Frax Finance In-depth Report Eco-Status, FraxChain, and Future Potential

Comprehensive Analysis of Frax Finance Environmental Sustainability, FraxChain Advancements, and Promising Prospects

TL;DR

1. This report serves as an initial analysis of Frax Finance, providing an overview of its current ecosystem, describing its product suite, and exploring its future potential.

2. In the last bull market, $FXS outperformed Bitcoin due to key events such as exchange listings, halvings, and airdrops, although it did not reflect price surges like leading liquidity staking derivatives tokens such as $LDO and $RPL, as frxETH was issued later. Meanwhile, $FRAX has shown strong resilience in the face of market volatility, mainly thanks to its advanced AMO strategy and robust $FXS staking.

3. Frax Finance is rolling out a series of major upgrades in line with major DeFi trends: FRAX V3 aims to strengthen its stablecoin mechanism and reduce dependence on $USDC; FinresPBC will enter real-world assets through Fraxbond (FXB); frxETH V2 focuses on decentralization and yield optimization; the upcoming EVM-compatible Layer 2 solution FraxChain aims to enhance scalability and security, providing potential growth opportunities for the protocol and $FXS.

4. Driven by a focused team and innovative mechanisms, Frax Finance is evolving into a comprehensive DeFi ecosystem with strong synergies, and upcoming developments such as FRAX V3, frxETH V2, and FraxChain are expected to greatly boost its growth and create value for $FXS token holders.

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1. Background

Frax Finance, although one of the OG DeFi protocols, has always been a complex protocol for many newcomers. Due to its diverse product line and complex mechanisms, the initial exposure might be intimidating. However, it is a protocol that everyone should be aware of, as it is one of the most innovative protocols and has gained attention through its proactive sectoral expansion. This report will serve as a beginner’s guide to Frax Finance, reviewing its current state, introducing its products, and examining its potential. As a beginner, not all aspects of the protocol are covered in this report, but its purpose is to help readers quickly have a basic understanding of the protocol and the future direction of Frax. Readers are encouraged to conduct thorough due diligence to fully understand the protocol and its related risks.

2. Introduction

Frax Finance was launched in May 2019 as an algorithmic stablecoin protocol and has since evolved into today’s complex DeFi tech stack. Frax Finance now operates multiple business verticals, including three types of stablecoins, and is supported by three major infrastructures. Frax’s operations cover multiple sectors, including stablecoins, DEX, money market, liquidity staking, with RWA also on the horizon. Therefore, Frax is one of the most innovative protocols in the DeFi space, but also one of the most complex.

3. Performance Overview

Comparing token prices to $BTC is a useful way to see how tokens perform in the crypto market, as $BTC is often seen as the beta of the market. Additionally, increased key events allow us to gauge how the market perceives a protocol. If positive news does not result in any significant price movement, it may indicate a shift in market attention, making it a less attractive investment target.

From the chart, we can see that during the previous bull market, $FXS followed the overall market and experienced a decent price increase. Then, from December 2021 to March 2022, $FXS outperformed $BTC and experienced two significant price increases. These increases may be attributed to several positive events during that period, including the Binance listing on 12/10, $FXS halving on 12/20, $FPI airdrop announcement on 2/19, and FTX listing on 3/24. Afterward, $FXS followed the overall market without any significant divergence. Recently, despite Frax team’s release of news about future plans, the reaction to $FXS has not been the same as before. This may be due to the bearish sentiment prevalent in the current market, and further observation is needed when those catalysts actually materialize.

Compared to the two leading LSD narrative tokens, $LDO and $RPL, we can see that $FXS didn’t experience the same price increases as the other two during the Merge approaching, as it entered this field relatively late. However, it did experience a pump during the Shanghai Upgrade. With frxETH v2 about to launch, the performance of $FXS compared to $LDO and $RPL will be interesting to observe.

As an algorithmic stablecoin, $FRAX has maintained a strong peg for an extended period. During the LUNA-UST crash, $FRAX remained within a tight peg range. While there were occasional slight deviations, there were always quick rebounds to prevent further ruptures. The most significant deviation occurred when Circle disclosed its risk exposure to SVB. As $FRAX is primarily backed by $USDC, it was affected. However, considering the small risk exposure, the peg quickly normalized. The stability of $FRAX can largely be attributed to the protocol’s complex AMO strategy and the high lock-up rate of $FXS, which protects Frax from the death spiral that other algorithmic stablecoins may experience.

Despite the crash of LUNA-UST not breaking Frax’s anchor, this event still triggered a massive outflow of liquidity, causing a sharp decline in the market value of stablecoins, especially decentralized stablecoins like $DAI and $FRAX. The subsequent SVB event further reduced the market share of $USDC, with liquidity shifting towards $USDT, which we have seen is the only stablecoin that has seen continuous market value growth since 2023.

Two other key performance indicators for Frax are stablecoin market share and LSD market share. Although $FRAX is the second largest decentralized stablecoin, its market share is only 0.5%, which is 8.8 times less than $DAI and 136 times less than $USDT. This gap is caused by various factors. The most important is that centralized stablecoins serve as the key entry point for new crypto users, as new users primarily use CEX initially. The huge liquidity gap and adoption rate also contribute to this significant difference. Unless there are major factors that drive users away from centralized stablecoins, this gap is likely to persist for a considerable period of time.

In terms of LSD market share, Frax is performing well. Apart from Lido, the difference in market share between sfrxETH and the other three major LSDs is minimal. The main reasons for this are its higher yield and the regulatory pressure faced by CEX. With the arrival of frxETH V2, it is expected that Frax’s growth in the LSD field will continue to surpass its growth in the stablecoin field.

4. Protocol Mechanism

Frax Finance is one of the most complex protocols in the DeFi space. Its expanding product line and business divisions essentially give the protocol its own ecosystem consisting of various stablecoins and DeFi infrastructure that supports stablecoin growth. In this report, we classify the three stablecoins issued by Frax as flagship products and consider the support mechanisms as core infrastructure. The concepts and importance of each stablecoin are presented, as well as how these infrastructures contribute to business operations.

4.1 Flagship Products

4.1.1 Frax

FRAX is the first USD-pegged stablecoin issued by Frax. Unlike the largest decentralized stablecoin, DAI, which is overcollateralized, Frax is an algorithmic stablecoin partially backed by USDC and Frax’s native token FXS. The design goal of FRAX has always been to equal 1 USD, and how 1 FRAX is collateralized is determined dynamically by the market. Initially, FRAX was 100% backed by USDC, and the protocol’s algorithm gradually reduces the collateralization ratio (CR) based on market demand. For example, an 85% CR means 1 Frax is supported by 0.85 USD worth of USDC and 0.15 USD worth of FXS. As demand increases, the CR decreases, and vice versa. Arbitrageurs intervene when the anchor is imbalanced, alongside the protocol’s algorithm.

FRAX is currently in its V2 version, which utilizes multiple Automatic Market Operations (AMOs). Essentially, AMOs are smart contracts that carry out open market operations (i.e., minting, burning, deploying FRAX) to maintain the peg of FRAX to $1. In V1, the protocol only used one AMO, namely the Core Stability Module, to dynamically adjust the Collateral Ratio (CR) to maintain the anchor of $1. AMOs are one of the core mechanisms that contribute to the success of Frax. In the next section, a deeper explanation of the underlying concepts will be provided.

Lastly, it is worth noting that in 2023, the DAO has voted to increase the CR to 100%, as it is the safest way to continue the expansion of FRAX. Despite providing greater flexibility and capital efficiency, the DAO has decided that it is no longer necessary given Frax’s mature state, while the use of AMOs can still make FRAX highly capital efficient.

4.1.2 FPI

The Frax Price Index (FPI) is the second stablecoin released by the protocol. It is designed to maintain purchasing power by pegging it to real inflation, as defined by the Consumer Price Index for All Urban Consumers (CPI-U) in the United States. Frax utilizes a dedicated Chainlink oracle to fetch and report the inflation rate from the US federal government, which is then applied to the redemption price of FPI. Since the anchoring of FPI is closely related to the inflation rate, the redemption price of FPI increases (or decreases) with inflation (or deflation). This means that users who convert other assets to FPI are anticipating that the purchasing power of CPI will grow faster than the assets they sell.

The motivation behind FPI is to create the first on-chain stablecoin that can be used as a representation of trade, value, and debt. Using FPI as a benchmark measurement helps determine whether the value of treasuries or income is growing or declining relative to the ever-increasing inflation. This approach can be particularly useful for DAO operations or similar activities.

4.1.3 frxETH

Frax Ether (frxETH) is the third stablecoin released by Frax. It is pegged to ETH and earns zero-collateral rewards. Users can collateralize frxETH to obtain sfrxETH and reap all the collateral rewards. Each uncollateralized frxETH contributes to the yield of sfrxETH. Therefore, the collateral rewards earned per sfrxETH are higher than those for ETH, which is why the yield of sfrxETH is higher than all other LSDs. Users can provide fexETH-ETH liquidity to the Curve pool and earn trading fees and launch rewards. Due to Frax’s significant holdings of $CRV and $CVX, it can incentivize liquidity provision with substantial rewards for the pool.

The introduction of frxETH/sfrxETH represents Frax’s strategic expansion into the LSD narrative and deepens its influence within the DeFi ecosystem. Frax cleverly leverages its prominent position in the Curve War to successfully erode the market share of blue-chip LSDs like stETH and rETH. With Frax’s upcoming release of V2 for Frax Ether, another wave of adoption growth is expected.

4.2 Core Infrastructure

4.2.1 AMOs

For stablecoin protocols like Frax, maintaining stability is crucial. Unlocking not only weakens users’ confidence but can also lead to a chain reaction that tears the protocol apart. Algorithmic Market Operations (AMOs) are smart contracts that perform various currency operations to maintain the stability of FRAX. Frax Finance has evolved from a single AMO in V1 to four major AMOs in V2. Although each one has slightly different operations, AMOs share three common attributes: de-minting – reducing the CR strategy, market operations – running in balance without changing the CR strategy, and re-minting – increasing the CR strategy.

4.2.2 Fraxswap

Fraxswap is the first Constant Product Market Maker (CPMM) combined with Time-Weighted Average Market Maker (TWAMM), used to optimize the execution of long-term orders such as order pools and aligning order expiration, and efficiently handle large orders. The purpose of Fraxswap is to enable the protocol to effectively implement its stablecoin monetary policy. Specifically, Frax will use Fraxswap for the following operations:

– Repurchase and burn FXS using AMO profits

– Mint new FXS to repurchase and burn Frax

– Mint Frax by purchasing hard assets with the seigniorage tax

Fraxswap is fully permissionless, allowing other protocols and DAOs to utilize it for monetary policy. Fraxswap V2 is also under development, which will support centralized liquidity (current version based on Uniswap V2) and integrate with relevant asset liquidity, further expanding its functionality.

4.2.3 Fraxlend

Fraxlend is Frax Finance’s native money market, supporting lending activities using ERC-20 pairs. Each pool is over-collateralized and independent, protecting the protocol from counterparty risks and insolvency threats. As a stablecoin protocol, Frax’s primary mission is to expand the adoption and usage of its stablecoin naturally, with Fraxlend being a vital component in achieving that goal. By allowing users to have CDPs (debt positions) on FRAX, it increases FRAX’s utility as a currency in DeFi. It’s worth noting that Fraxlend adopts a feeless model as an incentive measure for adoption. Like other infrastructure, Fraxlend also has a v2 plan that may introduce low-collateral loans to the platform.

4.2.4 Fraxferry

Frax Finance has launched Fraxferry, a seamless bridging mechanism for multi-chain extension of the protocol. Fraxferry bridges user assets in a slower but more secure manner, with the aim of maximizing security. Version 2 is also coming soon, which will make the mechanism more decentralized.

The functions bridged through Fraxferry are as follows:

1. Users initiate the process by sending tokens to the ferry contract.

2. The designated “captain” checks and batch processes the transactions.

3. There is a 24-hour waiting period before the transfer occurs, allowing for further validation.

4. During execution, the system ensures transaction validity by comparing hashes.

5. Token Economy

Frax Share ($FXS) is the staking and governance token of Frax Finance, with all earnings and utilities centralized around $FXS. Specifically, to enjoy all benefits, users are encouraged to lock their $FXS to receive $veFXS, similar to Curve’s veToken model. $veFXS holders have voting rights, scale farming boost, and cash flow from AMOs, Fraxlend loans, and Fraxswap fees. Currently, 37.484M $FXS is locked, accounting for 50.88% of circulating supply and 37.6% of total supply. It’s worth noting that after FIP-256, whenever $FXS falls below $5 and $4, the protocol will conduct buybacks, consolidating the token economy through implied valuation basis for the token.

 

6. Growth Incentives

Due to its diverse range of business areas, Frax Finance has multiple upcoming upgrades, making it well-suited for different major narratives that could become important drivers of its future growth. This section will review and explore their prospects.

6.1 FRAX V3

Although not many details have been disclosed yet, FRAX V3 aims to eliminate reliance on $USDC and create a new decentralized stablecoin mechanism, with the goal of significantly improving the protocol’s robustness. According to Frax co-founder Sam Kazmien, FRAX V3 will abandon the current anchoring mechanism and not rely on fiat currencies. However, more details are still pending release by the Frax team. Another highlight of V3 is the expansion into RWA field. A non-profit entity called FinresPBC has been launched to tap into attractive returns from US government bonds. FinresPBC can facilitate off-chain transactions of US government bonds, and users can participate through Fraxbond (FXB), which can be exchanged with $FXS. RWA is a major narrative in the current DeFi market, and this expansion could mirror the success of MakerDAO, whose token price has performed quite well due to its RWA operations. Combined with a more robust stablecoin mechanism, this could drive FRAX adoption to new heights.

6.2 frxETH V2

Regarding frxETH, the continuous complaint from users is the centralization of this mechanism, where the protocol relies on its internal validators. In response, frxETH V2 is about to be launched with the aim of decentralizing this mechanism while providing users with the same or higher returns. At its core, frxETH V2 includes two innovations: rate based on usage and decentralized lending market. Frax considers the LSD market as a lending (collateralizers) and borrowing (validators) market, hence prompting these modifications.

Through the peer-to-pool model, anyone can provide collateral and borrow ETH from collateralizers to become a validator. The rate is determined based on utilization. Ultimately, LSD borrowers and lenders will have a dynamic market, promoting the growth of Frax LSD.

6.3 FraxChain

Three months ago, in a podcast with FlyWheel DeFi, Sam revealed that the protocol will launch its own EVM-compatible L2 called Fraxchain. Although not many details have been disclosed yet, this upcoming L2 has two highlights. First, it will be a hybrid rollup using Optimistic architecture but also incorporating ZK technology to enhance security. Second, frxETH will be used as gas fees. The importance of frxETH as a fuel token lies in the fact that as demand increases, the supply of frxETH will decrease, thereby increasing the returns of sfrxETH, further expanding its LSD market share. The fees will flow to $veFXS holders, adding to the already existing sources of income flowing to $veFXS, significantly increasing the value accumulation of $FXS. Fraxchain is scheduled for release by the end of this year, and with the market interest potentially surging due to the L2 narrative brought by the Cancun Upgrade.

7. Growth Potential

The above-mentioned growth drivers could significantly boost the performance of respective areas. To further showcase Frax’s potential, this section will provide some insights into the growth prospects of the LSD market (one of Frax’s main business areas) through a simple comparative analysis.

In terms of LSD market share, Lido, Coinbase, and Rocket Pool are leading the pack. For this analysis, we will use the top three LSDs as representative samples. Currently, the top three LSD protocols have a total of approximately 10.85M staked ETH, accounting for 90.72% of the market share. Frax’s current staked ETH quantity is about 0.26M. Assuming conservatively that the current numbers of the top 3 LSD protocols represent Frax’s targets and setting Rocket’s quantity at 50% of that, the median of the top three, and the average trading volume of the top three as our bear, baseline, and bull market scenarios, we can roughly estimate the potential upside for Frax LSD.

Although this basic comparison emphasizes the potential of Frax LSD, it must be recognized that reaching the amount of ETH staked in the top 3 protocols is not necessarily a simple process and is influenced by various factors. Nevertheless, this analysis clearly highlights the potential of Frax, combined with the upcoming V2 update, the future is undoubtedly bright.

(This analysis is a simplified approach to estimate the potential growth of Frax LSD, using top protocols as a baseline and their staked ETH amounts as targets. For more detailed predictions, several additional factors need to be considered, meaning that this analysis should only be seen as a rough measure of Frax’s potential with ETH.)

8. Conclusion

Starting from an algorithmic stablecoin protocol, Frax Finance has successfully transformed into a powerful DeFi stack, including every core area within its ecosystem. The team’s ongoing efforts are the main reason for Frax’s success today and support its future growth. Its mechanisms and products have been cleverly designed, creating a strong synergistic effect that may trigger a positive flywheel effect for the protocol’s growth and the accumulation of $FXS value. Looking ahead, it is recommended to closely monitor FRAX V3, frxETH V2, and Fraxchain, as these will be key developments determining Frax’s future.

References

https://docs.frax.finance/?source=post_LianGuaige—–9c23b056d46c——————————–

https://flywheeldefi.com

Disclaimer: This report is an original work completed by @BC082559, a contributor to @GryphsisAcademy. The author is solely responsible for all content, which does not necessarily reflect the views of Gryphsis Academy or the organization commissioning the report. Editorial content and decisions are not influenced by readers. Please note that the author may hold cryptocurrencies mentioned in this report. This document is for informational purposes only and should not be relied upon as the basis for investment decisions. It is strongly recommended to conduct your own research and consult independent financial, tax, or legal advisors before making any investment decisions. Please remember that past performance of any assets does not guarantee future returns.

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