MakerDAO created one of the first and arguably the most successful stablecoin, DAI (which is pegged to the USD 1:1). Maker’s DAI launched in 2017 and has been used throughout the DeFi ecosystem for lending, borrowing, and treasury reserves. DAI is created when collateral is placed into the Maker smart contract. To add a layer of stability, Maker requires that DAI is overcollateralized, but this also makes their stablecoin more capital inefficient. DAI, USDT, and USDC became some of the more prevalent stablecoins in the DeFi landscape throughout 2018-2020 as users and protocols leveraged these stablecoins to earn yield and expand their digital product offerings to users. USDC has inherent centralization risks since it’s reliant upon the USD and Maker’s DAI is heavily collateralized by USDC. Regardless, Maker’s DAI and usage attracted the attention of others in the industry as to the necessity and growth potential of stablecoins in the web3 ecosystem.
Until FRAX launched on Ethereum mainnet on 21 December 2020, stablecoins had either been fully backed by collateral (e.g. DAI) or entirely algorithmic (no collateral backing). Frax Finance was first announced in May 2019 (known then as Decentral Bank) as a fractional-algorithmic stablecoin protocol. The project was founded by Sam Kazemian, Jason Huan, and Travis Moore. Frax was created to be the “world’s first decentralized stablecoin with parts of its supply collateralized and parts algorithmic stabilized.”
Frax is the first stablecoin protocol to implement design principles from both fully collateralized (e.g. Maker Protocol) and fully algorithmic stablecoins to create a new scalable, trustless, stable on-chain money (FRAX Docs). FRAX is pegged 1:1 to USD, which means it attempts to maintain 1 FRAX = 1 USD$.
The growth of FRAX has been impressive with massive adoption and system-wide traction occurring in Q4 2021 with the launch of Frax v2. As of January 25, the Frax treasury is earning an average of ~$500K income daily (~$180M annualized) through the AMOs, Algorithmic Market Operations Controllers, which the team launched in early Q4 2021. Additionally, the FRAX supply has climbed from under $500M FRAX to an incredible $2.6B FRAX in this same time period.
Understanding Frax Protocol
At genesis, FRAX was 100% collateralized, meaning that minting FRAX only requires placing collateral into the minting contract. Today, Frax is operating in the fractional collateral phase, which means to mint FRAX requires placing the appropriate collateral and FXS into the Frax protocol. While the protocol is designed to accept any type of cryptocurrency as collateral, Frax will mainly accept on-chain stablecoins to keep volatility low so that FRAX can transition to higher algorithmic ratios smoothly. As FRAX gains traction and the system’s velocity increases, it could become easier and safer to include more volatile cryptocurrencies such as ETH and wrapped BTC into future pools.
The Frax protocol implements a two token system design: a stablecoin, FRAX, and a governance token, FXS. The two token system allows for FRAX to be backed by both collateral and an algorithm (burning and redeeming of FXS). FRAX is minted when collateral and FXS are deposited into the Frax protocol contract. The amount of collateral needed to be deposited to mint 1 FRAX is determined by the collateralization ratio. The Frax collateralization ratio determines the ratio between collateral and algorithm that makes up the $1 FRAX value.
For example, let’s assume the collateralization ratio is 80%. This means that 80% of 1 FRAX is backed by collateral, like USDC, and 20% is backed by the algorithm that manages FXS supply. For both minting and redemption purposes, the protocol obeys the collateralization ratio, guaranteeing that 1 FRAX is backed by $1 of value.
Peg stability is a crucial component for any stablecoin. FRAX maintains its USD 1:1 peg through deep liquidity pools. One such pool, also the largest liquidity pool, is on Curve Finance in FRAX3CRV. As of writing, the FRAX3CRV pool holds approximately 1.3B FRAX and this deep FRAX liquidity enables FRAX to be traded and swapped for other stablecoins with low or no slippage. The Curve AMO, implemented as part of Frax v2, furthers the stability of FRAX by automatically supplying excess collateral plus FRAX from the Frax protocol to the FRAX3CRV pool to ensure this deep liquidity remains (more on this below in the AMO section).
The price of FRAX, FXS, and collateral are calculated using a time-weighted average of the Uniswap pair price and the ETH:USD Chainlink oracle. The Chainlink oracle allows the protocol to get the true price of USD instead of an average of stablecoin pools on Uniswap. This allows FRAX to stay stable against the dollar itself which would provide greater resiliency instead of using a weighted average of existing stablecoins only.
Frax is an agnostic protocol and allows the market to determine the collateralization ratio that it will settle on long term. The Frax protocol does not make any assumptions about what collateralization ratio the market will tolerate. Instead, Frax allows for the ratio to fluctuate and the market determines what collateral ratio the market prices FRAX at $1.
Tokenomics and Value Accrual
The FXS supply has been initially set to 100 million tokens at genesis. As more FRAX is used in DeFi ecosystems, this drives value to the FXS holders because minting FRAX requires burning FXS (thus decreasing FXS supply, and increasing value to FXS holders). As the value of FXS goes up, the price stability of FRAX increases creating a positive feedback loop for all those who are lending or borrowing FRAX to do DeFi or other digital economic transactions.
Frax Finance also allows investors to become liquidity providers by bonding FRAX/FXS or FXS/ETH on Uniswap, which generates fee revenue for the liquidity providers on trades and swaps.
The protocol has also implemented the vote escrowed (ve) governance token model. This model is generally analogous to the well known veCRV framework, with slight variations for the Frax protocol (more on this below). In addition, Frax has developed a unique protocol feature called algorithmic market operations modules, or AMO. These are discussed in further detail below, but this mechanism further drives value back to holders of FXS.
Performance upgrades: veFXS and Frax v2 AMOs
veFXS and cvxFXS
Shortly after the project launched in 2020, FXS holders were allowed to lock up their FXS tokens to generate veFXS (voting escrow FXS) and earn special boost, governance rights, and AMO (Algorithmic Market Operations Controller) profits. The vote escrow, or “ve”, mechanism has been popular across several DeFi protocols. FXS holders are eligible to lockup their FXS tokens for up to four years. The longer the FXS tokens are locked, the more bonuses awarded to the veFXS holders. It should be noted that the veFXS tokens are non-transferable.
Additionally, veFXS holders are also able to participate in Frax gauges and influencing or directing FXS to different FRAX gauges – a similar mechanism that was established by the Curve protocol and it’s gauge system. veFXS holders are eligible to direct FXS to one or multiple Frax gauges of their choosing. Once all of the FXS has been emitted, the gauges will turn to managing FRAX stablecoin expansion to continue to reward liquidity providers.
Recently, Convex has partnered with Frax protocol to further align the two protocols’ incentive programs, specifically around locking veFXS into the CVX protocol. Before diving into this partnership, it’s important to understand Convex’ place in the DeFi ecosystem.
Convex was launched in May 2021 as a platform intended to boost CRV rewards and simplify staking CRV for liquidity providers and stakers by creating an access point to CRV benefits through its native CVX token. Thus, as soon as Convex was launched it began actively acquiring the CRV and veCRV tokens. By early summer 2021, it became the largest holder of veCRV tokens in what’s been dubbed the Curve Wars. Curve Finance rewards liquidity providers with CRV tokens, which allows governance rights on which protocols’ pools are funded with CRV rewards and fee sharing. By the end of 2021, Convex Finance has solidified its lead role as the main shareholder of Curve governance.
With Convex as the main holder of veCRV tokens, DeFi protocols have begun to acquire and partner with Convex as a way to access the governance rights and benefits allocated to veCRV holders (recall veCRV holders dictate which Curve pools are rewarded with CRV emissions every 10 days).
Back to Frax and Convex. Frax holds 19% of CVX giving them substantial governance power in the Convex protocol, which can be thought of as a proxy for veCRV governance power and directing future CRV rewards.
The Frax and Convex partnership comes with added benefits to the veFXS holders. veFXS holders are able to lock their veCVX into the Convex protocol in return for cvxFXS. This deposited veFXS will be irreversible and locked forever. All cvxFXS holders will be rewarded with a future FPI (Frax Price Index) token airdrop. In the future, cvxFXS/FXS bonding pair will be created so that protocols and users may exit their cvxFXS position. As of writing, cvxFXS staking and rewards are still being developed and are not finalized yet.
Frax v2: AMOs
Frax v2 launched the algorithmic market operations modules, or AMO. An AMO creates smoother operations for Frax by automating the movement of FRAX and its collateral across the DeFi ecosystem. The Frax AMOs further enable FRAX growth by leveraging Frax’s assets in a capital efficient way by programmatically moving collateral and/or FRAX to capital efficient locations depending on the collateral ratio. Frax has implemented several key AMOs: FXS 1559, Collateral Investor, Curve AMO, Uniswap v3, and FRAX lending.
FXS1559 is an in-protocol rule that all AMOs must utilize. FXS1559 calculates all excess value in the Frax system above the collateral ratio and uses this value to buy FXS for burning. Until October 2021, FXS1559 stated that 50% of value would be used to buy then burn FXS (creating value for FXS holders by decreasing supply) and 50% was given directly to veFXS holders. In October 2021, Frax passed a proposal to give 100% of AMO revenues and profits to veFXS holders. This change further incentives FXS holders to lock their FXS in the Frax protocol as veFXS rather than hold FXS.
The Collateral Investor AMO puts idle USDC collateral from the Frax treasury to work across several DeFi protocols such as Aave, Compound, and Yearn. This AMO will loan out or reclaim collateral automatically as the collateral ratio changes. As the collateral ratio lowers and more of FRAX is backed algorithmically, the Collateral Investor AMO will automatically send collateral to the aforementioned protocols to generate additional yield on its USDC for veFXS holders. If the collateral ratio rises and more collateral is required to back FRAX, the Collateral Investor AMO will work in reverse and pull collateral back to the Frax treasury in accordance with the collateral ratio that the market deems necessary to keep confidence in Frax. Since implementation, the Collateral Investor has accrued $63.4M profits for veFXS holders.
The Curve AMO moves idle USDC collateral and/or new FRAX to the FRAX3CRV Curvel pool to create more liquidity and tighten the FRAX peg. The FRAX3CRV pool will earn Curve trading fees, CRV, and other LP rewards (by loaning out the CRV LPs to Yearn, StakeDAO, and Convex). The trading fees and LP rewards will be used to reward veFXS holders, while the CRV rewards will be used to boost the FRAX3CRV pool rewards. Similar to the Collateral Investor AMO, as the collateral ratio changes, FRAX then USDC will be added (collateral ratio lowers) or removed (collateral ratio rises) from the FRAX3CRV pool to make sure that FRAX is appropriately backed by the right percentage of collateral within the FRAX treasury.
The Uniswap v3 AMO (or Liquidity AMO) puts FRAX and idle collateral to work by providing liquidity Uniswap v3. This provides liquidity for other stablecoins to be traded and swapped for FRAX. Since the AMO is able enter any position on Uniswap v3 and mint FRAX against it, the Uniswap v3 AMO allows for expansion to other stablecoins and later more volatile collateral that is on Uniswap v3. The trading fees generated from the liquidity provided are brought back to reward veFXS holders. As with the other AMOs, as the collateral ratio changes, FRAX and collateral can be added or withdrawn from it’s LP position on Uniswap v3.
The FRAX Lending AMO allows for FRAX to be minted into money markets such as Aave to allow anyone to borrow FRAX by paying interest instead of the base minting mechanism. The collateral provided in these protocols treasuries would back the FRAX minted. The mechanism used here is very similar to Maker’s D3M feature, where DAI supply is expanded/contracted from a lending market based on the current borrowing demand. This AMO creates risk as FRAX is backed by collateral held by other protocols, but the protocol is able to moderate this risk by controlling the amount allowed to be minted directly into money markets.
Of these AMOs, Collateral Investor AMO brings in the majority of the profits for Frax Finance. As seen in the graph below, the Collateral Investor has accrued profits worth ~$75M since being implemented in October 2021.
Currently, there are other AMOs in the works, such as Collateral Hedge and a Tornado Cash integration. These too will follow the same principles that all AMOs comply with. AMOs will likely continue to be proposed and implemented as FRAX is expanded and leveraged as a stablecoin in more DeFi protocols.
Market Overview
Frax Finance operates in the stablecoin market, which has largely been dominated by fiat-backed stablecoins such as USDC and USDT. Algorithmic flavors of stablecoins have recently seen tremendous growth, specifically FRAX whose market cap has grown nearly 530% since October 2021. This trend will likely continue as the wider ecosystem seeks liquidity to match its overall growth, and algorithmic stablecoins such as FRAX can leverage their capital efficient AMOs to fill this gap.
However, FRAX is not the only algorithmic stablecoin seeking to expand it’s supply in the ecosystem and DeFi space. Stablecoins like FEI and UST have both seen rapid growth as of late, with UST hovering around $10.6B in market cap and FEI seeing ~50% growth in its market cap over the past quarter (Q4 2021). Developments and growth are happening at a breakneck pace in stablecoins. One example would be the Fei and Rari protocols merger. With this merger, Fei will look to capitalize on integrating its stablecoin FEI further into DeFi by leveraging Rari’s lending markets.
It’s unlikely the market has reached a state of winner-take-all dynamics regarding algorithmic stablecoins. Frax and other similar stablecoin protocols will likely continue to grow together as the overall stablecoin market and DeFi products grow. From a systemic perspective, FRAX has done a remarkable job holding its peg, and exhibiting the powerful efficiencies of an algorithmic stablecoin. Now that supply has grown and deep FRAX liquidity exists, it would seemingly require a catastrophic (ecosystem-wide) event to destabilize it. This risk exists for FRAX as well as the other, robust stablecoins.
Roadmap and other partnerships
The multichain universe
Frax is built to be interoperable across all chains. There is not an independent Frax implementation for each chain. For this reason, the protocol has a bridging system that allows it to maintain a tight peg and fungibility. Importantly, the AMO functions and FRAX gauges can be deployed across different chains, allowing for FRAX expansion into new and growing markets and chains.
As stated by the Frax team: “The Frax Protocol is a multichain protocol with global state consistent across all deployments. FRAX + FXS tokens are a single distribution across all networks.” Each blockchain has one canonical FRAX and one canonical FXS contract that are referred to as “FRAX” and “FXS”. These tokens are what AMOs expand or contract and users can mint or redeem.
FPI: Frax Price Index token
On 1 January 2022, Sam tweeted that the Frax team has been and is working on the Frax Price Index ($FPI). This would enable decentralized applications to reference $FPI as an algostable peg. Not much has been said or revealed yet, however, cvxFXS holders will be rewarded a FPI airdrop.
Other recent partnerships: OlympusDAO & Ondo Finance
There have been other partnerships, such as a token swap between OlympusDAO and Frax Finance (OHM FRAX) to “further incentivize team] collaboration.” The OlympusDAO team has been actively building a treasury filled with DeFi tokens and stablecoins, which can be bonded to their OHM token. This has allowed OlympusDAO to create an entire marketplace for [protocol owned liquidity.
Another recent partnership is between Ondo Finance and Frax Finance. This partnership aims to create a product that Ondo will market and sell called “Frax-as-a-Service” or FaaS. The idea is that a new protocol will be able to deposit their native token into an Ondo vault and Frax and Ondo will match the protocol’s deposited amount with equal amounts of FRAX, creating a liquidity pair. This enables the protocol to immediately have liquidity for their token for users and protocols to onboard and offboard without needing to set up liquidity mining programs. As a participating party, Frax Finance will receive 5% APR on the liquidity it provides.
Conclusion
Frax allows for the market to determine the collateralization ratio that it is comfortable with for $1 FRAX. As demand for FRAX increases, the veFXS holders will benefit as rewards and profits from the AMOs implemented to leverage idle collateral. While there are risks with FRAX and any token within the web3 finance space to consider, the Frax protocol experiment, a fractional-algorithmic stablecoin, has proven incredibly exciting and innovative.
Having multiple stablecoins (DAI, FRAX, MIM, UST, etc.) with different designs is a value-add to the crypto and web3 ecosystem as it derisks the blockchain ecosystems. FRAX and FXS are built with a long-term mindset and vision to have FRAX integrating into critical DeFi protocols. The novel fractional-algorithmic stablecoin design of FRAX allows for capital efficient stablecoin creation and allocation, and as the overall market continues expansion, FRAX should be well positioned to further this growth.
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