A Primer on Frax Finance: Navigating Innovations, Products, and Future Developments
TL;DR
- The present report serves as a preliminary analysis of Frax Finance, offering an overview of its current ecosystem, delineating its product suite, and probing its future potential.
- In the last bull run, $FXS outperformed Bitcoin due to key events like exchange listings, emission halving, and airdropping, though it has not mirrored the price surges of leading liquid staking derivative tokens like $LDO and $RPL due to late issuance of frxETH; meanwhile, $FRAX has shown resilience against market volatility, largely due to its advanced AMO strategies and robust $FXS staking.
- Frax Finance is introducing a series of significant upgrades aligned with major DeFi trends: FRAX V3 aims to strengthen its stablecoin mechanism and reduce $USDC dependency; FinresPBC will venture into Real World Assets via Fraxbond (FXB); frxETH V2 focuses on decentralization and yield optimization; and FraxChain, an upcoming EVM-compatible Layer 2 solution, aims to enhance scalability and security, providing potential tailwinds for future growth in both the protocol and the value of $FXS.
- Frax Finance, propelled by a dedicated team and innovative mechanisms, is evolving into a comprehensive DeFi ecosystem with strong synergies, and upcoming developments like FRAX V3, frxETH V2, and FraxChain are poised to significantly drive its growth and value for $FXS token holders.
1. Background
Frax Finance, notwithstanding its status as one of the pioneering protocols in the DeFi landscape, remains an enigma for many new users in the field. Its multifaceted suite of offerings, coupled with intricate operating mechanisms, can appear daunting upon initial inspection. Nonetheless, Frax Finance merits close attention given its groundbreaking innovations and strategic forays into new market sectors. This report serves as a preliminary analysis of Frax Finance, offering an overview of its current ecosystem, delineating its product suite, and probing its future potential. While this analysis is not exhaustive, it aims to furnish readers with a foundational comprehension of the protocol and to preview forthcoming developments within the Frax Finance framework. Readers are strongly advised to engage in rigorous due diligence for a more comprehensive understanding of the protocol and the risks inherent therein.
2. Introduction
Incepted in May 2019, Frax Finance commenced as an algorithmic stablecoin protocol but has since transitioned into a sophisticated stack within the Decentralized Finance (DeFi) sphere. Presently, Frax Finance orchestrates a diversified portfolio of initiatives, encompassing three distinct categories of stablecoins, underpinned by a trinity of foundational infrastructures. Its operational reach extends across a multifaceted spectrum of sectors, including but not limited to, stablecoins, decentralized exchanges (DEXs), money markets, and liquid staking. Additionally, the integration of Real World Assets (RWA) is forthcoming. As a result, Frax Finance not only stands as a paragon of innovation within the DeFi landscape but also ranks among the most labyrinthine of protocols.
3. Performance Overview
As Bitcoin’s performance is often used as the Beta for the broader cryptocurrency market, contrasting any given token’s price action against $BTC can offer insights into that token’s relative performance. When accompanied by an analysis of key events, this comparative framework provides a critical barometer for assessing market sentiment. Specifically, if optimistic developments fail to catalyze positive price action, it may indicate a potential shift in market focus away from the given protocol, thereby diminishing its investment allure.
According to the chart, during the most recent bullish run, Frax Shares ($FXS) closely mirrored general market trends, experiencing substantial price appreciation. Notably, between December 2021 and March 2022, $FXS outperformed $BTC, marked by two salient price surges. These upticks can likely be ascribed to a series of bullish events during that interval, including Binance's listing on December 10th, $FXS's emission halving on December 20th, the announcement of $FPI airdrop distribution on February 19th, and FTX listing on March 24th. Subsequently, $FXS has largely tracked the broader market without significant deviations. While the Frax team has announced forward-looking plans, $FXS's recent price action has deviated from historical patterns, perhaps due to a prevailing bearish market sentiment that necessitates closer scrutiny as these catalysts approach.
When juxtaposed with leading liquid staking derivative (LSD) tokens like $LDO and $RPL, $FXS, owing to its belated entry into this sector, failed to experience the price surges precipitated by the approaching Ethereum Merge, though it did capitalize on the Shanghai Upgrade. With the imminent launch of frxETH v2, it remains a topic of avid speculation how $FXS will fare in relation to $LDO and $RPL.
For an algorithmic stablecoin, $FRAX has demonstrated laudable stability, particularly during tumultuous periods such as the LUNA-UST downturn. Although intermittent peg deviations occurred, swift corrective mechanisms precluded further deterioration. The most severe de-pegging incident transpired when Circle disclosed its exposure to SVB; given that $FRAX is substantially backed by $USDC, the stablecoin was not insusceptible to the news. However, owing to the negligible scale of the exposure, the peg was promptly restored. This resilience can primarily be attributed to the protocol’s advanced Algorithmic Market Operations (AMO) strategies and the robust staking of $FXS, thereby safeguarding Frax from the downward spirals that have beset other algorithmic stablecoins.
Notwithstanding its stability, the LUNA-UST crash triggered a liquidity exodus, leading to a precipitous contraction in the market capitalization of decentralized stablecoins like $DAI and $FRAX. Subsequent developments, such as the SVB event, led to a further erosion of $USDC’s market share, with liquidity increasingly gravitating towards $USDT, which has sustained a rising market cap since 2023.
Two critical metrics for assessing Frax’s performance include its market share within the stablecoin and LSD sectors. Although $FRAX is the second-largest decentralized stablecoin, its market share is a paltry 0.5%, lagging 8.8 times behind $DAI and 136 times behind $USDT. These disparities can be attributed to various factors, including the predominant role of centralized stablecoins as the primary entry point for nascent cryptocurrency users. Unless unforeseen developments significantly alter this landscape, these discrepancies are likely to persist in the long term.
In the realm of Liquid Staking Derivatives (LSDs), Frax demonstrates an exceptional market standing. Excluding Lido, the market share differential between sfrxETH and its three primary LSD competitors is remarkably narrow. This can largely be ascribed to two critical factors: Frax’s superior yield offerings and the increasing regulatory scrutiny pressuring centralized exchanges (CEXs). With the impending launch of frxETH V2, it is projected that Frax’s expansion within the LSD sector will continue outstrip its growth in the stablecoin arena.
4. Protocol Mechanism
Frax Finance boasts one of the most intricate protocol architectures in the DeFi landscape. Its continual expansion of product offerings and business sectors has culminated in an autonomous ecosystem replete with diverse stablecoins and the foundational infrastructures that catalyze their growth. In this report, we designate the trio of stablecoins issued by Frax as its flagship products, while identifying the supporting mechanisms as the core infrastructure. We elucidate the conceptual frameworks and overarching significance of each stablecoin and expound upon the ways in which these infrastructures synergistically contribute to the protocol’s operations.
4.1 Flagship Products
4.1.1 Frax
$FRAX is the first stablecoin from Frax Finance. Unlike DAI, which leads in terms of market cap and relies on over-collateralization, $FRAX is an algorithmic stablecoin partially collateralized by USDC and Frax’s native token, FXS. Designed to maintain parity with the U.S. dollar, FRAX uses market dynamics to determine its collateralization levels. Initially, FRAX started as 100% USDC-collateralized. Over time, the protocol algorithm adjusts the Collateral Ratio (CR) based on market demand. For instance, an 85% CR signifies that one FRAX is backed by $0.85 in USDC and $0.15 in FXS. Arbitrageurs and the protocol’s own algorithms work in concert to maintain this $1 peg.
FRAX is now in its V2 stage, utilizing multiple Algorithmic Market Operations (AMOs) to conduct open-market operations. This ensures FRAX remains pegged to $1. AMOs have become a cornerstone of Frax’s success, offering a sophisticated adjustment mechanism beyond the Core Stability Module used in V1.
In 2023, the DAO voted to elevate the CR back to 100%, deeming it the most prudent route for sustaining FRAX’s growth. The rationale is that while a fluctuating CR enhances capital efficiency, the mature state of the Frax ecosystem makes it unnecessary. AMOs continue to provide FRAX with high capital efficiency nonetheless.
4.1.2 FPI
Frax Price Index (FPI) is the protocol’s second stablecoin, designed to adjust according to real inflation rates as measured by the U.S. Consumer Price Index for All Urban Consumers (CPI-U). A specialized Chainlink oracle fetches this data. As FPI’s peg is tightly bound to inflation rates, the redemption price of FPI either ascends with inflation or descends with deflation. This design allows users to effectively “bet” on the CPI’s purchasing power when they exchange assets for FPI.
FPI serves as an innovative on-chain benchmark for transactions, valuations, and debts, providing a valuable tool for DAOs and similar entities to measure value accrual against inflation.
4.1.3 frxETH
Frax Ether (frxETH) represents Frax’s foray into the realm of liquidity staking market. Pegged to Ethereum, frxETH can be staked to generate sfrxETH, which earns the ETH staking rewards. The total rewards for sfrxETH are amplified by any frxETH that remains unstaked. This innovative model positions sfrxETH as a higher-yield alternative to other liquidity staking tokens like stETH and rETH. For frxETH, liquidity providers can provide liquidity to the frxETH-ETH Curve pool to earn transaction fees and emission rewards.
With its substantial holdings $CRV and $CVX, Frax can direct significant rewards to incentivize liquidity. The upcoming launch of frxETH V2 is expected to further boost adoption, strengthening Frax’s foothold in the competitive DeFi landscape.
4.2 Core Infrastructures
4.2.1 Algorithmic Market Operations (AMOs)
For stablecoin protocols like Frax Finance, maintaining stability is crucial. A failure to do so not only undermines user confidence but can also trigger a chain reaction that disintegrates the entire protocol. AMOs are sophisticated smart contracts that manage various monetary operations to uphold FRAX’s stability. Frax Finance has evolved from utilizing a single AMO in its V1 to employing four major AMOs in the current V2 iteration. While each AMO has its unique operation, they share three common features: Decollateralization, Market Operation, and Recollateralization. These strategies adjust the Collateral Ratio (CR) as needed.
4.2.2 Fraxswap
Fraxswap is the first Constant Product Market Maker (CPMM) integrated with the Time-Weighted Average Market Maker (TWAMM). This integration optimizes the execution of long-term orders by pooling and aligning them, thus facilitating larger orders more efficiently. Fraxswap serves multiple purposes:
-Buying back and burning FXS using AMO profits -Minting new FXS to repurchase and burn FRAX -Issuing FRAX to acquire hard assets via seigniorage
Fraxswap is fully permissionless, allowing other protocols and DAOs to tap into it for their monetary policy. The upcoming Fraxswap V2 will support concentrated liquidity and correlated asset liquidity, expanding its utility further.
4.2.3 Fraxlend
Fraxlend, Frax Finance’s native money market, facilitates borrowing and lending of ERC-20 token pairs. Each lending pool is overcollateralized and isolated, mitigating counterparty risk and potential insolvency. Fraxlend aims to boost $FRAX adoption organically by permitting users to maintain Collateralized Debt Positions (CDPs) in $FRAX. Notably, Fraxlend operates on a no-fee model, incentivizing greater adoption. A V2 iteration is also in the pipeline, which may introduce undercollateralized loans.
4.2.4 Fraxferry
Fraxferry is an innovative solution designed to facilitate Frax Finance’s multi-chain expansion. It serves as a secure, albeit slower, bridge for transferring assets across different networks. An upcoming V2 aims to further decentralize this mechanism.
The asset transfer process via Fraxferry involves several steps:
1. Users begin by sending tokens to the Fraxferry smart contract.
2. A designated “Captain” reviews and batches the transactions.
3. A 24-hour waiting period ensues for additional verification.
4. Upon execution, the system validates the transactions by comparing their hash values.
5. Tokenomics
$FXS serves as the staking and governance token for Frax Finance, accruing all yields and utilities. To unlock the full range of benefits, users are encouraged to lock their $FXS tokens to obtain $veFXS, which operates on a model similar to Curve’s veToken. Holding $veFXS grants users various benefits including voting rights, gauge farming boosts, and a share of revenue streams from AMOs, Fraxlend loans, and Fraxswap fees.
As of the current data, approximately 37.484 million $FXS tokens are locked, accounting for 50.88% of the circulating supply and 37.6% of the total supply. It’s important to highlight that following the implementation of FIP-256, the protocol is committed to buying back $FXS
whenever its price falls below $5 and $4. This buyback proposal enhances the token’s economics by establishing an implied valuation floor.
6. Growth Drivers
Due to its diversified business sectors, Frax Finance has several upgrades in the pipeline that align well with major narratives. These could serve as significant tailwinds for its future growth. This section reviews each upcoming development and examines its potential impact.
6.1 FRAX V3
Although details are scant, FRAX V3 aims to eliminate dependency on $USDC and introduce a novel stablecoin mechanism to enhance protocol robustness. Sam Kazmien, co-founder of Frax, revealed that FRAX V3 will abandon its current pegging mechanism and steer clear of fiatcoins. Additional information is yet to be released.
Another key highlight is the expansion into the Real World Asset (RWA) sector. A non-profit entity, FinresPBC, is being launched to capitalize on US government bond yields for users. This entity will facilitate off-chain transactions involving US government bonds, and users can participate through Fraxbond (FXB), which can be swapped with $FRAX. Considering that RWAs are a major trend in the current DeFi market, this move could potentially replicate the success of MakerDAO, whose token has recently shown impressive performance.
6.2 frxETH V2
In response to user complaint about the centralization of frxETH, the protocol is set to launch frxETH V2. This version aims to decentralize the mechanism while maintaining or even increasing yields for users. Two key innovations have been introduced: a utilization-based interest rate and a decentralized lending market. The team views the LSD market as a lending and borrowing market, warranting these changes.
In this model, any user can provide collateral and borrow ETH to become a validator. The interest rate will dynamically adapt based on market demand, thereby creating a vibrant marketplace for both lenders and borrowers in the LSD sector.
6.3 FraxChain
Sam Kazmien disclosed in a recent podcast with FlyWheel DeFi that the protocol plans to launch its own EVM-compatible Layer 2 solution, dubbed FraxChain. While specific details remain under wraps, two key features have been announced. Firstly, FraxChain will be a hybrid rollup that employs Optimistic architecture while integrating ZK technology for added security. Secondly, frxETH will be used for gas token, which should boost its demand and thereby improve yields for sfrxETH holders. The accrued fees will funnel to $veFXS holders, further boosting the token’s value. With the Cancun Upgrade highlighting Layer 2 narratives, the end-of-year launch of FraxChain is likely to attract significant market interest.
7. Growth Potential
The above mentioned growth drivers could boost the according sector sinificanlty. To furthure demonstrate Frax’s potential, this sectio presents a straightforward comparative analysis on the the LSD market, one of Frax major business sectors, to provide some insight into the protocol’s growth outlook.
Lido, Coinbase, and Rocket Pool lead the way in terms of the LSD market share. For the purposes of this analysis, we will use the top three LSDs as representative samples. Currently, the top three LSD protocols have an a total of 10.85M stkaed ETH, which informs a 90.72% of market share collectively.The current staked ETH amount of Frax is around 0.26M. Assuming conservatively that the current numbers for top 3 LSD protocol represent the targets for Frax, and setting 50% of Rocket’s amount, the median of the top 3’s amount, and the average of top 3’s’ volume as our bear, base, and bull case scenarios, we can roughly estimate the potential growth upside for Frax’s LSD.
While this basic comparison emphasizes the potential for Frax’s LSD, it’s essential to recognize that matching the staking amount of the top 3 protocols isn’t necessarily a straightforward process, and the process is influenced by multiple factors. However, this analysis has clearly highlights the potential of Frax, coupled with the upcoming V2 update, the future is certainly bright.
(This analysis is a simplified way to gauge the potential growth of Frax’s LSDs, using the top protocols as a baseline and their staked ETH amount as a target. For a more detailed forecast, several additional factors need to be considered, meaning this analysis should only be viewed as a rough measure of Frax Ether potential.)
8. Conclusion
Starting as an algorithmic stablecoin protocol, Frax Finance has successfully evolved into a comprehensive DeFi stack, covering all core sectors within the ecosystem. The team’s dedication and ingenuity are the driving forces behind Frax’s current state and its promising future outlook. The mechanisms and products within the Frax ecosystem are skillfully designed to create strong synergies. These synergies have the potential to initiate a positive flywheel that could spur both the protocol’s growth and value accrual for $FXS token holders.
Looking ahead, it’s crucial to closely monitor key upcoming developments such as FRAX V3, frxETH V2, and FraxChain. These initiatives will be pivotal in shaping the future of Frax and will likely have a significant impact on its success and market adoption.
References
Declaration
The present report is an original work of @BC082559, a contributor of @GryphsisAcademy. The author(s) alone bear the responsibility for all content, which does not essentially mirror Gryphsis Academy’s views or that of the organization commissioning the report. The editorial content and decisions remain uninfluenced by the readers. Be informed that the author(s) may own the cryptocurrencies mentioned in this report.
This document is exclusively informational and should not be used as a basis for investment decisions. It is highly recommended that you undertake your own research and consult a neutral financial, tax, or legal advisor before making investment decisions. Keep in mind, the past performance of any asset does not guarantee future returns.
