Frax Finance Series Part 1: Basics of FRAX Mechanism (Intro)
Frax Finance launched relatively late compared to its competitors in the stablecoin and liquid staking markets, but has managed to grow rapidly. In this article series, we’ll analyze the strategy behind its growth, with a focus on on-chain data and Frax’s mechanics. Through our articles, we aim to convey our thoughts on how to grow a DeFi product in a sustainable way, and we believe that Frax Finance is a good example to follow as it has achieved both price stability and competitiveness against its peers. After a brief introduction to the mechanism, Frax Finance article series will analyze how Frax has grown.
Known as a fractional-algorithmic stablecoin, FRAX launched in December 2020 and grew rapidly in 2021, reaching a market capitalization of $2.9B in March 2022. Despite a bear market in 2022 that saw other stablecoins’ market capitalization shrink dramatically, Frax maintained a market cap of $800M as of July 2023, which is just below DAI among decentralized stablecoins. We believe Frax Finance is one of the few DeFi projects that has achieved both growth and price stability, as the price has remained stable at the $1 level with the exception of March 2023, when USDC was depegged. Even after the Liquid Staking Derivative (LSD) market became highly competitive between protocols in late 2022, Frax Finance grew rapidly despite entering the LSD market late compared to other services, and is currently ranked behind Lido, Coinbase, and Rocket Pool.
Before analyzing what strategies Frax Finance has used to grow their product in the stablecoin and LSD markets, this article will briefly introduce the basic mechanics of the FRAX stablecoin: its fractionally algorithmic mechanism (in fact, we prefer to call it fractionally collateral-based) and the Algorithmic Market Operations (AMO) proposed by Frax. These two concepts are essential to understanding how the growth of the stablecoin FRAX and the growth of frxETH in the LSD market were created, so we’ll cover them in this article. We’ll cover the growth of FRAX and frxETH in the next two articles, respectively. This article is to provide backgrounds on Frax Finance, so if you’re familiar with the concepts, you may start with the next article.
Frax Mechanism
FRAX identifies itself as a stablecoin that is only partially algorithmic: it sets a target collateral ratio (denoted ‘CR’) for the stablecoin. When a user issues FRAX, it requires the issuer to provide USDC worth CR and FXS tokens worth $(1-CR) to Frax Finance for every 1 FRAX. When a user burns FRAX, the protocol returns USDC and FXS in the same ratio to the address that burns 1 FRAX. Frax Finance calls these mechanisms Mint and Redeem, by which FRAX is issued and burned according to the protocol-defined logic.
The mechanism is such that the higher the CR value, the stronger the identity of the FRAX stablecoin as a collateral-based stablecoin, and the lower the CR value, the stronger the identity of the FRAX stablecoin as an algorithmic stablecoin similar to the UST-LUNA relationship. The CR value is adjusted depending on the stability of the FXS price in the market. For example, when the market is unstable, Frax Finance increases the CR value to improve the price stability of FRAX. Likewise, Frax Finance decreases the CR value when the market is stable, allowing the mechanism to elastically increase its issuance volume.
If the protocol’s target collateralization rate changes as a result of the CR value adjustment, the protocol also tries to adjust the amount of USDC it holds as collateral for FRAX already issued. For example, if the CR value increases from 0.8 to 0.9 with 100 FRAX issued, the protocol needs to increase the amount of USDC it holds as collateral by 10. The mechanism that works here is called Recollateralization, where Frax Finance sells FXS at slightly below-market price to arbitrageurs who will provide the USDC it needs, and holds the USDC it gets from selling FXS as collateral. Conversely, if the CR value decreases, Frax Finance will dispose of the surplus USDC by purchasing FXS from the market and burning them, which is known as the Buyback mechanism.
For a more in-depth introduction to Frax Finance, check out our previous Frax Finance report.
Backgrounds to AMO
Frax Finance attempted to take the best of both worlds — an overcollateralized stablecoin and an algorithmic stablecoin — with a partially algorithmic mechanism. However, by mid-2021, FRAX’s growth was slow, and demand for FRAX didn’t show much sign of increasing. Frax Finance needed to create demands for FRAX while maintaining the price stability. To solve this problem, Frax Finance announced FRAX V2 and proposed the concept of AMOs. As a result, Frax Finance experienced rapid growth through multiple AMOs.
Limitations of a Single Stablecoin Mechanism
Until 2021, most stablecoins were issued and burned by a single price maintenance mechanism that was the identity of the stablecoin, and that maintained its price. For example, MakerDAO’s DAI was issued and redeemed through overcollateralized loans operated through the Vault. Terra Protocol’s UST was issued and burned through the exchange of UST for LUNA in the on-chain market module, with the price maintained by controlling the stablecoin supply.
However, stablecoins that rely on a single mechanism are bound to face their own limitations. DAI’s overcollateralized issuance mechanism, as we all know, is not capital-efficient in that it requires overcollateralization. In this model, DAI issuance cannot be increased in an elastic manner. This is why DAI had a hard time reducing the price of DAI when it was above $1 (until PSM came along). In the case of UST, it relies on the market liquidity of LUNA. In the absence of LUNA market liquidity, it essentially becomes unstable.
We mentioned that Frax Finance was trying to strike a balance between an overcollateralized stablecoin and an algorithmic stablecoin, by utilizing a partially algorithmic mechanism. However, in 2021, Frax Finance was not taking advantage of this structure, given that FRAX’s presence in the stablecoin market was not growing. Therefore, in order to grow the FRAX token, the team needed an operational strategy that would maximize the best of both mechanisms.
Introduction of AMO Concept
Frax Finance has gone beyond just using the CR value to adjust the level of its stablecoin’s algorithm. They’ve chosen a strategy that more openly uses various mechanisms. This is where the concept of AMO comes in. AMOs are algorithms that use collateral to either issue or burn FRAX independently with its own mechanism. While AMOs are limited in how much FRAX they can issue based on the amount of collateral they have, as set by Frax Finance’s CR value, they each operate with their own unique mechanism.
Additionally, Frax Finance operates AMOs that have their own specific purposes. Some AMOs are specialized in increasing the amount of FRAX issued, while others focus on strengthening its price stability. By making these AMOs interact with each other, Frax Finance aims to achieve both price stability and growth for FRAX — essentially trying to catch two birds with one stone.
Concept of AMO
Explanation of AMO Mechanism
AMO refers to the algorithms set by Frax Finance that determine how FRAX is issued and burned when interacting with the market, as well as how the collateral assets obtained in the process are utilized. Depending on the AMO, there can be various methods. As long as the value of the collateral assets held by an AMO and the amount of FRAX issued from that AMO meet the CR value set by Frax Finance, FRAX can be issued independently at any time.
To be qualified as an AMO by Frax Finance, certain components are required. These components are the same as those of the FRAX mechanism, which I explained at the beginning of this article.
- Mint & Redeem: This is the logic in the AMO for issuing FRAX and retrieving it from the market. When an AMO issues FRAX, it defines what collateral will be received, how to receive collateral, where FRAX will be issued, and how the collateral assets will be returned when retrieved.
- Decollateralize: This corresponds to the Buyback in the FRAX mechanism. It defines how the collateral assets held by that AMO will be disposed of to reduce the ratio of collateral assets when the protocol’s CR value decreases.
- Recollateralize: This defines the logic of how an AMO will increase the value of its collateral assets relative to the FRAX issued when the protocol’s CR value increases.
- FXS1559: This defines the logic for the profits earned from managing the collateral assets acquired when the AMO issues FRAX.
Examples of AMO
Depending on how the components I described above are defined, each AMO will play a different role in the market. And each AMO will have different logics based on their specific objectives. Most AMOs are designed with one of the following purposes in mind: increasing the amount of FRAX issued, stabilizing the price, or boosting the protocol’s profits.
The Lending AMO directly issues FRAX to FRAX pools on AAVE or Compound. Similar to MakerDAO DAI’s D3M, this AMO flexibly supplies FRAX to the lending protocol’s pool based on its utilization. This ensures that borrowers in the market who want to borrow FRAX borrow FRAX at a fixed interest rate. Thanks to the Lending AMO, borrowers can more reliably predict their loan interest rates. The main goal of the Lending AMO is to increase the demand for FRAX by increasing the borrowing demands. In the process, since FRAX is continuously issued to the lending pool, the amount of FRAX in circulation also increases.
The Collateral Investor AMO is a mechanism where Frax Finance manages its USDC collateral to generate profits for the protocol. It primarily invests the USDC in protocols like AAVE, Compound, and Yearn. The interest earned from these investments is either used to burn FXS or is distributed as rewards to FXS holders.
Besides these, various AMOs like the Curve AMO and Uniswap V3 AMO are deployed and utilized within Frax Finance. Among all the AMOs, the Curve AMO plays the most crucial role, but I’ll delve deeper into that in the next article. Given that these diverse AMOs interact in different ways, Frax Finance continuously tracks how much FRAX each AMO issues, how much each AMO contributes to the overall on-chain liquidity of FRAX, and how much FRAX has been issued through the Lending AMO to each protocol.
The concept of AMO is still challenging for many in the community, leading to frequent questions. To avoid making this article too lengthy, I’ve kept the explanation of AMO brief. For those who wish to delve deeper into AMO, I recommend referring to the AMO section in our Frax report.
Conclusion
Frax Finance introduced a partially algorithmic stablecoin mechanism, aiming to strike a balance between its algorithmic nature and the characteristics of an over-collateralized stablecoin by adjusting the target collateral ratio. However, this alone did not capture the flexibility of algorithmic stablecoins and the price stability of over-collateralized stablecoins. Subsequently, Frax Finance introduced AMOs, algorithms that issue FRAX in their unique ways, allowing them to interact with market in their own way. This laid the groundwork for the growth of FRAX witnessed in the latter half of 2021.
In this article, I’ve provided a summarized overview of the mechanisms proposed by Frax Finance for foundational understanding. In the next article, we will discuss how Frax Finance’s strategy in the stablecoin and LSD markets has allowed them to secure liquidity for their tokens while exploding their token issuance.
