After last year’s star stablecoin project Terra collapsed rapidly in just a few days, both decentralized and algorithmic stablecoins were hit hard. Against this background, Frax Finance, which also belongs to the stablecoin track, remains stable and continues to build. The ETH liquidity staking function launched in October 2022 has grown rapidly since its launch, and the current TVL has reached US$100 million. What is the trump card of the agreement? Is it an innovative business mechanism, a well-designed token economy or super marketing capabilities? How far can future agreements go? Will it be the next Terra? The following will provide an in-depth analysis of Frax from three aspects: business, economics, and governance.
Business mechanism: the Lego bricks of a central bank
The protocol stablecoin $FRAX adopts a mechanism of part collateral (external assets) + part algorithm (minting and burning of $FXS).
$FRAX: A stablecoin pegged 1:1 to the U.S. dollar: $FXS: The governance token of the protocol and used to absorb the volatility of $FRAX, which is pegged to the U.S. dollar.
When minting new $FRAX, you need to put in both collateral (currently $USDC) and $FXS, and the ratio of these two assets (i.e., the collateral ratio CR) is controlled by the protocol’s algorithm. For example, a collateralization rate of 100% when the protocol was first launched (to prevent the death spiral when stablecoins were first launched) meant that minting $1 of $FRAX required $1 of $USDC. As demand for $FRAX increases and the collateralization ratio is reduced to 90%, then minting $1 of $FRAX requires depositing $0.9 of $USDC and $0.1 of $FXS.
$FRAX combines the best of both collateralized and algorithmic stablecoins. Collateralized stablecoins can maintain a tight link and have high trust, but low capital utilization. Although algorithmic stablecoins can provide high scalability and high capital utilization, they are easily affected by the market and suffer from large fluctuations.
Business Stabilization Mechanism: Arbitrage + Market Force Affects Mortgage Rate
$FRAX Demand Expansion: When market demand for $FRAX rises, pushing the price of $FRAX above $1. Assuming CR = 90%, the arbitrageur would use $0.9$USDC and $0.1$FXS to mint a $FRAX and then sell the $FRAX on the market for a price higher than $1. $0.9$USDC is deposited into the protocol, while $0.1$FXS is destroyed. The price of $FRAX recovered to $1 due to selling pressure in the market. At the same time, due to rising demand, the protocol automatically reduces the system's collateralization ratio, minting $FRAX will require less $USDC and a greater proportion of $FXS.
The demand for $FRAX shrinks: the price of $FRAX is less than $1, arbitrageurs will buy $FRAX at a price less than $1 in the market, and then redeem $1 worth of $USDC+$FXS to the protocol. At CR=85%, arbitrageurs can redeem $0.85$USDC and newly minted $0.15$FXS. Through arbitrage, the price of $FRAX in the market returned to $1. At the same time due to the drop in demand, the protocol automatically increases the collateralization rate, $FRAX will require more $USDC and a smaller proportion of $FXS to mint.
Innovation Module 1 AMOs: Improving Capital Utilization Efficiency
The mechanics mentioned in the previous paragraph are the core stable foundation of Frax v1. With Frax v2, the protocol introduced an important innovative module, AMOs (Algorithmic Market Making Controllers). AMOs are scalable based on v1. Think of it as a smart contract that regulates the supply of $FRAX. In v1, the mechanism of partial collateral + algorithm is considered a basic AMO. In v2, AMOs introduced more methods to regulate the market, including FXS1599, Collateral Investor, Curve AMO, etc. The role of AMOs is to turn the collateral deposited into the protocol into more assets in other DEFI protocols while maintaining the anchoring of $FRAX, earning income for the protocol, strengthening cooperation with other protocols, and integrating with the entire DEFI ecosystem. A closer connection was created. The following takes Curve AMO as an example.
Curve AMO uses Frax3CRV on the Curve protocol to control the supply of $FRAX and provide capital utilization
Curve AMO has three states:
When the market demand for $FRAX increases and the price is >$1, CR will decrease. The AMO will put the portion of $USDC above CR as well as the newly minted $FRAX into the DEFI pool.
When the market demand for $FRAX decreases, CR will increase when the price is <$1. AMO will withdraw part of $FRAX from the DEFI pool and destroy it, as well as withdraw part of $USDC in response to the increase in collateralization rates.
When the $FRAX price is stable, the protocol earns transaction fees for providing liquidity in the Curve pool and reward fees for staking in the Convex pool.
What are the specific rules for the new minting and destruction of $FRAX mentioned in the above state? As traders buy more $FRAX from the pool, the 3crv ($DAI+$USDT+$USDC) ratio in the pool will increase, the $FRAX ratio will decrease, and it will become unstable. At this time, Curve AMO will mint more $FRAX and put it into the pool, making the price of $FRAX stable at $1.
On the contrary, when more 3crv are redeemed, the proportion of $FRAX in the pool increases and the price will be <$1. Curve AMO will take out the previously minted $FRAX for destruction.
Innovation Module 2 Frax Ether: Seize the ETH2.0 Staking Track
First, users need to deposit $ETH on the protocol official website and obtain $frxETH at a ratio of 1:1. This process is irreversible and there are no additional benefits from holding $frxETH. Next, users can have two strategies:
Continue to stake $frxETH and obtain $sfrxETH and ETH2.0 Staking rewards $frxETH;
Combine $ETH and $frxETH to form LP in the Curve pool to provide liquidity and earn transaction fees; and stake LP in the Convex pool to earn staking rewards.
The current average annualized returns for both strategies are around 8%, with Strategy 2’s returns slightly higher. Judging from the ETH pledge amount of the two strategies, they are basically the same, and most users choose strategy 2. The APR indicators of the two strategies require balanced control for the protocol.
Similar to the model of the previous stablecoin $FRAX, $frxETH and $ETH are pegged at a ratio of 1:1. Anchoring is the basis for maintaining market confidence and ensuring continued business growth. The protocol uses the $ETH pledged by users to be the pledge node of ETH2.0 to earn pledge income. At the same time, the $frxETH/$ETH pool deployed on Curve improves capital utilization by regulating the supply of $frxETH, balancing the pool to ensure price anchoring, and earning transaction fees and rewards. (The principle is like Curve AMO adjusting $FRAX).
Innovative module three Frax Swap: TWAMM for efficient execution of large orders
FraxSwap is the first Time Weighted Average Market Maker (TWAMM). It works by decomposing long-term orders into an infinite number of infinitely small orders and executing them step by step in the market according to the embedded algorithm. Such a design can effectively reduce market shocks and provide better liquidity.
The core advantage of TWAMM is its ability to complete the execution of large orders without affecting market prices, which is particularly important for institutional investors and large investors. The launch of FraxSwap adds more application scenarios and revenue sources to the Frax protocol, further consolidating its position in the DEFI ecosystem.
Token economy
The token economy of the Frax protocol is well designed and mainly consists of two tokens: $FRAX and $FXS. $FRAX, as a stable currency, is mainly used for transactions and payments; while $FXS, as a governance token, is used for protocol governance and decision-making.
The value support of $FRAX: The value of $FRAX mainly comes from its stability and liquidity. Through the design of part collateral and part algorithm, $FRAX is able to maintain a 1:1 peg to the US dollar and ensure its price stability through the regulation of arbitrage mechanisms and AMOs.
Value support of $FXS: The value of $FXS comes from its governance function and value capture mechanism. Users holding $FXS can participate in the governance of the protocol and vote on major decisions of the protocol. In addition, $FXS is able to absorb the volatility of $FRAX through the burning mechanism, thereby increasing its own value.
governance mechanism
The governance mechanism of the Frax protocol relies primarily on $FXS holders. All major decisions, including parameter adjustments, introduction of new features, etc., require votes from $FXS holders. This decentralized governance model ensures the transparency and fairness of the agreement.
Governance process: Proposal submission: Any $FXS holder can submit a governance proposal. The content of the proposal can be the adjustment of protocol parameters, the introduction of new features, etc.
Discussion and voting: After the proposal is submitted, it will enter the discussion stage, and all $FXS holders can discuss the proposal and make suggestions and opinions. After the discussion, the voting phase begins, where $FXS holders can vote based on their opinions.
Execution: After the voting, if the proposal is passed, it will enter the execution stage, and the agreement will be adjusted and updated accordingly according to the content of the proposal.
in conclusion
As an innovative decentralized stablecoin protocol, Frax Finance has successfully occupied a place in the stablecoin track through its unique business mechanism, sophisticated token economic design and decentralized governance mechanism. Whether it is its partial collateral + partial algorithm stability mechanism or its innovative AMOs and FraxSwap, it has demonstrated its strong technical strength and market adaptability. In the future, with the further development of the DEFI ecosystem, the Frax protocol is expected to play an important role in more application scenarios and become an important member of the stablecoin market.