Frax Ecosystem 101: A Beginner’s Guide to the Revolutionary DeFi Protocol and its Primitives
The world of cryptocurrencies has been rapidly expanding over the past decade, with new innovative projects and technologies constantly emerging. One such project that has been garnering attention is Frax Finance.
So, what is Frax Finance?
Frax Finance is a decentralized cross-chain protocol that aims to establish a scalable, digital currency with a flexible supply, backed algorithmically and by collateral.
However, to truly appreciate the significance of Frax Finance, it’s important to understand the history behind it. From its early beginnings as Decentral Bank to its revolutionary fractional-algorithmic stablecoin protocol.
Frax Finance’s journey is a fascinating one. Join me as I explain in detail, what this protocol is all about.
Meaning and Origin of Frax Finance
Frax Finance is a decentralized protocol founded by Sam Kazemian, Travis Moore, and Jason Huan in 2019. Formerly known as Decentral Bank, its mission is to provide a stable and decentralized currency through the use of a fractional-algorithmic stablecoin called FRAX.
The working principle of the protocol is based on the academic paper “A Note on Cryptocurrency Stabilisation: Seigniorage Shares” by Robert Sams, which proposes a way to stabilize cryptocurrency prices by using a combination of algorithmic and collateralized stabilization mechanisms.
Drawing inspiration from the academic paper, the Frax protocol was launched on the Ethereum mainnet on December 20, 2020, with early users testing it on a testnet a month prior. Within an hour of launch, the protocol had over $43 million worth of cryptocurrency locked in its system.
As of January 13, 2021, 100 million FRAX tokens had been minted, with an 85% collateral ratio. On January 19, 2021, Frax Finance became the fifth most liquid token on Uniswap, surpassing Wrapped Bitcoin, with over $130 million in liquidity.
By February 17, 2021, Frax Finance became the first algorithmic stablecoin to be listed on Binance, with trading pairs opening the following day.
Prior to its (Frax) launch, in 2020, existing stablecoins were either collateral-backed or relied solely on algorithmic minting and burning processes. Collateralized stablecoins were not very efficient in terms of capital usage, while fully algorithmic ones were inherently fragile and susceptible to failure during unpredictable market conditions.
However, Frax Finance managed to combine the strengths of both models to create the world’s first fractional-algorithmic stablecoin protocol, which addresses their respective shortcomings.
Upon its release, FRAX, the protocol’s stablecoin, was partially collateralized, with the remaining supply being flexible. This means that the level of collateralization was determined by the protocol’s collateral ratio.
Frax Finance is also a multi-chain protocol, currently compatible with several blockchains including Ethereum, Dogechain, Avalanche, Fantom, BSC, Polygon, Arbitrum, and Moonbeam. The protocol offers three DeFi financial services: stablecoins, liquidity, and lending markets.
In January 2022, Frax Finance expanded its collaboration with Chainlink to bring the U.S. CPI data on-chain in support of the Frax Price Index. (I’ll talk about this soon enough).
The founders of Frax Finance wanted to create a protocol that covers all three sectors of the DeFi industry, combining stablecoins, liquidity, and lending markets in one integrated platform. This unique approach to stablecoins and its innovative use of both algorithmic and collateral backing has created a niche within the stablecoin space, with an aim to be the first on-chain central bank that controls the monetary policy of a fractional-algorithmic stablecoin.
Understanding the original FRAX Stablecoin
A stablecoin is a type of cryptocurrency designed to maintain a stable value, usually pegged to a fiat currency like the US dollar. Stablecoins are important in the crypto industry because they provide a reliable means of exchange, store of value, and unit of account, without the volatility associated with other cryptocurrencies like Bitcoin.
Initially, the Frax stablecoin, or $FRAX, was partially collateralized by USDC and Frax Shares (FXS), the governance token of the Frax Finance ecosystem. The collateral ratio, or the amount of collateral required to back $1 of FRAX, is determined by market forces and changes over time.
Now, before we go too far, I’ll explain what partial collateralization and collateral ratio are.
- Partial collateralization in this context refers to a situation where only a portion of an asset is secured by collateral A while the other half is secured by collateral B.
- The collateral ratio is the percentage of a loan amount that is covered by collateral, and it is calculated by dividing the value of the collateral by the loan amount.
The protocol also utilized an algorithmic mechanism to maintain the stable value of FRAX. If the price of FRAX falls below $1, arbitrageurs are incentivized to buy FRAX and redeem it for USDC, thereby increasing demand and stabilizing the price. Similarly, if the price of FRAX rises above $1, arbitrageurs can mint new FRAX tokens by providing USDC and FXS, sell them on the market, and profit from the difference in price, thereby increasing supply and stabilizing the price.
This combination of collateralization and algorithmic mechanisms allowed Frax to create a stablecoin that is scalable, decentralized, and able to adjust to changing market conditions. This feature also provided users with a stable and decentralized currency that can be used for a wide range of financial applications, from payments to lending and more, while avoiding the volatility associated with other cryptocurrencies.
The rebrand
Now, despite the conservative approach that Frax Finance had taken in the past regarding the algorithmic backing of FRAX, the circumstances surrounding the project have changed. We all saw what happened to the Luna-Terra ecosystem and other algorithmic crypto projects over the last year.
To avoid this happening to the Frax Finance ecosystem also, the team had to come up with an idea that would have to make FRAX an asset that users are comfortable holding for the long term without any incentives. The idea was to increase the “money” attributes of FRAX, and specifically, to increase the collateralization ratio (CR) to 100%.
To do so, a proposal was made suggesting retaining protocol earnings as the protocol grew. This proposal would increase protocol assets and remove the need for FXS emissions towards locked liquidity. Additionally, it authorized protocol comptrollers to strategically exchange up to $3m of protocol assets for frxETH each month, which would increase the CR and the supply of frxETH and validators. (we’ll talk about frxETH later on).
So, on February 23rd, 2023, a vote was passed to fully collateralize its flagship stablecoin, signifying the end of partial collateralization.
So, what does this mean?
It means that the FRAX stablecoin is now backed by assets that are worth at least the value of the outstanding supply of FRAX (backed 1:1 with USDC).
To bring the proposal- now formalized- to fruition, Frax Finance developed an algorithmic market operations controller (AMO) module that is designed to maintain the stability of the FRAX price peg. This module can perform open market operations autonomously, but cannot mint FRAX out of thin air, as doing so would break the peg.
Under this new model, Frax Finance’s AMOs play a critical role in maintaining the peg of FRAX to USDC. These AMOs deploy idle USDC collateral and mint FRAX into different decentralized exchanges (DEXs) to create liquidity and tighten the peg.
Now, let’s get a bit technical about these AMOs.
Algorithmic Market Operations (AMOs)
Before we continue, I’ll want to remind you that the implementation of AMOs in the Frax protocol, is to maintain a stable value of its stablecoins by dynamically adjusting the collateral ratio. These AMOs are designed to automate the movement of FRAX and its collateral across DeFi ecosystems in a capital-efficient way.
Frax has implemented five AMOs:
- the Collateral Investor AMO,
- Curve AMO,
- Uniswap v3 AMO,
- Frax Lending AMO, and
- FXS1559 AMO.
Each AMO serves a specific purpose in the Frax ecosystem, such as depositing idle collateral from the Frax treasury across several DeFi protocols or providing liquidity for other stablecoins to be traded for FRAX.
To back this up, Frax also launched Algorithmic Market Operations controllers, which are smart contracts that algorithmically execute different open market operations to generate revenue and ensure the protocol is more secure and robust by putting its collateral to work. These AMOs generate substantial profits for the protocol, which eventually accrue to the FXS holders through buybacks and token burns.
Each AMO has four properties:
- de-collateralize,
- market operations,
- recollateralize, and
- FXS1559
Decollateralize refers to actions that lower the collateral ratio, while recollateralize refers to actions that increase the collateral ratio. Market operations refer to actions that run in equilibrium and don’t change the collateral ratio, and FXS1559 is a formalized accounting of the balance sheet of the AMO that defines exactly how much FXS can be bought and burned with profits above the targeted collateral ratio.
To generate yield,
- The Investor AMO deploys the protocol’s collateral to yield aggregator protocols and money markets like Yearn, Aave, Compound, and OlympusDAO.
- The Curve AMO deploys idle USDC and newly minted FRAX into the FRAX3CRV pool on the Curve exchange to earn revenues from trading, admin fees, and CRV incentives.
- The Lending AMO mints FRAX directly into pools on money markets like Compound and CREAM, allowing users to acquire it through over-collateralized borrowing instead of the standard minting mechanism.
- Finally, the Liquidity AMO puts FRAX and part of the protocol’s collateral to work by providing liquidity against other stablecoins on Uniswap V3 to earn revenue from trading fees and further deepen FRAX’s liquidity.
Under this new model, Frax Finance’s AMOs adjust the supply of FRAX in circulation to maintain its price stability. Thus causing the collateral ratio of FXS backing to also be determined by market forces. This is similar to a central bank conducting open monetary operations for their economy.
Frax Finance’s fully collateralized model has proven successful so far, as FRAX has yet to depeg against USDC, even during market turbulence.
FRAX3CRV Pool
Now, Frax Finance earns trading revenues generated from the LP position and also the rewards emitted to the pool. But how does it do this?
Frax Finance owns a significant portion of the Frax-3CRV pool and the Frax Base Pool (FRAXBP) on Curve, two of the largest stablecoin pools on the DEX, which allows them to have a strong reserve of Protocol Owned Liquidity (POL) and a continuous revenue source.
Currently, the FRAX3CRV pool has a total value locked (TVL) of $1 billion, making it the largest stablecoin pool on Curve. This has recently overtaken the 3Pool, which is composed of DAI, USDC, and USDT, and had previously held over $3 billion worth of liquidity.
The FRAX3CRV pool on Curve is designed to move idle USDC collateral and newly minted FRAX tokens to the pool, where they can earn trading fees, CRV, and LP rewards. These rewards are then given to veFXS holders, who hold a governance token for the Curve protocol (we’ll discuss that soon). The trading fees and LP rewards are distributed to veFXS holders, while the CRV rewards are used to boost the rewards given to the FRAX3CRV pool.
FRAX gauge weighted system
FRAX gauge weighted system is a system designed to control FXS (Frax Share) emissions and expansions. It is designed to align incentives for long-term FXS holders and LP providers, giving them control over the future emission rate of FXS and eventually, FRAX stablecoin expansions.
The system allows FXS holders to stake their tokens for up to 4 years and generate veFXS (vested FXS) tokens, which give them voting rights on where future FXS emissions are directed. The more veFXS a user has, the more voting power they have.
Using their veFXS balance, users can vote for FRAX gauge weights. They can distribute their voting power across multiple gauges or a single gauge, which allows long-term users of the protocol to have control over the future FXS emission rate. This system also lowers the influence of FRAX pairs where the majority of rewards are sold off since LPs (liquidity providers) for those pairs will not have veFXS to continue voting for their pair.
The FRAX gauge system favours LP providers who stake their rewards for veFXS to increase their pool’s gauge weight. These gauge weights are updated every week on Wednesdays at 5 pm PST.
So, what does it mean?
It means that the FXS emission rate for each pair is constant for 1 week and then updates to the new rate each Wednesday.
Once all the FXS has been distributed, the gauge system will transition to controlling FRAX stablecoin expansions as rewards for LPs. This switch from FXS to FRAX rewards will not occur for a few years until FXS emissions are nearing completion and the stablecoin has built trust and confidence.
In addition, veFXS stakers can feel confident staking their tokens for the maximum duration of 4 years, knowing that the gauge program is not temporary and won’t be deprecated when FXS rewards end. The gauge weights will simply transition to distributing FRAX stablecoins as rewards perpetually.
Through this, the Frax protocol provides a more capital-efficient and automated approach to managing collateral and generating revenue. This approach allows for greater security and stability in the protocol while also providing benefits to the FXS holders.
There’s still much to learn about Frax, and many questions to be answered about its long-term viability and potential risks. In part two of our exploration, we’ll delve deeper into the mechanics of Frax and examine some of the challenges it faces as it seeks to establish itself as a major player in the DeFi ecosystem.
So stay tuned for part two, where we’ll explore these issues and more, and continue our journey through the exciting and rapidly evolving world of decentralized finance.
