The State of Stablecoins with Frax Finance w/ Sam Kazemian - Ep.73 Podcast Notes

Frax Finance

Frax Protocol is among the OG DeFi protocols in the cryptoverse. While it started out as a stablecoin project, it has recently branched out into providing other DeFi services such as liquid staking, lending and trading via Fraxlend and Fraxswap. It currently rakes in ~$80M of revenue annually. 

Sam Kazemian

Sam is the founder of Frax Finance. His crypto journey started way back in 2013 when he was a student at UCLA and heard about Bitcoin and mining, which got him into researching crypto and mining POW coins like BTC, DOGE, LTC and more. After college, Sam started Everpedia - think Wikipedia but on the blockchain. In 2019, just around the time DeFi was starting to pick up, Sam started to think about the stablecoin space and where it was headed. That’s when Frax was born, with its first version released in 2020. Now, Frax is the 5th largest stablecoin by market capitalization. 

Ep.73 Podcast Summary / Notes

1. What is Frax? How does it work and how does it maintain its peg?

• Frax is the first fractional stablecoin, modeled after fractional reserve banking

• Idea behind it is that they don’t think original algostables like basis etc. would work without exogenous collateral

• Frax is a hybrid, having the best of both worlds with peg stability + capital efficiency and usability (caveat regarding USDC collateral is acknowledged, more on this later)

• Frax is about addressing the stablecoin trilemma (peg stability, decentralization, and capital efficiency) which is based on Vitalik’s blockchain trilemma (scalability, security, decentralization) - So far projects only achieve two and compromise on the third

  • E.g. LUSD is decentralized and pretty stable, but not capital efficient; UST was decentralized and capital efficient, but not peg-stable

  • Sam thinks that Frax performs the best with regards to the trilemma in comparison to every other stablecoin now

2. Terra’s collapse was one of the biggest black swan events in crypto - how do you think it will affect Frax? 

• The event has spooked the industry and brought stablecoins into the regulatory spotlight, but Sam is generally optimistic on inevitable regulations as stablecoins have real utility and are not going away

• Sam believes that financial disclosures for fiatcoins being mandated would also be useful, and that most stablecoin protocols are already compliant to any regulation that may be rolled out (barring an outright ban or sanction) as there’s like a disclosure every 15s when a new block is added on the Ethereum blockchain. 

• Sam thinks that the stablecoin space will be one of the most interesting/innovative over the next 6-12 months - most lucrative but also technologically interesting

3. On Fraxlend, Fraxswap, Frax Price Index (FPI)

• Frax started out as just a dollar pegged stable, but has now grown enough to branch out into AMMs (Fraxswap), a lending market (Fraxlend), and a non-USD-pegged stablecoin (FPI)

• This is important as the whole vision for Frax is not just to build a bunch of fun products, but to build “the trinity” - the DeFi stack composed of a lending market (debt origination facility e.g. Maker CDPs, Fraxlend), a liquidity AMM (e.g. Curve, Uniswap, Fraxswap), and stablecoins (a liquid, useful, widely circulating unit of account)

• He calls this the trinity because they are the same product - a financial economic stack. As one piece of them (whichever a project starts out with) gets bigger, in order to capture more market share in DeFi the project will inevitably branch out into the other two pieces that it lacks. 

• No other project today has all three pieces of the trinity other than Frax

  • E.g. MakerDAO has two (internal lending + stablecoin, but no AMM - Sam guesses they’ll probably think more and more about that market, which proves that the trinity vision is probably accurate)

  • GHO stablecoin by Aave - Aave has lending and you can see Aave is trying to capture stables as well, but probably still far out from the AMM part. Sam is confident that if Aave’s GHO goes well, they’d also be looking into building their own AMM. 

  • Curve is an AMM, but now launching its own stablecoin. If their crvUSD goes well, then they’d probably try to roll out some type of lending protocol. 

• Sam thinks that whether projects think of it this way or not, everyone is moving towards the ‘trinity’, and that’s why Frax has rolled out the AMM and lending part.

• Endstate of DeFi - building a full financial digital economy, like bringing a central bank onchain. Sam thinks that Frax is in the lead in regards to this, and a lot more projects will be thinking about how to do it.

4. TornadoCash’s sanction by OFAC has revived concerns and discussions on centralized stables. How has Frax been impacted by having USDC as its primary collateral?

• Two things Sam wants to highlight before talking about USDC exposure:

  • Most important thing for a stablecoin project is being able to survive sanctioning, but also to avoid being sanctioned at all in order to avoid social death

  • E.g. LUSD which is only backed by ETH and is decentralized. So if LUSD was sanctioned, it would technically survive, but if most people can't use it without fearing penalty and it stops being useful, LUSD would still die off

  • A stablecoin project should aim to be so useful to common law-abiding users that any sanctioning of the protocol would bring a massive backlash

• USDC collateral is a common concern, both MakerDAO and Frax hold a significant amount of collateral in some centralized fiat coins

  • For MakerDAO its 82% of every DAI in existence being collateralized by USDC

  • Frax also has USDC exposure, but Sam thinks not nearly as much

  • One of the things that Frax does is that it deploys USDC and other collateral to different DEXs e.g. Curve, Uniswap, Fraxswap

  • In order for Frax to get blacklisted and its USDC be inaccessible, Circle has to blacklist Curve, Uniswap, and individual pair contracts that other people are LPing in, swapping in, staking in, etc. While this is technically possible and admittedly would be really bad, this is a different trust model than e.g. MakerDAO which holds its USDC in a smart contract that they control and that Circle can surgically strike and blacklist

  • However if the former situation does happen, what that would also do is also break all those pools and make it so that all the Frax in those pools are inaccessible are unswappable - so even if this is bad, this makes it so that there’s less Frax on the open market that users can pull out and redeem from the protocol

  • It’s interesting that changing the place where the protocol holds USDC makes it so that it becomes much more costly for Circle/any fiatcoin issuer to blacklist Frax

  • And if MakerDAO follows suit, then it becomes difficult to blacklist Maker as well

  • With that said, ideally there should be little to no USDC/fiatcoin collateral exposure - this goes back to the stablecoin trilemma. In order for peg stability and elastic money supply, it seems like the compromise is decentralized collateral. No surprise/coincidence that Frax and DAI are the largest decentralized stablecoins by far. All other onchain dollar-pegged stablecoins combined don't add up to either Frax or DAI, which shows that they have sacrificed on scalability.

• Perhaps there’s some completely new innovation that breaks the stablecoin trilemma, e.g. Vitalik claims that POS, sharding, and L2s break the blockchain trilemma, so perhaps there’s an answer to the stablecoin trilemma

  • Sam thinks the answer has to be something similar to Fraxlend or lending onchain that’s extremely malleable, and the ability to originate debt in many different ways that isn’t just overcollateralized ETH or BTC. So Fraxlend is their lending system that’s isolated pairwise lending, which is different to what Aave or Compound is. Hopefully as Fraxlend grows they can lower their reliance on USDC and fiatcoins. But we haven't seen any stablecoin project break this trilemma. Perhaps Frax would, perhaps MakerDAO first. 

  • Sam is confident that in the next year Frax would have the lowest fiatcoin reliance with one of the largest amount of circulating supply 

5. On stablecoin adoption, why would people pick Frax over other stablecoins?

• Sam thinks that adoption can’t be easily attained, either you pay people which is unsustainable, or you have something unique, useful and safe.

• So if Frax can solve the stablecoin trilemma, then that’s going to be something that is useful. Something that is non custodial, is stable, and has no risk of blacklisting. If Frax is successful with that then there’s a value prop for it over USDC/USDT etc.

• Frax is among the most peg-stable stablecoins which can be used to earn yield on many DeFi projects, which is why it still has an appeal to users. Over time, Sam thinks that this will lead to more adoption of Frax

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Wendy M.

Wendy is a research intern at CoinGecko. Follow the author on Twitter @alfalfawm