How did the established algorithmic stablecoin Frax Finance regain its "status in the community" with the popularity of LSD?

Author: Grapefruit, ChainCatcher

Since early February, Ethereum Foundation core developers have indicated that the Shanghai upgrade is planned to be completed in March, and the LSD (Liquid Staking Derivatives) track has started to become lively.

On March 15, the Ethereum Goerli testnet announced that it had completed the Shanghai upgrade. This Thursday, Ethereum developers will hold a meeting to determine the specific date for the mainnet upgrade. This Shanghai upgrade is also the first large-scale upgrade for Ethereum since it transitioned to a Proof of Stake (PoS) mechanism last September. This is significant for users, as the completion of the Shanghai upgrade will allow users to retrieve their staked ETH on-chain, making deposits and withdrawals more flexible, which will also stimulate more users to stake ETH on-chain.

As is well known, to become a validator on the Beacon Chain, one needs to stake 32 ETH (or its multiples), which involves bearing the liquidity and opportunity costs of ETH while earning rewards. Users who want to become validators themselves also need to set up node servers, which requires a certain technical threshold.

The emergence of LSD liquid staking platforms aims to help users simplify the ETH staking process while providing them with liquidity. Users only need to stake ETH on the LSD platform, which will participate in the PoS mechanism on behalf of the users to earn rewards, and will issue staking certificate assets to users at a 1:1 ratio, releasing the liquidity of ETH during the staking period.

Since the LSD platform provides ordinary users with the opportunity to participate in staking without maintaining staking infrastructure and without barriers, it has quickly captured a large number of users and assets, evolving into an independent track. As the time for the Shanghai upgrade approaches, the LSD track has naturally become a focal point in the crypto market.

As of March 15, the Ethereum Beacon Chain browser shows that there are currently about 549,000 active validators, with staked ETH exceeding 17.579 million, valued at approximately $29.8 billion, setting a new historical high. Data shows that the market share of staked ETH on LSD platforms such as Lido and Rocket Pool accounts for about 30%.

The later entrant, Frax Finance (referred to as Frax), has already staked over 100,000 ETH on its platform, with the staking amount increasing by over 20% in the past 30 days, ranking first in growth across the entire LSD track. Its excellent performance in staking ETH-related data has successfully attracted user attention to Frax.

As an established algorithmic stablecoin DeFi application, Frax fell into silence after the collapse of Terra's UST. How has it regained user attention and secured a place in the market through the LSD boom?

fxsETH launched for 5 months, staking value exceeds $1.932 billion

As of March 15, fxsETH has been live for less than 5 months, with locked ETH amounting to 115,000, valued at approximately $1.932 billion.

fxsETH is a liquid staking product launched by the established algorithmic stablecoin application Frax on October 21, 2022, supporting users to lock ETH on its platform to earn staking rewards and bonuses from the Ethereum 2.0 (ETH2.0) blockchain network.

Compared to Lido, which launched in 2020, and earlier staking platforms like RocketPool and Stakewise, Frax is a latecomer in the LSD track. Although it started late, Frax's staking ETH-related data (such as growth rate and returns) seems to perform on par with other platforms.

According to data from the Dune data platform, the amount of staked ETH on fxsETH has increased by over 20% in the past 30 days, with its market share ranking fourth in the entire LSD track, only behind Lido, RocketPool, and Stakewise.

LSD platform staking-related data, source: Dune

Why has Frax been able to attract so much ETH staking in such a short time? What distinguishes it from earlier liquid staking platforms like Lido and Rocketpool?

The biggest difference is that the staking rewards users earn by staking ETH on Frax are higher than those on Lido, RocketPool, and other platforms.

In the relatively equal environment of Ethereum 2.0 block rewards, how does Frax achieve higher returns? This can be attributed to Frax's ability to adjust the yields of "frxETH/ETH" and "sfrxETH" through an arbitrage mechanism. The former is the trading fee revenue earned by users using frxETH to form LPs, while the latter is the ETH2.0 staking rewards obtained by re-staking frxETH.

frxETH collateral official process

Specifically, Frax positions frxETH as "just a wrapped/synthetic asset pegged to ETH," which users can mint using ETH on the platform. However, the process of minting frxETH using ETH is irreversible, meaning users cannot exchange frxETH back to ETH on the official website, and holding frxETH does not yield any rewards.

On previous staking platforms like Lido and RocketPool, users could earn staking rewards simply by staking ETH. For example, Lido users receive a certificate (stETH) that allows them to claim both the original asset and staking rewards. However, users holding frxETH need to take additional actions to earn rewards, primarily through two methods:

• Staking to earn Ethereum block network rewards: Users must first stake ETH as frxETH, and then stake frxETH as sfrxETH to earn Ethereum 2.0 staking rewards, with an annual percentage rate (APR) of about 7.8% in January, which has now decreased to 6.49% for sfrxETH;
• Providing liquidity to earn trading fees: Users must first stake ETH as frxETH, and then provide liquidity for the frxETH/ETH pool on the Curve platform to earn trading fees, with yields reaching over 10% at peak times. Currently, the LP APR is about 5% through the Convex platform.

During the same period, Lido's staking ETH yield was about 6%, and the yield for ETH/stETH on Curve was about 6.43%.

Frax's higher staking rewards compared to other LSD platforms are mainly because Frax allocates the staking rewards that users choose not to re-stake frxETH as sfrxETH to sfrxETH users. In other words, the frxETH used to form LPs transfers the block network rewards obtained from the underlying staked ETH to sfrxETH stakers.

It can be simply understood that staking ETH as frxETH allows users to earn Ethereum 2.0 staking rewards, but these rewards are only distributed to users who re-stake frxETH as sfrxETH. Users holding frxETH without staking will not receive any rewards; to earn rewards, they must either choose to re-stake or provide liquidity to earn rewards from the Curve platform or Convex.

Seizing LSD market share and controlling liquidity through yield adjustment

Theoretically, whether users choose to provide liquidity for the Curve frxETH/ETH pool using frxETH or re-stake as sfrxETH mainly depends on the yield differences between the corresponding trading fee revenue and staking rewards.

What impact does this have on Frax's yield adjustment?

Because there is a difference between these two yields, it creates a dynamic arbitrage range, which is a key area for Frax's official operations and adjustments. It needs to keep the yields of the two different choices within the same range.

According to data from Frax's official website, on March 15, the yield for the Curve frxETH/ETH liquidity pool was 6.89%, while the yield for re-staking sfrxETH was 6.49%. The yields are quite close, and the distribution of frxETH between the two is also roughly equal.

Distribution of frxETH in frxETH/ETH and sfrxETH

In fact, by controlling the relationship between the "ETH/frxETH LP yield" and the "sfrxETH staking yield," Frax can not only influence the balanced distribution of frxETH assets but also seize LSD market share and control the liquidity of frxETH. For instance, it can adjust the ETH staking yield to be higher than the market level to attract more users to stake ETH, and it can also control the depth and stability of the frxETH/ETH liquidity pool through LP yield.

How does Frax achieve yield control? Frax holds the largest amount of Convex governance tokens (CVX, about 20.5%), while Convex controls more than half of the voting power on Curve (veCRV). This provides Frax with the ability to influence the reward distribution of liquidity pools on Curve through CVX voting, thereby creating the potential for higher yields.

For example, if the sfrxETH yield is below the market average and Frax wants to increase it, it can increase the bribery efforts to make the Curve LP yield significantly higher than the sfrxETH staking yield. This will attract more frxETH to choose to become Curve LPs, and the increased proportion of frxETH choosing to be LPs will raise the sfrxETH staking yield, while the corresponding increase in LPs will also enhance the depth of the liquidity pool.

Conversely, if the Curve LP yield is lower than the sfrxETH staking yield, frxETH/ETH LPs may choose to withdraw liquidity, leading to more frxETH being re-staked as sfrxETH, which will lower the sfrxETH staking yield until the two yields balance.

From this perspective, Frax is attempting to find a differentiated competitive advantage for frxETH compared to similar products like stETH (Lido) through its influence and control over Curve's reward policies, allowing users to have higher yield choices under the arbitrage balance between frxETH and sfrxETH.

This tactic is similar to Frax's strategy last year during the liquidity war (Curve War) with its stablecoin FRAX, where it influenced Curve's incentive policies through holding CVX to maintain the depth and stability of liquidity pools related to the stablecoin FRAX. However, following the collapse of Terra's UST last May, this liquidity war seemed to be put on hold.

Now, with the launch of frxETH, Frax has successfully monetized its influence over Curve once again.

Amid skepticism, a second spring arrives: What are Frax's business boundaries?

Through the frxETH liquid staking product, Frax has attracted users to stake ETH, correspondingly increasing the value of locked crypto assets (TVL) within the Frax application. According to DeFiLlama data, Frax's TVL is $1.34 billion, ranking 12th among all DeFi applications.

The new frxETH product seems to have brought this established DeFi application back to life.

However, some community users have raised questions: Since 2022, Frax has launched a series of products including FPI (an anti-inflation stablecoin pegged to CPI), lending platform Fraxlend, trading platform Fraxswap, and asset bridge Fraxferry. Why has it now launched the staking product frxETH? The team seems to be continuously developing new products, and the product roadmap appears to be quite scattered. Where are its business boundaries?

The head of the Frax Chinese community responded during an online live stream that developing frxETH was a natural step, as they are optimistic about the growth of the LSD track. FrxETH will increase Frax's asset management scale, and the construction ideas and gameplay of the frxETH product are similar to the stablecoin FRAX, also creating new application scenarios for the stablecoin FRAX. He also revealed that Frax may build its own application chain in the future.

Some users also expressed that it is normal for DeFi applications to develop various products and try different businesses in the early stages, and they should be allowed to experiment.

However, Frax's most well-known and core business remains the stablecoin.

Founded in 2019 by a programmer named Sam Kazemian (Sam), Frax is the first algorithmic stablecoin application to adopt a hybrid mechanism, utilizing a dual-token model consisting of the stablecoin FRAX and the governance token FXS. The former is an algorithmic stablecoin pegged to the dollar, while the latter is a community governance token that can be used as part of the collateral for minting stablecoins.

The so-called hybrid algorithmic stablecoin means that the stablecoin FRAX issued by Frax consists of a portion of collateral (mostly USDC) and a portion of algorithmic mechanisms (the minting and burning of FXS). The unique CR (collateral ratio) mechanism created by Frax is likened by users to an "on-chain Federal Reserve" due to its similarity to central banks issuing base currency.

Additionally, in the v2 upgrade version in 2021, Frax introduced the concept of AMO (Algorithmic Market Operations), which can enhance the capital utilization within the protocol and is regarded by DeFi players as the most innovative feature worth learning and referencing by major DeFi applications.

According to CoinGecko, FRAX currently has a market capitalization of $1.04 billion, making it the second-largest stablecoin on-chain, with DAI ranking first at $6.24 billion.

FRAX's ranking in the stablecoin track

During the boom of algorithmic stablecoins like Terra (UST) in April last year, Frax was also considered a leading project, competing closely in popularity. It was a significant player in the Curve War and had attempted to collaborate with Terra to create the 4pool (UST-FRAX-USDC-USDT) on Curve as the most stable cross-chain stablecoin exchange pool, aiming to disrupt the leading 3pool (USDT-USDC-DAI) and replace DAI with UST and FRAX. However, following the collapse of UST in May last year, this vision was abruptly halted, and interest in Frax declined, entering a period of instability.

In February 2023, Frax announced that it would set the target collateral ratio (CR) to 100%, removing the algorithmic support, making FRAX a fully collateralized stablecoin.

It wasn't until the LSD track heated up that the new product frxETH brought this long-quiet established DeFi application back to the forefront of users.

However, Frax still has a long way to go. Regarding this hot new staking product, Frax currently faces a series of questions:

The reason users choose to stake ETH on Frax at this stage is that its yields are relatively higher compared to other LSD staking platforms. The portion of yield that exceeds the ETH2.0 staking rewards can be seen as an additional subsidy provided by Frax through the Convex and Curve platforms, but the high bribery costs of Convex are not sustainable. How long will this additional subsidy last? If there is no extra support, will the yields of frxETH align with those of current LSD platforms, and will users still choose it?

Currently, the yield for users staking ETH on Frax has dropped to about 6.3%, while Lido's staking yield for the same period is 6.6%. Additionally, more and more established DeFi applications are entering the LSD track, such as the yield aggregator Yearn, which announced the launch of its liquid staking product "yETH" in February. What competitive edge does Frax have against these newcomers?