What Is Frax Finance?
Frax Finance is a DeFi protocol that includes a multi-chain stablecoin protocol (FRAX), liquid staking on Ethereum (frxETH), lending markets, and liquidity systems like DEXs. The protocol uses vetokenomics and Frax Shares (FXS) for governance, where users can lock up FXS in exchange for veFXS, which are used for governance votes.
Key Takeaways
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Frax Finance’s first product was FRAX, a USD-pegged stablecoin. Since its inception, it has evolved from a fractional algorithmic stablecoin to a 100% collateralized model that does not rely on external fiat reserves or other stablecoins, instead using AMO smart contracts and certain real-world assets held by partner entities.
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Along with stablecoins, Frax Finance is also focused on building out its own DeFi ecosystem across verticals like liquidity systems and lending markets, such as FraxSwap and Fraxlend. It also has its own liquid staking system, Frax Ether, that comprises of frxETH and sfrxETH.
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Frax Shares (FXS) can be locked up in exchange for veFXS, which are used for governance votes.
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In this article, we take a look at how the assets and algorithms that make up the protocol work together as designed by Frax Finance.
Frax Finance started out as only a fractional-algorithmic stablecoin protocol, but has since evolved to become a full-fledged DeFi ecosystem across multiple verticals. Sam Kazemian, a co-founder of Frax Finance believes that DeFi’s core services can be broken down into three categories: stablecoins, liquidity systems like DEXs, and lending markets, and Frax Finance has started offering all three categories under its umbrella on Ethereum.
What Is the Frax (FRAX) Stablecoin?
FRAX is a stablecoin pegged to the value of the US dollar. As the name suggests, stablecoins are designed to maintain a close peg to its related asset, such as the USD. In crypto, stablecoins provide a way for traders to store their profits in between trades by providing a stable value without requiring users to off-ramp.
CoinGecko reports over $123 billion in total market capitalization of stablecoins. These projects share similarities in how they develop and maintain a stable value. Either through collateralization (or over-collateralization) or through algorithms that are intended to keep the value regulated in dynamism. The latter are known as algorithmic stablecoins while the former are referred to as asset-backed stablecoins.
However, both systems have their shortcomings such as the centralization risk around asset-backed stablecoins like USDT and USDC, while algorithmic stablecoins have an increased risk around depegs, as seen in the UST depeg. This brings us to FRAX v1, a fractional algorithmic stablecoin.
FRAX V1
In the first version of FRAX, the protocol defines a generation and distribution technique that aims to keep the value of the Frax stablecoin at around 1 USD. This technique involves a partly collateralized and partly algorithmic self-functioning and decentralized system that shifts the whole system in response to slight variations in the value of FRAX. This system involves two assets, USDC and the Frax Share (FXS).
Two assets make up the pool; USDC and FXS. To mint FRAX, a user locks up USDC and FXS at a ratio defined by the system, this ratio is known as the collateralization ratio (CR). For instance, if the collateralization ratio is 60%, a user who wishes to mint $1 worth of FRAX will commit $0.60 USDC and $0.40 worth of FXS. This $0.40 of Frax Shares will be burnt.
There are three main states for the FRAX stablecoin:
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Decollateralize: Lower the CR when FRAX > $1
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Equilibrium: No change in CR when FRAX = $1
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Recollateralize: Increase the CR when FRAX <$1
FRAX V2
FRAX v2 introduces AMOs (Algorithmic Market Operations Controller), an autonomous contract that enacts arbitrary monetary policies that do not change the price of FRAX off its peg (like minting FRAX out of thin air) to the v1 stablecoin.
Generally, AMOs work by placing idle collateral in yield generating protocols (Aave, Yearn, Compound) or liquidity pools (Curve, Uniswap v3) in the decollateralization state, and withdrawing assets based on needs when recollateralization is required. In the meantime, the protocol accrues transaction fees, interest, and other rewards. This revenue can be used for FXS buybacks that are distributed to veFXS stakers.
FRAX V3
The V3 is the latest version of the FRAX stablecoin, and it plans to peg FRAX directly to the USD also move away from reliance on USDC (and potential third-party vulnerabilities) as seen in its earlier models.
V3 deployment is ongoing at the time of writing and is expected to be completed in a few weeks, according to information from the project team. With the upgrade to V3, the FRAX finance team plans to achieve a 100% collateralization ratio for the FRAX stablecoin using AMOs and real-world assets (RWA). FRAX V3 will leverage oracles, and other protocols in the FRAX ecosystem like Fraxlend and Fraxswap to create a ‘sovereign USD peg’ for the FRAX stablecoin.
AMOs in V3 are deployed on Fraxlend, external protocols like Curve Finance, and FRAX RWA partners. The Frax governance makes a decision on the RWA partners and the external protocols where the AMOs are deployed. On V3, the FRAX governance system will gain more control over the protocol.
Oracles tracks the price of FRAX, the IORB (Federal Reserve Interest on Reserve Balances), or real-world assets in the FRAX collateral system. When the oracle reports an increase in the IORB, the AMO utilizes the RWAs held by FRAX protocol partners. When the oracle reports a decrease in the IORB the AMO will move to re-balance the system using overcollateralized loans on Fraxlend and other crypto assets.
In summary, the FRAX V3 intends to create a fully collateralized stablecoin system and make the FRAX stable coin non-redeemable, just like fiat currencies.
Frax Shares (FXS): Governance
Frax Shares (FXS) is the governance and utility token of Frax Finance. Unlike FRAX, it is not pegged to any value point and therefore, its value is subject to market forces. FXS plays a major role in the project’s governance, where users can lock up their FXS for up to four years for four times the amount of veFXS (i.e. locking up 100 FXS for 4 years returns 400 veFX). While every veFXS is equal to 1 vote in governance proposals, the veFXS balance will eventually decay from 4 to 1 veFXS after 4 years, at which time users can redeem their veFXS for FXS. veFXS also gives users additional boosts when collecting certain farming rewards.
As a governance token, veFXS holders participate in voting events to decide on changes to the project, such as the decision to onboard FinresPBC as FRAX v3's offchain RWA partner. However, the team believes that "the less parameters for a community to be able to actively manage, the less there is to disagree on" and the team "(takes) a highly governance-minimized approach to designing trustless money in the same ethos as Bitcoin."
Frax Ether (FrxETH): Liquid Staking on Frax
Frax Ether is Frax’s Ethereum liquid staking and stablecoin system. Whenever ETH is deposited into Frax Ether, frxETH is minted to the user, and the ETH is staked by the protocol and is used to earn staking rewards. Unlike other liquid staking providers like Lido and Rocketpool, where users earn rewards in stETH or rETH, Frax uses two tokens: frxETH and sfrxETH.
FrxETH is pegged 1:1 with ETH, and essentially is similar to a stablecoin, as it is not a yield generating asset. To earn yield on frxETH, users have to deploy it elsewhere, or deposit into the sfrxETH vault to start earning staking yield. This means the less frxETH is staked, the more sfrxETH stakers can earn since the same amount of rewards is distributed to fewer vault owners, which lets sfrxETH offer higher yields than its competitors. At time of writing, Frax Ether offers 3.91% APR to Lido’s 3.3%.
The Frax Finance Ecosystem and Subprotocols
As mentioned above, Frax Finance is also focused on liquidity and lending markets along with stablecoins, and the ecosystem also consists of the following subprotocols:
Frax Price Index (FPI)
FPI is a stablecoin pegged to the US Consumer Price Index, which is based on a basket of real-world consumer items, and is intended to hold its purchasing power through on-chain stability mechanims. According to Frax, FPI also serves as a unit of account, where denominating DAO treasuries and measuring revenue in FPI along with benchmarking performance against an FPI trading pair helps stakheolders gauge whether value accrual is actively growing against inflation in real world terms.
Fraxswap
Fraxswap is a decentralized exchange in the Frax ecosystem, its design is based on the Uniswap V2. Fraxswap uses a time-weighted variant of the AMM (TWAMM). Unlike the AMM, TWAMM allows users to permissionlessly swap crypto assets over a stipulated time. That is, instead of swapping assets instantly, users can schedule assets to be swapped over a number of blocks. For instance, users can submit an order to the system to trade 5 ETH over the next 2,000 blocks. To execute this order, the TWAMM splits the 5 ETH trade into smaller sub-orders which will be executed over the stipulated number of blocks.
FraxSwap is designed this way to enable the protocol to utilize the exchange for its stablecoin system. Using the TWAMM, Frax Finance claims that the protocol can stabilize the price of one asset by acquiring a specific collateral asset over a prolonged period or acquiring the asset itself. For instance, the protocol can commit the recurring profits made from the algorithmic money market into periodically purchasing and burning FRAX to keep the system stable.
Fraxlend
Fraxlend is a money market in the Frax Finance ecosystem. On Fraxlend, lenders commit assets to the lending pool and receive fTokens. Assets committed to the lending pool are known as Asset tokens. fTokens are interest-bearing ERC-20 tokens and can be redeemed for asset tokens. The interest earned on fTokens is determined by the interest rate which is in turn determined by the available capital to loan. The interest is paid by the borrower. Interest rates typically climb as more borrowers request funds from the lending pool.
To borrow an asset from the pool, borrowers lock up tokens known as collateral assets and receive a desired token. A borrower’s loan position has a loan-to-value (LTV) ratio. LTV ratio is the ratio between the Collateral asset and the Asset tokens. The LTV ratio changes when the value of the collateral asset or the asset token changes. Fraxlend features an oracle protocol that feeds the lending protocol with the value of assets in the lending pool and the collateral assets.
When a borrower’s LTV increases beyond the maximum LTV, the loan is considered unhealthy. The borrower can maintain the loan by adding more collateral assets or paying the interest and redeeming the loan. However, when the LTV ratio reaches the maximum level, anyone can redeem the loan by repaying it and claiming the collateral assets. This is the liquidation strategy of Fraxlend, which is meant to keep the whole protocol healthy and in operation.
FraxFerry
FraxFerry is Frax Finance’s interoperability protocol. FraxFerry executes asset movement between exclusive networks. Frax Finance claims that FraxFerry’s approach is effective in curtailing the alarming bridge hacks. A major improvement in the FraxFerry is the inclusion of a 24-hour lock period for bridging requests. How this works, the FraxFerry protocol features a ‘captain’. The captain is the validator, when a user makes a bridging request, the captain screens the transaction to rule out foul plays.
The transaction is then subjected to a 24-hour probation period. During this period, other role players in the protocol, known as ‘crew members’ screen the transaction further. If no issues are found after the probation period, the transaction is finalized as the ‘Ferry’ ships the assets to the target chain. During the probation period, the details of the transaction can be changed. The multi-sig will move to block any irregular bridging request.
Frax Roadmap
Frax Finance is still in development at the time of writing. Here are some notable events that could take place in the protocol in the near future.
Frax V3
Beyond the FRAX v3 stablecoin, Frax Finance is also deploying a series of other Frax v3 products, such as sFRAX, which is somewhat similar to MakerDAO’s DAI Savings Rate, which gives DAI holders exposure to Treasury yields.
sFRAX is a staking vault that taps into the corresponding hike in Treasury yields, where users can deposit sFRAX and receive 10% yield that would eventually shrink to around 5.4%, the current IORB rate.
“In order to complete a dollar-pegged stable coin, you need a way to bring the Fed yield on-chain.”
- Sam Kazemian, co-founder of Frax
There is also Frax Governance, which is aimed at decentralizing Frax Protocol operations. Previously, most actions were taking by key Frax stakeholders through Gnosis Safes, with the expectation that these stakeholders would not act maliciously and that external actors won’t force them to execute malicious actions.
However, with the introduction of Frax Governance, Frax Protocol is only controlled by veFXS holders through onchain governance, with veFXS holders having the fnal say over everything in the protocol.
FraxBonds are also coming to the Frax Finance ecosystem as part of the upgrade to V3. FraxBonds (FXB) are FRAX stablecoin debts at a specified time. FRAX holders can buy FRAX at a discount at a given time through bonds; however, the discounted Frax will go through a period of maturation before they are available for redemption, giving investors the opportunity to earn low-risk profits just through buying FXB and waiting for it to reach maturity.
FraxChain
According to information from the Frax Finance team, FraxChain is scheduled to launch in 2024. FraxChain will be an EVM-compatible Layer 2 network on the Ethereum blockchain, with frxETH as its gas token.
By developing an execution layer of its own, Frax Finance hopes to create a flexible platform for the protocols in its ecosystem. The basic functionality of the FraxChain is similar to other Layer 2 networks, although Frax Finance will take a hybrid approach for its Layer 2. The hybrid network will combine the strength of optimistic and zero-knowledge rollup technologies. The zero-knowledge proofs will be used to verify the authenticity of transactions on the FraxChain. Frax Finance hopes to develop a network that lets its protocols thrive. Users could also enjoy cheaper fee and faster transactions while also receiving the security and decentralization benefits of zk-rollups.
Final Thoughts
Frax Finance started as a stablecoin protocol, and has since evolved to include an entire ecosystem, including other key DeFi offerings like liquid staking, DEXs, lending, and even its own Layer 2 chain. With its v3 initiatives like sFRAX and FXB, Frax Finance is channeling treasury yields to the crypto industry, offering higher low-risk yields. Also, by moving away from USDC collateralization for FRAX, Frax Finance is also lowering its third-party risks while introducing a new method of peg maintenance through AMOs, RWAs, and governance actions.
However, Frax Finance is not without competitors in addressing the Trinity of stablecoins, liquidity systems and lending: Aave and Curve are already launching their own stablecoins, suggesting an industry-wide shift in favor of this trend.
Finally, not that this article is only for educational purposes and not financial advice, and featuring a project is also not a recommendation or an endorsement in any way. Always do your own research before investing in any protocol.
Joel is deeply interested in the technologies behind cryptocurrencies and blockchain networks. In his over 7 years of involvement in the space, he helps startups build a stronger internet presence through written content. Follow the author on Twitter @agboifesinachi
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