Frax v3 and the Quest for the “Final Stablecoin”

In true Frax fashion, the quest for the ultimate stablecoin continues.

In the latest upgrade, Frax v3 introduces sFRAX, an integral component that Frax Founder Sam Kazemian hails as “The Final Stablecoin.” This innovative approach to stablecoin design addresses the lessons learned from past iterations and the ever-evolving landscape of global financial markets.

The Need for Evolution

Frax v1 was the first iteration of the fractional algorithm used to create FRAX.

The protocol used fully on-chain oracles to obtain the prices of FRAX, FXS, and collateral. The Uniswap oracle provided the time-weighted average prices of ETH, USDT, and USDC, while the Chainlink oracle provided the USD price. The v1 algorithm was essentially a banking algorithm that adjusted its collateral ratio (akin to a bank’s balance sheet ratio) according to market forces, evidenced by arbitrage trades that occurred on the FRAX and FXS tokens.

In March 2021, Frax v2 was launched, introducing the concept of Algorithmic Market Operations controllers (AMOs) as Lego pieces to build and enact fully autonomous monetary policies on the Frax protocol.

These AMOs ran on the foundation of the base stability mechanism conceptualized in Frax v1. At the time of writing, four AMOs were fully implemented and currently utilized the protocol’s capital assets more efficiently, thus accruing even more value to FXS holders. Two more AMOs were currently in development and had to pass through the protocol’s decentralized governance process before implementation.

Frax v2 had served its purpose, but the rapid ascent of Luna/UST and the unprecedented surge in interest rates highlighted the inadequacy of the existing protocol for ensuring long-term safety.

The journey toward the “Final Stablecoin” was driven by the realization that fully algorithmic stablecoins, such as Frax v2, are susceptible to instability and the risk of rapid de-pegging.

Earlier this year, the Frax DAO took a significant step by voting to eliminate algorithmic backing, opting to raise the collateral ratio to 100% or more.

This marked the end of a nearly two-year experiment, during which market forces determined the collateral backing of Frax. The decision was a response to the highly responsive nature of the collateral ratio during bullish markets. However, raising the ratio amid a global economic downturn presented its own set of challenges.

Lessons from Fallen Brothers

The history of algorithmic stablecoins has been marred by instances where they lost their peg when the market sensed inadequate collateral backing. A recent example is the collapse of Tangible, a real estate-backed “stablecoin” with a 30% reserve buffer.

According to Tangible’s docs, “Real USD (USDR) is a first-of-its-kind natively rebasing, yield-bearing, overcollateralized stablecoin, pegged to the US dollar. USDR is primarily collateralized by yield-generating, tokenized real estate.”

All USDR is redeemable 1:1 for DAI at all times with a .25% fee. The protocol kept several million dollars in cash to act as a capital buffer and facilitate redemptions.

When its DAI buffer was depleted, the price of its stablecoin USDR plummeted to $0.50. Tangible’s demise serves as a stark reminder of the fragility of on-chain stablecoins when their treasuries fall short of capital or contain illiquid assets.

It has become increasingly clear that only stablecoins with fully liquid backing or sufficient locked liquidity to buffer against illiquid assets can withstand the trials of the market.

Navigating the High-Rate Environment

The evolving landscape of decentralized finance has revealed another critical aspect: the need for stablecoins to provide safety when economic conditions weaken.

Sam Kazemian, in a recent interview, stressed that stablecoins must “function extremely well in a high rate environment and really well in a low rate environment.” In essence, for a stablecoin to succeed, it must track four key prices of money:

• parity,
• interest rates,
• exchange rates, and
• price levels

When pegging a stablecoin to the dollar, it is imperative that the asset closely follows the actions of the issuer, akin to the Federal Reserve. While maintaining parity is straightforward, tracking on-chain interest rates poses a more complex challenge.

Accessing minimum IORB rates without an off-chain KYC’d entity is impractical. This need led to the creation of FinresPBC, an entity set up explicitly for this purpose, and run by members of the Core Dev Team, who are aligned with the Frax DAO and can act as beneficial owners.

FinresPBC is a Delaware-registered public benefit corporation. Its public interest mission consists of bringing traditional financial assets to the public, as well as providing the Frax protocol with safe cash equivalents and yields close to the Federal Reserve rate without profiting from the relationship. Additionally, FinresPBC has partnerships with compliant and crypto-friendly financial institutions like Lead Bank.

FinresPBC will provide to the Frax protocol, including holding USD deposits, issuing and redeeming Paxos USDP and Circle USDC stablecoins, and handling U.S. Treasury bonds. FinresPBC will publicly release a comprehensive asset breakdown and reserve report for the Frax Protocol on a monthly basis.

In response to community inquiries, Sam Kazemian explained that USDT was not included due to difficulties in obtaining permission to mint/redeem the stablecoin and the private nature of Tether. However, Kazemian emphasized he was not implying any issues with Tether’s reserves; should the aforementioned problems be resolved, he may consider incorporating USDT in the future.

While some protocols employ multi-entity RWA strategies to invest on behalf of the DAO, it introduces default risk and complicates exposure analysis. In contrast, Frax v3’s model transforms it into an “All-Weather Stablecoin,” designed to navigate any market condition effectively.

The Role of sFRAX

At the heart of the evolution to a “final stablecoin” is sFRAX, which allows the deposit of FRAX into sFRAX and empowers the Frax DAO to allocate funds to FinresPBC. In turn, FinresPBC invests in a variety of yield-bearing assets. These assets are subject to specific limitations, with Finres committing to a level of transparency that is unparalleled in the world of finance.

sFRAX operates in a manner akin to DAI within the DSR framework, leveraging EIP-4626 to enable FRAX stablecoins to generate yield.

Contract address: 0xA663B02CF0a4b149d2aD41910CB81e23e1c41c32

The yield offered by sFRAX is designed to align with the prevailing Interest on Reserve Balances (IORB) interest rate, which currently stands at approximately 5.4%.

Users can easily participate by placing their FRAX into the sFRAX contract and getting weekly yield in the form of FRAX stablecoins issued at 00:00 UTC every Wednesday. AMO contracts are used to oversee the collateralization of sFRAX in order to react to fluctuations in the sFRAX yield, which are linked to the IORB rate and market conditions.

In the event of an IORB rate increase, AMO strategies focus on substantial collateralization of $FRAX, often involving real-world assets such as short-term US T-bills, reverse repurchase contracts, and deposits in USD at Federal Reserve Banks that offer the IORB rate.

In case of an IORB rate decrease, the strategy shifts and real-world assets are transformed back into decentralized assets and overcollateralized loans through Fraxlend to provide a competitive yield.

But with the deployment of sFRAX featuring a 10% APR, does this render FPI obsolete? What would be the current purpose of FPI and how it differs from sFRAX in terms of retaining the value of money?

It’s simple anon…

sFRAX is designed to track the IORB rate, distinct from the CPI inflation rate that the FPI peg is based on. This marks one of the rare instances in the past two decades where the Fed pays a higher IORB rate than the inflation rate. Typically, this is not the case, as inflation usually exceeds the IORB rate.

As long as the IORB rate remains higher than the inflation rate, holding sFRAX is indeed preferable. However, the FPI peg aligns with CPI, allowing you to use it as a unit of account without concerns about the upcoming IORB rate.

Wrapping it up, Frax v3’s sFRAX represents a significant stride toward a more robust and adaptable financial instrument.

As the quest for the “Final Stablecoin” continues, Frax v3’s approach offers valuable insights into addressing market challenges and creating a stablecoin that can weather any storm.