Frax Finance Stablecoin Universe Atlas Full Explanation

Complete Guide to Frax Finance Stablecoin Universe and its Atlas Mechanism

Author: Chen Mo, founder of BV DAO

The Holy Grail

Decentralized stablecoins face the impossible trilemma of balancing capital efficiency, decentralization, and price stability. It is a challenging goal to constantly seek a balance among these three aspects.

USDT and USDC are particularly outstanding in terms of capital efficiency and price stability, which has contributed to their immense market value and wide range of applications. However, they are highly centralized in terms of decentralization.

As the oldest decentralized stablecoin, DAI initially excelled in decentralization by using ETH as collateral to over-collateralize stablecoins. However, the excessively high collateralization ratio sacrificed capital efficiency, resulting in less application scenarios and market value compared to centralized stablecoins. Over time, DAI gradually accepted centralized assets as collateral in exchange for an increasing market value.

UST is the most controversial decentralized stablecoin. It achieves extreme capital efficiency while maintaining decentralization characteristics. At one point, it even created a market value second only to USDT and USDC. However, its aggressive strategy can lead to a death spiral in extreme situations.

Thus, until today, a “perfect” decentralized stablecoin has yet to emerge. It remains an elusive “Holy Grail” pursued by builders.

Frax Finance is a full-stack protocol centered around decentralized stablecoins. Starting with a partially collateralized algorithmic stablecoin, it gradually transitions to a fully collateralized stablecoin while maximizing the improvement of capital utilization. It also expands horizontally into multiple fields, ultimately forming a matrix-like full-stack DeFi protocol driven by stablecoins. It is also the longest surviving non-fully collateralized stablecoin.

Its product lineup includes:

1. FRAX stablecoin: Decentralized USD stablecoin ★

2. FPI: Inflation-resistant stablecoin backed by a basket of commodities ★

3. frxETH: LSD ★

4. Fraxlend: Lending ★

5. Fraxswap: Time-weighted decentralized exchange ★

6. Fraxferry: Cross-chain transfer ★

7. FXS & veFXS: Governance module ☆

8. AMO: Algorithmic open market operations controller ★

9. Frax Bond – Bonds (v3 coming soon) ☆

10. RWA – Real World Assets (v3 coming soon) ☆

11. Frax Chain – Layer2 (not yet launched) ☆

Since its launch, Frax has gone through three versions: v1, v2, and v3. Unlike many other protocols in the market, each version of Frax is not just an upgrade in functionality, but also involves major strategic adjustments. This means that if you missed a particular version, your understanding of Frax may be completely different.

Frax v1: It aimed to become an algorithmic stablecoin, gradually reducing the collateral ratio using a “fractional algorithm” to maximize capital efficiency.
Frax v2: Strategically, it abandoned the approach of gradually reducing the collateral ratio for an algorithmic stablecoin and shifted towards increasing the collateral ratio to full collateralization. It developed AMOs for entry into the Curve War to compete for on-chain liquidity governance resources and developed frxETH for Ethereum liquidity staking in the LSD track.
Frax v3: Introduces Real World Assets (RWA) and continues to use AMOs to maintain on-chain and off-chain liquidity.

This article will start with the latest upcoming version, v3, and analyze and summarize each product in the Frax Finance ecosystem, unveiling the full picture of Frax Finance.

Frax Finance v3

Frax v3 is an upcoming version that will focus on RWA. It will continue to utilize the AMOs from v2 to gradually transform FRAX into a fully collateralized stablecoin that captures both on-chain and off-chain assets, providing a decentralized and multi-collateral stablecoin solution.

Fully Collateralized

According to the FRAX balance sheet, the current version of FRAX has a Collateral Ratio (CR) of 91.85%.

CR = (Owned assets + Lent assets) / LiabilitiesCR = (615,357,001 + 65,654,459) / 741,400,658 = 91.85%

Starting from Frax v3, the protocol will introduce Real World Assets (RWA) to increase the CR until it reaches >= 100%, achieving 100% externally collateralized FRAX. In fact, the process of transitioning from algorithmic stability to using AMOs and protocol revenue to increase CR began with the community proposal FIP188 in February 2023:

FIP188

This proposal is significant for Frax. Starting from FIP188, Frax will completely stop the fractional algorithm and “de-collateralization” feature. It will gradually transition from a partially collateralized algorithmic stablecoin to a fully collateralized one. Here are some key points from the proposal:

The initial versions of Frax included a “fractional algorithm” that adjusted the collateralization ratio based on the market demand for FRAX, effectively letting the market determine the combination of external collateral and FXS needed to equal $1.00.
The reason for stopping the fractional algorithm is that, in the market environment, the cost of slightly insufficient collateral far outweighs the benefits. The market’s concern about the insufficient 1% collateral far exceeds the demand for an additional 10% yield.
Over time, growth, asset appreciation, and protocol revenue will increase the CR to 100%. It should be noted that this proposal does not rely on minting and issuing any additional FXS to achieve a 100% CR.
Protocol revenue will be retained to fund the CR increase, while FXS buybacks will be paused.

FRAX Balance Sheet 2023.10.10

FIP 188 Proposal Passed

RWA

As one of the important means to enhance CR>=100% in Frax v3, the upcoming frxGov governance module in Frax will approve real-world entities to achieve AMO-controlled asset purchase and holding of real assets, such as US Treasury bonds.

Users who hold FRAX can deposit it into the specified smart contract and receive sFRAX, which is similar to the relationship between DAI and sDAI. Let’s compare the differences between sFRAX and sDAI:

One reason why sDAI can achieve slightly higher than average treasury yields (currently 5%, maximum 8%) is that not all DAI holders have deposited their DAI into the DSR contract, and Maker only needs to share the income from the investment in RWA with those who have deposited DAI into the DSR to receive sDAI, so it’s like some people get all the RWA income.
sFRAX also meets this condition, but Frax has accumulated a large number of Curve and Convex tokens in the v2 version, and has obtained a large amount of voting power through lock-ups, so it can control a certain amount of CRV and CVX rewards on-chain, and this on-chain income will enhance the overall yield of sFRAX. At the same time, when there is poor income or increased risk on either the on-chain or off-chain end, it can quickly switch to the other end.

IORB Oracle

The FRAX v3 smart contract uses the Interest on Reserves Bond (IORB) as a deposit rate to provide data for certain protocol functions, such as the equity yield of sFRAX.

When the IORB rate increases, the Frax protocol’s AMO strategy will collateralize a large amount of FRAX with Treasury bills, reverse repurchase agreements, and dollars held in Federal Reserve Banks that pay the IORB rate.
When the IORB rate decreases, the AMO strategy will start to rebalance the FRAX collateral using decentralized assets on-chain and collateralized loans in Fraxlend.

In simple terms, FRAX v3 adjusts its investment strategy based on the Interest on Reserves Bond (IORB) rate. When off-chain income is high, funds are sent to Treasury bills, government bonds, etc. When on-chain income is high, they are sent to on-chain lending platforms like Fraxlend, ensuring maximum returns and stablecoin stability.

frxGov Governance Module

In Frax v3, multisig will be removed and governance (veFXS) will be fully implemented through the frxGov smart contract module. This is an important step for Frax towards decentralized governance.

FraxBond (FXB) Bonds

Both sFRAX and FXB introduce treasury yields into Frax, but they have their differences:

sFRAX serves as the zero-maturity portion of the yield curve, while FXB represents the forward portion. Together, they form an on-chain comprehensive stablecoin yield curve.

If 50M FRAX is pledged as sFRAX, then approximately 50M USDC (assuming CR=100%) can be sent to the off-chain treasury to purchase short-term government bonds worth 50M.
If 100M FXB with a one-year maturity is sold for 95M USDC, it means that off-chain entities can buy one-year government bonds with 95M USD.

In addition, FXB is a transferable ERC-20 token that can build its own liquidity in the secondary market and freely circulate, providing users with stablecoin investment choices with different maturities, interest rates, and risk levels. It also provides new components for building new LEGO sets.

Frax Finance v1

Frax v1 introduces the concept of a fractional algorithmic stablecoin, which means a part of its supply is supported by exogenous collateral (USDC) and a part is unsupported (supported by the algorithm using endogenous collateral FXS).

For example, with CR at 85%, each redeemed FRAX will provide users with 0.85 USDC and 0.15 FXS in value.

USDC and FXS are used to mint $FRAX in Frax v1

In v1, AMO exists in its simplest form, known as the fractional algorithm. Its main function is to adjust the CR for minting FRAX based on market conditions. Initially, FRAX is minted with CR=100%, meaning 1 FRAX = 1 USDC. This phase is known as the “integer phase”. Subsequently, AMO will adjust the CR downwards or upwards to enter the “fractional phase” based on market conditions.

If FRAX >1 exceeds the peg and needs expansion, the CR will decrease, allowing fewer collateral assets to mint more FRAX.
If FRAX <1 falls below the peg, the CR will increase to add more collateral support for each FRAX, restoring confidence in the system.

Although the fractional algorithm can intervene in the CR during the minting of new FRAX, it is relatively slow to affect the entire system’s CR. In addition, Frax v1 has added two functions to facilitate dynamic changes in CR in conjunction with the fractional algorithm to achieve the required precise state of the protocol:

Decollateralization and Recollateralization

Recollateralization: When the fractional algorithm increases the collateralization ratio of the system, to make the actual collateralization ratio equal to the system’s collateralization ratio, the amount of USDC in the system must be increased. FRAX has set up an incentive mechanism: anyone can add USDC to the system and receive more FXS in exchange. For example, a user can add 1 USD worth of USDC to the system and receive 1.2 USD worth of FXS.
Decollateralization (Buyback): When the collateralization ratio of the system decreases, users can use FXS to exchange for an equivalent value of USDC from the system, and the FXS will then be burned. There is no incentive mechanism in the buyback mechanism.

Go Mortgage (Buyback) and Re-mortgage Operation Page

When Frax v1 was launched, it was in the midst of the dominant DeFi market for algorithmic stablecoins. Other projects launched around the same time included Basis cash and Empty Set Dollar (ESD), but in terms of market trends, Frax was the most conservative algorithmic stablecoin project. As the market hype subsided, Frax remained standing and made a turnaround in the subsequent Frax v2 version by supplementing collateralization rates and utilizing treasury funds.

Frax Finance v2

Frax v2 is the most active version, where the fractional algorithm was stopped and AMO was introduced for treasury fund management. Profits are used to gradually fill the collateralization ratio (CR), and new services such as Fraxlend and frxETH were launched. Frax also participated in the Curve war and emerged as the winner of on-chain liquidity governance.

AMO (Algorithmic Market Operations Controller)

AMO is a tool similar to the Federal Reserve for executing monetary policy. Its operation mechanism allows it to formulate any FRAX monetary policy as long as it doesn’t decrease the collateralization ratio and change FRAX price. Within the limits of the strategy algorithm, AMO can mint, burn, and allocate funds. This means that the AMO controller can execute open market operations through algorithms (hence the name), but they can’t simply mint FRAX out of thin air to break the peg.

Currently, Frax operates four AMOs, with the Curve AMO having the largest amount of funds. Alongside AMO operations, the protocol utilizes idle assets in the treasury (primarily USDC) and mints a certain amount of FRAX controlled by the algorithm, which is then invested into other DeFi protocols:

Maximize the utilization of treasury funds to earn additional income. For example, if the treasury holds 1M USDC, AMO mints 1M FRAX, creating a USDC-FRAX LP for mining and actually earning mining income worth 2M.
Since the FRAX minted in AMO (controlled by the protocol) is owned by the protocol and can be withdrawn and burned in the AMO strategy, it doesn’t have a significant impact on the peg of FRAX.
Increases the market value of FRAX without actually increasing new collateral.

Let’s take the Curve AMO strategy as an example:

Decollateralize – Put idle collateral and newly minted FRAX from AMO into the Curve Pool.
Recollateralize – First, extract FRAX-USDC LP from the pool, burn excess FRAX (previously minted and controlled by the protocol), and return USDC to increase the collateralization ratio (CR).
Protocol income – Accumulate transaction fees, CRV rewards, and regularly rebalance the fund pool. Deposit LP tokens into platforms such as Yearn, Stake DAO, and Convex Finance to earn additional income.

Let’s analyze the crucial “money printing” ability of AMO.

The core of AMO’s “money printing” strategy can be summarized as follows:

When AMO wants to add treasury funds USDC to the Curve Pool, if a large amount of USDC is added individually, it will affect the proportion of USDC in the pool, which will in turn affect the price. So, by combining USDC with the corresponding amount of FRAX to create LP, AMO will join the fund pool with the minimum slippage. The LP will be held and controlled by AMO.

In addition to this, there is another scenario for maximizing “money printing”:

Assume a pre-“money printing” supply of FRAX is Y, and the market tolerates a decrease in FRAX below $1 by X%.

If all Y is sold to a Curve Pool with a TVL of Z and an amplification factor of A, it will have an impact on the price of FRAX that is less than X%. This proves that the extra “money printed” amount of FRAX can be accepted in the open market.

In other words, because Curve AMO can combine FRAX+USDC to create LP and control TVL in its own Curve Pool, in the event of an X% decrease in FRAX, it can use AMO Recollateralization and retracement operations to withdraw and destroy the excess FRAX, in order to improve CR and bring the price back to anchor. The more LP AMO controls, the stronger this ability becomes.

So, before FRAX decreases by X%, based on AMO’s ability to control LP, a quantity of FRAX can be calculated, which is allowed to be sold in one go to the Curve Pool without causing enough impact on the price to move the CR. This quantity represents the maximization of “money printing”.

For example, the 330 million TVL FRAX3Pool can support at least $39.2 million worth of FRAX sales without the price changing by more than 1 cent. If X=1%, then in the open market, you can have at least 39.2 million algorithmic FRAX for “maximized money printing”.

The above strategy is an extremely powerful market operation. It mathematically creates a lower limit for algorithmic FRAX circulation without any danger of breaking the anchor.

Fraxlend

Fraxlend is a lending platform that provides a lending market between ERC-20 assets. Unlike the mixed lending pool of Aave v2, each lending pair in Fraxlend is an isolated market. When you choose to deposit a collateral to be borrowed by a borrower, it shows that you fully acknowledge and accept the value and risks of this collateral. At the same time, this design of isolated pools has two characteristics:

Any issues related to collaterals or bad loans are limited to individual pairs and do not affect other lending pools.
Collaterals cannot be lent out.

The Fraxlend Mechanism – Interest Rate Model

Fraxlend offers three interest rate models (in practice, it’s 2 and 3). Unlike most lending protocols, Fraxlend’s interest calculators automatically adjust based on market dynamics, without the need for governance intervention. The Frax team believes that letting the market determine interest rates is better than relying on the team to propose governance proposals every time there’s a market fluctuation (because that approach is slower).

1 Linear Interest Rates

When the utilization rate exceeds the critical threshold, the interest rate curve starts to steepen. Most lending protocols use this basic interest rate growth model to encourage lenders to deposit and borrowers to repay when the funds pool is overloaded.

2 Time-Weighted Floating Rate

The time-weighted floating rate adjusts the current rate over time. It’s controlled by three parameters:

Utilization rate: Adjusts the rate based on fund utilization.
Half-life: Determines the speed of rate adjustment. Simply put, when the utilization rate is high, the rate increases using a multiplier, and when the utilization rate is low, the rate decreases.
Target utilization rate range: No rate adjustment is made within this range, as it’s considered the market’s expected value.

In the current available interest rate calculator, the half-life is 12 hours. If the utilization rate is 0%, the rate decreases by 50% every half-life, and if the utilization rate is 100%, the rate doubles every half-life, increasing by 100%.

This interest rate model played a crucial role in the Curve founder Mich’s CRV liquidation event and the vyper compiler 0-day vulnerability attack. Curve was affected, causing Mich’s CRV leveraged position on-chain to be squeezed, leading to a large withdrawal of lenders and the utilization rate skyrocketing to nearly 80%-100%. In Fraxlend, the CRV market uses the time-weighted floating rate model, with a half-life of 12 hours when the utilization rate approaches 100%. The interest rate for CRV collateralized loans doubles every 12 hours. This compelled Mich to repay the loan in Fraxlend first; otherwise, the doubling speed of the interest rate every 12 hours would be the first step towards Mich’s liquidation.

Multiplier for Interest Rate Adjustments at 85%-100% Utilization Rate

The following graph shows how the interest rate varies when the half-life is 4 hours and the target utilization rate range is 75%-85%:

3 Floating Rate V2

Variable interest rate V2 combines the concepts of linear interest rate and time-weighted floating interest rate. Specifically, it uses the linear function of linear interest rate to determine the current interest rate, but adjusts the vertex and maximum interest rate using the formula of time-weighted floating interest rate. Its feature is that the interest rate will immediately respond to changes in the utilization rate on the linear interest rate curve, while adapting to long-term market conditions by adjusting the slope of the linear interest rate curve.

Just like time-weighted floating interest rate, variable interest rate V2 adopts parameters of half-life and target utilization rate range. When the utilization rate is low, the vertex and maximum interest rate will decrease. If the utilization rate is high, the vertex and maximum interest rate will increase.

The decrease/increase in interest rate is determined by the utilization rate and half-life. If the utilization rate is 0%, the vertex interest rate and maximum interest rate will decrease by 50% every half-life. If the utilization rate is 100%, they will increase by 100% every half-life.

Fraxlend Mechanism Features – Dynamic Debt Restructuring

In typical lending markets, once the LTV exceeds the maximum LTV (usually 75%), liquidators can close the positions of borrowers. However, in volatile situations, liquidators may not be able to close unhealthy positions before the LTV exceeds 100%. In this case, bad debts may occur, and the people who withdraw funds last will bear the greatest loss, turning it into a “race to the finish” game.

In Fraxlend, when bad debts occur, the pool immediately “socializes” the losses and shares them among all lenders. This helps maintain market liquidity even after bad debts occur, preventing the immediate depletion of liquidity in the lending market.

Fraxlend AMO

Fraxlend AMO allows FRAX to be minted into the Fraxlend lending market, allowing anyone to borrow FRAX by paying interest instead of using the underlying minting mechanism.

FRAX minted into the money market does not enter circulation unless borrowers over-collateralize through the money market, so this AMO does not decrease the direct collateralization ratio (CR). It facilitates the expansion of FRAX and creates a new pathway for FRAX to enter circulation.

Strategies:

Decollateralize – Mint FRAX into the money market. The minted FRAX does not directly decrease the CR because all borrowed FRAX is over-collateralized.
Recollateralize – Retrieve minted FRAX from the lending market.
Protocol yields – Fees generated by borrowers.

In addition, due to its ability to “mint” and “burn” FRAX, Fraxlend AMO can lower interest rates by minting more FRAX or increase interest rates by burning FRAX. This ability to adjust interest rates is a powerful economic leverage as it changes the cost for all lenders borrowing FRAX.

In theory, if Frax is willing and confident in its direction, it can mint enough FRAX stablecoins to inject into Fraxlend, attracting users to borrow FRAX at rates lower than any other stablecoin on the market to scale up. This would create the optimal lending rate and increase rates through the Fraxlend AMO when market response is needed. Stablecoin projects, on the other hand, have a hard time controlling their lending rates.

Fraxswap

Fraxswap utilizes Time-Weighted Average Market Maker (TWAMM) for trustless large-scale transactions over an extended period. It is completely permissionless and built on core AMM Uniswap V2. TWAMM is detailed in another article: TWAMM Time-Weighted Average Market Maker.

FPI (Frax Price Index)

FPI is the first anti-inflation stablecoin, linked to the real-world consumer basket defined by the average US CPI-U. FPI stablecoin aims to maintain its purchasing power by keeping its price constant relative to all items in the CPI basket through on-chain stability mechanisms. Similar to the FRAX stablecoin, all FPI assets and market operations are on-chain and use AMO contracts.

FPI uses the 12-month unadjusted inflation rate of CPI-U reported by the US Federal Government: a dedicated Chainlink oracle submits this data on-chain immediately upon its public release. The reported inflation rate is then applied to the redemption exchange price of the FPI stablecoin. This redemption price increments on-chain every second (or decreases in the rare case of deflation).

FPIS

FPIS is the governance token of the system and also has the right to minting fees from the protocol. Surplus revenue is directly distributed to FPIS holders from the treasury, similar to the FXS structure.

If the income generated by FPI is insufficient to maintain the increase in FPI due to inflation, new FPIS tokens may be minted and sold to increase funding support for FPI.

FPI Stability Mechanism

FPI uses AMO of the same type as the FRAX stablecoin, but its model always maintains a 100% collateralization ratio (CR). This means that in order to maintain a CR of 100%, the protocol’s balance sheet must grow at least at the rate of CPI inflation. Therefore, the AMO strategy contract must earn revenue proportional to the CPI, otherwise the CR will fall below 100%. During periods when AMO earnings are lower than the CPI rate, a TWAMM AMO will sell FPIS tokens in exchange for FRAX stablecoins to ensure that the CR remains at 100%. The FPIS TWAMM will be removed when the CR returns to 100%.

frxETH – Ethereum Collateralized Derivative

Currently, Frax ETH ranks 4th in the LSD track with a TVL of $427.64M and a market share of 2.42%, but it can achieve yields of up to 3.88% as of the time of writing, ranking 1st in terms of provided returns. The reason Frax ETH is able to offer higher-than-market-level returns is also due to its control over on-chain liquidity governance resources.

LSD data comes from defillama

The Frax ETH ecosystem includes:

frxETH (Frax Ether): An Ethereum stablecoin pegged to ETH, where 1 frxETH always represents 1 ETH. Similar to Lido’s stETH, but holding frxETH alone does not undergo rebase and does not generate Ethereum staking rewards.
sfrxETH (Staked Frax Ether): sfrxETH is an ERC-4626 treasury designed to accumulate staking rewards from Frax ETH validators. At any time, frxETH can be exchanged for sfrxETH by depositing it into the sfrxETH treasury, allowing users to earn staking rewards on their frxETH. Over time, as validators accumulate staking rewards, an equivalent amount of frxETH is minted and added to the treasury, allowing users to redeem their sfrxETH for more frxETH than they initially deposited. So, in theory, the exchange rate of sfrxETH to frxETH will always increase over time. Holding sfrxETH allows users to claim a percentage of the growing frxETH in the treasury. It is similar to Aave’s aDAI principle.

So how does Frax ETH achieve interest rates higher than the market average?

Frax accumulates a large amount of CRV and CVX governance resources in the market through AMO, and builds a frxETH pool on Curve and Convex. This allows frxETH to receive incentives in third-party liquidity markets without issuing its own token, FXS. All Ethereum staking rewards are then fully covered by sfrxETH.

Let’s assume that out of the 270,000 ETH staked in Frax ETH, 100,000 ETH is not staked in sfrxETH, but instead participates in liquidity markets with other Ethereum assets like WETH and stETH. Additionally, 170,000 ETH is staked in sfrxETH. The incentives received are as follows:

The 100,000 ETH in the Curve, Convex, and other liquidity pools earns CRV and CVX incentives.
The 170,000 ETH staked in sfrxETH earns staking rewards from the total 270,000 ETH.

Therefore, Frax ETH utilizes its on-chain liquidity governance resources to introduce external incentives for frxETH, increasing overall returns and indirectly raising the market interest rate of LSD (sfrxETH).

frxETH Pool originates from Convex

crvUSD now supports sfrxETH as collateral

Frax Shares (FXS)

Funding Information

Frax Finance has conducted two funding rounds, in July and August 2021 respectively, with 12% of the total supply allocated for funding. However, the amount raised and valuation have not been disclosed.

Participating in Frax Finance investments are well-known investment institutions such as LianGuairafi, Dragonfly, Mechanism, Galaxy digital, as well as prominent founders of DeFi projects such as Stani kulechov from Aave, Robert Leshner from Compound, Kain Warwick from Synthetix, Eyal Herzog from Bancor, and investment from CEX backgrounds such as Crypto.com and Balaji Srinivasan (former Coinbase CTO and A16Z partner), and so on.

Frax Finance Investors

Token Distribution

60% – Liquidity Program/Farming/Community – Halves naturally every 12 months through governance
5% – Project Treasury/Grants/Partners/Bug Bounties – Decided by the team and community
20% – Team/Founders/Early Project Members – 12 months, 6-month cliff
3% – Strategic Advisors/External Early Contributors – 36 months
12% – Accredited Private Investors – 2% unlocked at launch, 5% vested within the first 6 months, 5% vested within 1 year, 6-month cliff

Currently, the circulating supply of FXS is 74.57M out of a total supply of 100M. The team, advisors, and external investors are fully unlocked, while the remaining unreleased portion belongs to the community (liquidity program/treasury).

FXS Market Cap and Circulating Supply Data

FXS Unlock Data from TokenUnlocks

veFXS Tokenomics

veFXS is an ownership and yield system based on the Curve veCRV mechanism. Users can lock their FXS for up to 4 years to receive veFXS. veFXS is not a transferable token and is not traded on the open market.

Currently, 36.15M veFXS is locked, accounting for 48.48% of the circulating supply.

As the token approaches the lock expiration, the veFXS balance linearly decreases, reaching 1 veFXS per 1 FXS when the remaining lock time is zero. This encourages long-term staking and an active community.

Each veFXS has 1 voting power in governance proposals. Staking 1 FXS for the longest period (4 years) generates 4 veFXS. The veFXS balance itself gradually decays to 1 veFXS after 4 years, at which point users can exchange veFXS back to FXS.

Gauge

Similar to the power of veCRV in the Curve system, veFXS can vote to determine the incentives emitted in the liquidity pools supported by Frax.

Gauge

Buyback

The main cash flow distribution mechanism of the Frax Protocol goes to veFXS holders. Cash flows earned from AMO, Fraxlend loans, and Fraxswap fees are typically used to buy back FXS from the market, and then distributed as earnings to veFXS stakers.

However, with strategic adjustments in Frax v2 and v3, the protocol will prioritize raising the CR to 100%, so buybacks may be suspended or limited. Once the CR reaches 100%, veFXS holders will have the opportunity to capture all protocol income.

Real Collateral Ratio Analysis

We have reorganized Frax’s balance sheet (as of October 10th, 2023), and the protocol holds a total of 616.8M assets, including:

The protocol holds a total of 450.1M FRAX
USD and other assets total 166.7M

Furthermore, there is 65.6M FRAX lent out in Fraxlend (over-collateralized), and the total supply of FRAX is 741.4M, resulting in a collateral ratio of 92.05%.

CR = Asset SUM / total FRAX

If we remove the FRAX held by the protocol on both the asset and liability sides, the collateral ratio value will decrease, but the absolute value of the collateral ratio gap does not change significantly. This absolute value is currently around 58.97M.

From here, we can see:

Frax leveraged 166.7M underlying assets to generate several times the stablecoin size without breaking the peg through the AMO strategy. (If we follow the traditional 1:1 issuance ratio, FRAX’s circulation equals the underlying asset value of 166.7M)
To achieve CR=100%, the protocol needs to earn 58.9M in profits for the treasury.

Frax’s Profitability Level

Currently, most of Frax’s profits come from AMOs:

Curve, Convex AMO yields 2%-8%
Fraxlend AMO yields 2%-6%
RWA yield 5.5%
sDAI yield 5%

Convex AMO Annual Percentage Yield

Estimating how long it will take for the protocol to reach CR=100% from two perspectives, taking the average AMO yield level of 5% APY:

If all AMOs control assets are maximally utilized 680M*5%=34M
If most AMO “printing” funds are recovered (current state)

200M*5%=10M

In the current market environment, it would take approximately 2-6 years for CR to reach 100% relying on AMO earnings. Of course, since the majority of earnings in AMO come from CRV and CVX tokens, if the market conditions improve and CRV and CVX tokens rise in value, this process will be accelerated.

1 Assessing the Impact of CRV and CVX Price Increase on CR

Currently, Frax holds 8M CRV (~$3.4M) and 3.7M CVX (~$9.8M).

If CRV and CVX prices increase by four times their current value, then CR can directly increase to nearly 100%.

CRV $0.44 → $1.76

CVX $2.68 → $10.72

2 The Impact of RWA Business on CR

In Frax v3, sFRAX is introduced to capture the yield of real-world assets, which is a prominent track in the bear market of DeFi. Currently, the earnings of sFRAX are calculated by tracking the IORB interest rate. Every Wednesday, 50K FRAX is pre-deposited to pay the current sFRAX earnings. The total annual earnings amount to 50K*52=2.6M, calculating with the actual annualized yield of RWA at 5.5%, Frax will deploy at least $47M of USD assets to RWA. (This data is estimated based on current earnings and may change with the fluctuation of IORB in the future).

When the deposit in the sFRAX contract falls below 26M, the annualized yield of sFRAX will be 10% and will gradually decrease as more FRAX is deposited.

From Sam, the founder of Frax

Currently, the potential earnings from the RWA business for the Frax Finance protocol is to deploy AMO funds here to earn profits. Additionally, there may be a possibility that Frax will charge fees or distribute dividends for these earnings in the future. Once the scale of Frax’s RWA business grows, and the protocol charges fees or distributes dividends for these profits, it will greatly accelerate the process of reaching CR = 100%.

3 The Impact of Frax ETH Business on CR

The current revenue of Frax ETH is $1.31M per year, compared to Lido’s profit level of $55.46M per year. Based on the current situation, the revenue from Frax ETH has a relatively small impact on CR. However, there is substantial growth potential in the LSD track, and once Lido’s monopoly position is shaken, other protocols will also experience significant improvements.

Frax ETH data from Tokenterminal

Lido data from Tokenterminal

Summary

In summary, it would take 2-6 years for CR to reach 100% conservatively based on the current situation. However, there is a lot of room for fluctuation, mainly depending on how Frax utilizes its AMO.

If we consider it optimistically, the rise of CRV and CVX will greatly help increase the speed of CR. However, Frax will also face a dilemma of whether to sell these voting rights to ensure CR or hold and lock CRV and CVX, which will have on-chain liquidity governance resources. Selling them will immediately increase CR but will lose the on-chain incentive measures.

If we consider the business potential, the growth of RWA business is a key factor in boosting CR. MakerDAO has already absorbed a large amount of USD liquidity through sDAI. If sFRAX gradually gains market recognition, its growth potential will far exceed other businesses. If Frax chooses to allocate RWA profits to the treasury to continuously increase CR, the process of CR = 100% will be greatly improved.

So from an investment perspective, we should pay attention to the following indicators:

The utilization and profitability of all AMOs
The prices of CRV and CVX tokens
The growth of RWA business and whether the protocol’s treasury can receive dividends

Frax has built a large-scale stablecoin system. We can see that whether it is Fraxswap, Fraxlend, or other than being listed on the public market, they are all serving Frax Finance itself. This is similar to the subDAO in MakerDAO’s endgame plan:

The similarity is that MakerDAO and Frax both plan to expand horizontally around their core (stablecoin) and build a full-stack product.
The difference is that MakerDAO decided to outsource these functions to other subDAOs, while Frax is governed by frxGov.

The advantage is that Frax captures almost all the right needs in the DeFi market, with a high ceiling and forward-looking mechanism design. But clearly, the possible problem is that it encompasses a huge system covering stablecoins, trading systems, lending systems, cross-chain systems, LSD, and possibly the future Frax Chain Layer2. Such a huge system requires a very efficient and sound governance module, and risk isolation between functions is also crucial, testing the stability of future protocol functions and on-chain governance.

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Frax

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