$FRAX: Revolutionary Stablecoin or Just Another Algo?
The quest for a fully decentralised, permissionless stablecoin has proved elusive. Has FRAX finally cracked the code?
Economics should be defined in terms of what it is about. It should be about how people produce things, how people exchange them, how people earn income…The subject has to be defined in terms of the object of inquiry
— Ha-Joon Chang
Algorithmic Stablecoin Blindspots
As best I can tell, crypto ‘maxis’ (I’m looking at you Bitcoiners) and stablecoin devs both have a couple of blindspots when it comes to money. In truth, I think there are many crypto blindspots, but the two most relevant to this discussion are that:
- Recency bias tends to play an outsize role in decision making; and
- There is a strong tendency to conflate currency with value.
Both are completely understandable. Recency bias happens to all of us and we are all vulnerable to its effects. Likewise, the vast majority of us use currency to exchange value without giving much thought to what it really is.
If you’re not a student of behavioural economics, recency bias is a cognitive distortion that causes people to place too much emphasis on recent events.
This tends to result in poor risk-based decision making. If you’ve ever heard a gambler say, ‘I’m on a roll, I can’t lose!’, that’s what it looks like, at least in the short-term. ‘Stocks always go up eventually’ is another common one for a longer time frame.
Point is, these ideas are true until they’re not. But someone evaluating from a longer time horizon can usually see through the distortion. That’s why history is important.
Currency and value
This is another one that’s pretty common. ‘Money is a store of value’ probably tops the list. You can thank the modern field of economics (or, what I call ‘the humanities dipped in math’) for this idea. Currency, or money as we generally refer to it today, is a promise.
Nothing more, nothing less.
In fact, what we call US dollars are Federal Reserve Notes. It’s printed right on the bill. The ‘promise’ is that the note will be accepted (mandated) to pay for all debts public and private.
The thing making that promise worthwhile is the US government guarantee (for what that’s worth) you can exchange the note for something that has actual value. By actual value, I mean, a good, a service, or to pay a debt — specifically the big one: your taxes.
So, a dollar kind of stores value. But it stores value the same way a friend’s promise to drive you to the airport ‘stores’ the value of that ride. The promise is valuable and fully redeemable…until your friend forgets to show up.
FRAX is a fractional-reserve algorithmic stablecoin. I know that’s a mouthful, but I’ll try to sum it. In terms of the algo stables I’ve looked at, it is by far — and I mean by FAR — one of the most elegant and thoughtful approaches I’ve seen.
I’ll say right up front, I’m 100% rooting for it and think it might work long-term — and I’m still skeptical.
The devs have done an excellent job improving on the algorithmic stability shortfalls that seem to plague the Basis.io derived ‘stable’ or ‘peg’ schemes. Moreover, as a hybrid system, I think it has a much better prospect for long-term viability than the current algo leader, Terra UST.
While a topic all on its own, I believe Terra will be facing significant stability issues sooner rather than later. I might cover it in a future article, but certainly not before my staking lock expires and I can dump my LUNA :)
And, yes, I just fudded my own bag.
FRAX is certainly more complex than the two protocols I just mentioned. While reading their documentation, I was reminded of a saying I heard often in grad school:
The readability of your paper decreases by a factor of 10 for every equation you include.
I imagine for the average defi baboon, most words look like ancient Greek even without equations. For the non-baboons (which is certainly all of my readers!), I’ll do my best to outline how FRAX works.
FRAX stability mechanics
Collateral Ratio (CR): FRAX is a fractional reserve algorithmic stablecoin. This means a fraction of the value deposited (USD$, in the form of USDC) is held in reserve (always available for redemption).
The ratio can range from 1:1 (full reserve) to 0:1 (no reserve). An algorithm dynamically sets the ratio depending on market demand for FRAX. More sellers than buyers = higher reserve; more buyers than sellers = lower reserve. In essence, the algo asks, ‘does the market trust they can redeem $1.00 FRAX for $1.00 USD?’
If the answer is yes, then we don’t need to keep as much money around. If the answer is no, then we need keep more money on hand to cover demand (e.g., to prevent a bank run).
Arbitrage: The practice of making profit from price discrepancies is called arbitrage. If you’ve ever seen someone with a list running around scanning items at Walmart, they’re probably Amazon Marketplace arbitrageurs.
If they can find a toy (or whatever) for $1 at Walmart, but the price on Amazon is $2, it’s easy money. Same is true for crypto, and the same mechanism works for FRAX.
FRAX can always (theoretically) be redeemed for $1. So, if the market price slips to $0.98, an arbitrageur can buy on the market and then sell back to the protocol for $1.00. Same in reverse, if the market price on an exchange is $1.02, the arbitrageur can mint a FRAX for $1 and then sell it on the market for profit.
It might not sound like much, but if you’re talking millions, it can add up fast.
Minting and Redemption: At genesis FRAX was full reserve (1:1). As such, to mint (create) one FRAX token, a user had to deposit one USDC. That USDC was locked in reserve and then the user gets their FRAX in return.
This is where FRAX is different. Remember the algo sets the CR (collateral ratio, if you forgot). Today, if a user wants FRAX, they’ll deposit one USDC. The protocol will then put a fraction , let’s say $0.70, in reserve and then burn some of the share token (which I’ll cover next) to ‘pay’ the other $0.30.
Same $1 FRAX token comes out. The difference is where the value came from to create the token. For the user, it looks exactly the same as the first example. One USDC goes in, one FRAX comes out.
For the protocol (and the market in general), the FRAX token you just created is partially backed by USDC and partially paid for by burning the share token. How much of each went into minting that FRAX is governed by the algorithm setting the CR.
To redeem, the same thing happens in reverse. You deposit one FRAX and you’ll receive $0.70 directly from the USDC pool and the $0.30 leftover will come from creating a share token. The share is ‘sold’ to the protocol at the current market price.
As the user, you won’t see any of this. You put one FRAX in, one USDC comes out. Same deal.
Share token: FXS is the share token. It is not pegged to anything and ‘floats’ on the open market. Market participants are incentivised to buy FXS tokens because they receive voting rights on the protocol, rewards from transactions, and price appreciation as more people use FRAX (it theoretically becomes more scarce).
Remember, every time someone buys a new FRAX (at a low CR level), a portion of FXS is burned. This is great for FXS holders if more and more people use FRAX. It’s not so great if more and more people dump FRAX though, because more and more FXS will be created to cover the spread.
However, the CR should minimise that, because the protocol will require more and more reserve collateral to mint FRAX. In turn, this should reduce the amount of FXS that is created, thus reducing the dilution of FXS value. Those ‘shoulds’ will become clearer in a later section.
Algorithmic Market Operations (AMO): Market operations are common to central banks. The nut-shell version is they buy and sell Treasury Bonds, Notes and Bills to raise or lower interest rates. Treasuries have a market price and a redemption price, e.g., they can be traded at a premium or a discount to the face value.
FRAX is basically doing the same thing, except the functions are governed by an algorithm instead of a committee (like the banks use). The AMOs are modular, but they all share core functions, restricted by the rule that anything the AMO does cannot break the FRAX peg.
The AMOs can:
- Raise the CR
- Lower the CR
- Buy and sell FXS and FRAX on the open market
- Determine FXS holder distributions (rewards) based on how much collateral is held above the CR.
There are now a few AMOs deployed. One AMO is geared towards providing liquidity through protocols such as Curve and Uniswap v3. A second provides a hedging position.
The hedge basically takes a straddle, where the protocol holds an asset long, but also takes a synthetic short position on the same asset. In other words, they hold long in case the asset goes up in price, but they also short it in case it goes down. This reduces downside (loss) risk for volatile assets like, well, all cryptos (creating a delta neutral position).
A third AMO is using lending platforms, such as Compound and CREAM to drive value to the protocol, and FXS holders in particular. Another is working on an anonymity solution, and yet another is working on a Decentralisation Ratio to manage centralisation risk from on and off-chain assets.
It’s not clear if off-chain assets such as oil, gold, or other commodities are currently being managed. But it’s pretty cool they’re thinking about it!
Sounds great, what’s the problem?
Going back to the beginning of the article, I’d say the two problems are:
- Recency bias; and
- The conflation of currency with value
Since this article is already long, I’ll try to be brief and simply ask some probing questions of you, dear reader. I’m going to pick on Terra UST for a second here.
- Do you think Terra UST would have retained peg during the 2008 financial crisis?
- Do you think UST would have retained peg during World War II?
- How about the Great Depression?
- Or, World War I?
- Or, the US Civil War?
The bigger question is, do you think things like that could never happen again? Remember, the Terra Foundation recently propped up the Anchor protocol with a $450 million dollar injection under relatively mild market turbulence.
My point with FRAX is, yes, it has held a very stable peg (with a couple little burps) since it launched. But what happens if China invades Taiwan and draws the United States into a global conflict with a legit economic and military peer?
What happens if North Korea has an ‘oopsie’ with one of their missile tests and it plunks down in the middle of Tokyo? Or what if NATO gets involved in Ukraine?
Yeah, but that probably won’t happen
Fair enough. But imagine if the Bitcoin maxis actually get their way and Bitcoin starts becoming a legitimate challenge to the US dollar. Do you honestly think the US Government will just throw up their hands and go, ‘aw shucks fellas, Bitcoin won.’
If Bitcoin threatens global use of the US dollar, the US will move to shut it down. They will declare Bitcoin a threat to national security and they will stamp it out of existence.
‘But Bitcoin is decentralised!’
Yes. And it requires network access to work. The US can shut down network access to miners in the US overnight. They are only one FISA warrant away. I guarantee you if you’re a miner in the US, you’ll pay attention to the secret letter you get from Homeland Security that tells you to pull the plug right now or you’ll never see the light of day again.
The US also has security partners and arrangements with most countries in the world. And they wield enormous financial and military power over those nations. The letter to them will sound something like:
We have identified Bitcoin as a threat to US national security. Please help us shut down all Bitcoin mining networks in your country or we will cut off your access to banking.
Please and thank you,
And if you think there will be some rogue country out there that throws up a finger and says, not to worry, we’ll take care of all that mining, I would remind you that all countries with a standing military decentralise their resources.
They don’t store all their equipment, gear, and ammo in one place, because it’s really easy to target that way. Do you know what the US is really, really good at doing?
Finding all those things and blowing them up.
An algorithm is only as good as what you put into it
I know the Bitcoin example is extreme and very unlikely. But let’s expand this a bit to the CR function of the FRAX algo. Let’s say the market has shown overwhelming appetite for FRAX and the CR ratio gets reduced down to 0.2:1.
Have the starting assumptions for the algo even considered major ‘black swan’ events like the ones I just mentioned? Can the algo recapitalise fast enough to cover demand after reducing the CR to 0.2:1?
If so, how? That capital will have to come from somewhere and FXS holders aren’t going to stick around long if their share price dumps 80%.
Point is, the recent market has demonstrated what the CR ratio should be. For FRAX to be truly resilient, it needs to determine a safe CR ratio to minimise effects of tail probabilities before they happen.
There might not be anything any crypto can do to protect against really extreme events. But there are certainly events (like another 2008) that are well within the probability distribution. Prudence dictates those should, at the very least, be modelled and tested for.
Perhaps they have been? I really don’t know. But the whitepaper seems to indicate the devs can see a future where the protocol is completely algo based, with no reserves at all. Reading that makes me think things like 2008 haven’t been accounted for.
Here’s a suggestion: Create a model and back test the protocol for 100 years. I’ll bet you ten $FRAX that CR will look very different.
Or, back test it against the British Pound Sterling. That’s got about 1200 years of data you could tinker with. Probably won’t be super relevant, but it could give some interesting insights.
And, who knows? It might just prove the protocol is far more resilient than they even realised. ‘We back tested the protocol over 100 years and it would have been stable through everything including the Great Depression and World War II!’
I’m not a marketing guy, but that sounds like a pretty juicy sell to me.
Conflating currency for value
The other, much smaller issue I have is the market exposure of FXS and the peg (promise) to the US dollar (another promise). FXS derives value from users adopting and using FRAX.
FRAX, in turn, is valuable because of the promise to return like value in dollars. Dollars, in turn, are valuable because of the promise to return the like value of taxable goods, wages, and productivity in the US.
Those goods, wages, and productivity are, in turn, dependent on the promise to be paid in stable US dollars. Recent news would suggest that promise isn’t quite as strong as it used to be.
So, where in that chain of ‘value’ does the FXS token live? From where I sit, it’s pretty low. To my five-year old mind, the example is:
Dad: I promised mommy that I’d clean the house. Because I promised that, she promised to take you out for pizza.
Then she promised to buy pizza from the pizza guy because she promised to take you for pizza because I promised to clean the house.
The pizza guy promised to buy pizza toppings because mommy promised to buy pizza because she promised you to take you for pizza because I promised to clean the house.
Kid: What happens if you don’t clean the house?
Dad: No pizza.
Don’t get me wrong, I think FRAX is a pretty awesome idea. I am super bullish on the project and as of ten minutes ago, I own FXS. It’s easily the strongest, most well constructed algo stable idea I’ve seen.
My hope is the devs dig a little deeper and spend more time thinking about some of the stuff I mentioned. To reference my five-year old mind, I think the house is going to get cleaned, but it’s probably going to get a lot messier first.
I just hope FRAX makes sure they buy the right toppings, because if they don’t, we might not get pizza anyway.
Of course, these are just my opinions. I’m not a financial advisor, this isn’t financial advice, and always DYOR. Following any of these ideas might cause you to lose all of your money. I am 100% serious about that. I like tinkering with this stuff, but I’m on record acting like a total baboon. Invest accordingly.
Until next time, be safe, be smart and be sure to tie the camel.
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