of DeFi using a black-listable, fiat-backed asset as your foundation. In part, addressing these concerns gave rise to Frax’s Algorithmic Market Operations (aka AMOs), which launched in April 2021.

Frax v2: AMOs and FXS/EIP1559 -- Ultrasound FXS

At their foundation, AMOs:

• Help FRAX keep peg through supplying and removing FRAX and other protocol owned liquidity in certain markets.

• Further insulate FRAX from centralization/blacklist risks by distributing USDC collateral across the DeFi ecosystem.

• Capture value for FXS holders through their operations.

AMOs consist of 4 basic operations (the basic building blocks of FRAX v1):

• Decollateralize: If FRAX is above $1, do an action that lowers the collateral ratio.

• Market Operation: Make yield when FRAX is at peg.

• Recollateralize: If FRAX is below $1, do an action that raises the collateral ratio.

• FXS1559: Return excess profits to veFXS contract.

These basic operations can be applied to "any arbitrarily complex market operation to create a Turing-complete design space of stability mechanisms" Frax on AMOs. In words that may register for those with smooth-brains, those are building blocks which can be applied to certain markets to move around USDC and FRAX owned by the protocol, to the benefit of FXS and FRAX holders.

The current AMOs for FRAX are:

• Investor ($179 Million): Idle collateral/protocol owned liquidity is used to generate yield across whitelisted protocols.

• Curve ($712 Million): Deploys FRAX and USDC to its own Curve pool to control the peg and earn yield.

• Liquidity ($80 Million): Puts FRAX and collateral to work by providing liquidity to other stablecoins against FRAX on UNI V3, Fraxswap, and other AMMs/DEXs.

• Lending ($71 Million): Adds Frax to whitelisted Money Markets.

It is not a coincidence that EIP1559 (what made ETH ultra-sound money) and FXS1559 share the same numbers. Similar to ETH, FXS became an interest bearing asset by distributing profits from AMOs to the veFXS contract.

frxETH, sfrxETH, and FIP - 182

FrxETH is an ETH stablecoin. Think of it as a better version of wETH. It is not a LSD.

sfrxETH is an ERC-4626 token that earns yield from the ETH sent to validators upon frxETH being minted.

Let that sink in, because it is innovative insofar as LSDs, and actually sets up frxETH to be a reasonable competitor to wETH.

FRAX’s conquests in the CRV wars allow them to direct liquidity in the CRV ecosystem (as well as create the FRAX-BP). 90% of ETH minted into frxETH is staked with validators, thereby giving frxETH the best risk free rate of return available on ETH. The remaining 10% is sent to the frxETH-ETH Curve AMO, as @wavey0x learned rather publicly.

How does this relate to wETH you ask? How could the flywheel turn even faster?

When withdrawals open after Shanghai, due to EIP improvements implemented in frxETH, the potential for an frxETH/ETH Base Pool on Curve with deep liquidity, and how frxETH is always backed 1:1 by ETH, frxETH could obtain deep market share across mainnet and L2s as a replacement/substitute to wETH. This is the long term goal of FIP - 182 – frxETHBP and WETHR Progam.

frxETH and sfrxETH have also seen recent governance proposals in other dapps to increase adoption:

• In early February, adding frxETH as collateral on Aave was proposed by Marc Zeller.

• Gearbox is proposing a CRV/Convex frxETH Strategy.

EigenLayer and frxETH

The FRAX team seems to be pursuing new ERC-4262 vaults for depositors that want to participate in EigenLayer validators. This would increase the yield for sfrxETH depositors in those vaults. EigenLayer allows validators to opt in to allow other dapps to use their staked ETH for additional services. Staked Eth is rehypothicated to bootstrap other services without the need of their own native token.  (https://flywheeloutput.com/p/eigenlayer-and-frax-the-next-generation)

FXS Emissions and the $18 Million Buy-Back

The total supply of FXS is 99.8 Million, and out of that, 76.6 Million is already in circulation. In June 2022, the team proposed and the community passed FIP-77, which allocates 20 million FRAX to buy back FXS. This was driven by a variety of factors, but one that stands out – FRAX made over $80 million in annual revenue, and if 20 million FRAX is used in an FXS buy back at $4, that would in effect be a 5% burn of the total supply. Keep in mind that the proposal explicitly states this metric. Look at a chart – there is strong support for FXS at/around this price level. Two million of the FRAX has already been used.

Federal Master Account

The Frax team wants to be the best risk free rate of return in DeFi. In their own terms, they strive to be DeFi's (non-Orwellian) Decentralized Bank (Empire Podcast). When you apply the logic of trying to find the best risk free rate of return to real work assets -- a loan to a business may yield interest and they exist in the real world, but it is not risk free. The only free lunch from the land of US Dollars is a Federal Master Account, similar to how the best risk free rate of return on ETH is with validators. As a stablecoin pegged to the USD dollar, the Frax team is taking a, “if you can’t beat them, at least earn their risk free yield” approach, as they are pursuing an account at the Federal Reserve bank (which at the time of writing yields over 4% APR).

Is it ambitious? Incredibly so. Potentially achievable? Given how recent stablecoin legislation in congress at least included a potential pathway for stablecoin issuers to get a FMA, maybe? For context, Custodia Bank, a crypto focused bank, was recently denied a Fed Master Account.

Other Products: FraxFerry, FraxSwap, and FPI/FPIS

All FRAX products are built to either increase the value accrual value for FXS/FPIS holders and/or increase the strength of their stablecoins peg.

• Fraxswap: Most of the liquidity sits on Mainnet. This is a TWAP Machine built for retail use and for DAOs. As stated earlier, concentrated liquidity is on the product’s roadmap.

• FraxFerry: 1 day transfer period prevents hacks as “the risks to peg far outweigh any benefits of immediate liquidity” (More information here). Peg is always maintained 1:1. sfrxETH and frxETH has already been bridged to L2s.

• FPI/FPIS: Inflation is a hassle. So is chasing yield. FPI is a stablecoin pegged to “the CPI-U average”. FPIS is the equivalent of FXS. A chainlink oracle is used to relay the unadjusted 12 month inflation rate on-chain.

frxBTC

FraxFerry can be built to bridge BTC to Ethereum. The FRAX team would run a BTC full node and “code a special purpose ferry that is basically a BTC SPV client… it isn’t trivial, but it isn’t insanely hard”. Recent chatter on telegram suggests it could be released in Q2 Q2023. From a value capture perspective, this would create an additional source of revenue through the minting and unminting process and the associated Fraxlend AMO (https://flywheeloutput.com/p/frxbtc-everything-we-know-so-far).

Frax on Cosmos

With Fraxferry there can be native FRAX on Cosmos. A purpose of Fraxferry is to ensure all FRAX deployed from the protocol is backed 1:1. They are open to the idea of building IPC compatibility, proving that although they appear to adore Ethereum mainnet, they are not overzealous maxis. Sam Kazemian telegram

AlladinDAO: Concentrator, CLever, and Autocompounders for FXS and frxETH

Concentrator builds autocoumpounders for Curve LP tokens and liquid yield tokens (aTokens). The protocol takes a 10% cut of the yield and distributes the fees 50/50 between the Concentrator treasury and CTR token holders. A vault for frxETH-ETH is built, as well as one for FXS.

CLever boots the earning power of convex through leveraged yield farming and automating yield harvesting. If you are a convex fan I recommend reading this thread by @winterSoldierxz.

FraxChain

The more value accrual for FXS/FPIS and supply sinks for the various stablecoins the  merrier. Fraxchain, especially if it utilized zkP/zkR technology, would be a potential bullish price catalyst. There has been discussions in early Q4 2022 that Fraxchain could be a hybrid rollup, meaning data availability would be present on ETH mainnet and an FXS validator.

Conclusions

Year-to-date FXS is up ~150%. Recent lows hover around $4 and since 01/19/2023 FXS now trades within a range between ~$9 to $13. The FRAX team ships but outside of the flywheel substack and podcast, twitter, telegram, and occasional podcast appearances by notable team members, their marketing infrastructure is not as strong as other tokens in the top 100 by market cap. This creates information asymmetry. Recent stablecoin FUD creates product market fit. None of this is financial or tax advice. Before aping or shorting, consider the following about FXS:

• 41% of FXS is locked as veFXS.

• Team and Investors received 35% of all FXS – the first private round was done in August of 2020, and the vast majority has now been vested (https://dune.com/queries/1087464/1862482).

• Each new product creates opportunities for value accrual to FXS holders.

• A goal in 2023 is to make the collateral ratio 100% for FRAX, which is allows FXS to have the same value proposition it does now – quick explainer.