Frax Finance Report: Ecological Status, FraxChain, and Future Potential
Frax Finance was launched in May 2019 as an algorithmic stablecoin protocol and has since evolved into today's complex DeFi tech stack. This report serves as a preliminary analysis of Frax Finance, providing an overview of its current ecosystem, describing its product suite, and exploring its future potential.Author: Gryphsis Academy
TL;DR
This report serves as a preliminary analysis of Frax Finance, providing an overview of its current ecosystem, describing its product suite, and exploring its future potential.
During the last bull market, $FXS outperformed Bitcoin due to key events such as exchange listings, halving emissions, and airdrops, although it did not reflect the price surge like leading liquid staking derivative tokens $LDO and $RPL due to the late issuance of frxETH. Meanwhile, $FRAX demonstrated strong resilience in the face of market volatility, largely thanks to its advanced AMO strategy and robust $FXS staking.
Frax Finance is rolling out a series of significant upgrades aligned with major DeFi trends: FRAX V3 aims to strengthen its stablecoin mechanism and reduce reliance on $USDC; FinresPBC will enter real-world assets through Fraxbond (FXB); frxETH V2 focuses on decentralization and yield optimization; the upcoming EVM-compatible Layer 2 solution, FraxChain, aims to enhance scalability and security, potentially providing a boost for the protocol and future growth of $FXS.
Driven by a focused team and innovative mechanisms, Frax Finance is evolving into a comprehensive DeFi ecosystem with strong synergies, and upcoming developments such as FRAX V3, frxETH V2, and FraxChain are expected to significantly drive its growth and create value for $FXS token holders.
1. Background
Frax Finance, despite being one of the OG DeFi protocols, has remained a complex protocol for many newcomers. Its diverse product line and intricate mechanisms can be somewhat daunting for first-time users. However, it is a protocol that everyone should be aware of, as it is one of the most innovative protocols and has gained attention for its proactive sector expansion. This report will serve as a beginner's guide to Frax Finance, reviewing its current state, introducing its products, and examining its potential. As a beginner, not all aspects of the protocol are covered, and the purpose of this report is to help readers quickly gain a basic understanding of the protocol and its future direction. Readers are encouraged to conduct thorough due diligence to fully understand the protocol and its associated risks.
2. Introduction
Frax Finance launched in May 2019 as an algorithmic stablecoin protocol and has continuously evolved into today’s complex DeFi tech stack. Frax Finance now operates multiple business sectors, including three types of stablecoins, supported by three main infrastructures. Frax's operations span several sectors, including stablecoins, DEX, money markets, and liquid staking, with RWA coming soon. Therefore, Frax is one of the most innovative protocols in the DeFi space, but it is also one of the most complex.
3. Performance Overview
Since the performance of $BTC is often viewed as the beta of the crypto market, comparing token prices against $BTC allows us to see token performance more clearly. Coupled with the increase in key events, this enables us to gauge how the market perceives a protocol; if positive news fails to trigger any positive price movement, the market may be shifting its attention, making it a less attractive investment target.
From the charts, we can see that during the last bull market, $FXS followed the overall market and experienced a significant price increase. Then, between December 2021 and March 2022, $FXS outperformed $BTC, experiencing two notable price surges. These increases can be attributed to several positive events during that period, including the Binance listing on 12/10, the $FXS emission halving on 12/20, the $FPI airdrop distribution announcement on 2/19, and the FTX listing on 3/24. Subsequently, $FXS followed the overall market without any significant deviations. Recently, although the Frax team has released news about future plans, the response of $FXS has not been as pronounced as before. This may be due to the prevailing bearish sentiment in the market, requiring further observation of how those catalysts perform when they actually arrive.
Compared to the two leading LSD narrative tokens $LDO and $RPL, we can see that $FXS, having entered the field later, did not experience the same price surge as the other two as the Merge approached, but did experience a pump during the Shanghai Upgrade. With frxETH v2 set to launch soon, the performance of $FXS alongside $LDO and $RPL will be interesting to watch.
As an algorithmic stablecoin, $FRAX has maintained a relatively good peg over time. During the LUNA-UST collapse, $FRAX remained within a tight peg range. Although there were occasional slight depegs, there was always a quick rebound to prevent further breaks. The most severe depeg occurred when Circle disclosed its risk exposure to SVB. Since $FRAX is primarily backed by $USDC, it was affected. However, given that the risk exposure was not significant, the peg returned to normal in a short time. The stability of $FRAX can largely be attributed to the protocol's complex AMO strategy and the high locking rate of $FXS, which shields Frax from the death spiral that other algorithmic stablecoins face.
Although the collapse of LUNA-UST did not disrupt Frax's peg, the event did trigger a significant outflow of liquidity, causing the market capitalization of stablecoins to plummet, particularly for decentralized stablecoins like $DAI and $FRAX. The subsequent SVB event further reduced the market share of $USDC, with liquidity shifting to $USDT, which has been the only stablecoin to see continuous market cap growth since 2023.
Two other key performance indicators for Frax are stablecoin market share and LSD market share. Although $FRAX is the second-largest decentralized stablecoin, its market share is only 0.5%, which is 8.8 times less than $DAI and 136 times less than $USDT. This gap is caused by various factors. Most importantly, centralized stablecoins serve as a key entry point for new crypto users, as new users primarily use CEX initially. The significant liquidity gap and adoption rates also contribute to this large disparity. As long as no major factors drive users away from centralized stablecoins, this gap is likely to persist for quite some time.
In terms of LSD market share, Frax performs well. Apart from Lido, sfrxETH has a small market share gap with the other three major LSDs. The main reason is its higher yields and the regulatory pressure faced by CEXs. With the arrival of frxETH V2, Frax's growth in the LSD space is expected to continue to outpace its growth in the stablecoin sector.
4. Protocol Mechanism
Frax Finance is one of the most complex protocols in the DeFi space. Its continuously expanding product line and business sectors mean that the protocol essentially has its own ecosystem composed of various stablecoins and DeFi infrastructure supporting stablecoin growth. In this report, we categorize the three stablecoins released by Frax as flagship products and view the supporting mechanisms as core infrastructure. The concepts and significance of each stablecoin are presented, along with how these infrastructures contribute to business operations.
4.1 Flagship Products
4.1.1 Frax
FRAX is the first stablecoin issued by Frax, pegged to the US dollar. Unlike DAI, the largest decentralized stablecoin, which is over-collateralized, Frax is an algorithmic stablecoin partially backed by USDC and Frax's native token FXS. The design goal of FRAX has always been to equal 1 dollar, and how 1 FRAX is collateralized is determined by market dynamics. Initially, FRAX was 100% backed by USDC, and the protocol's algorithm would gradually reduce the collateralization ratio (CR) based on market demand. For example, an 85% CR means that 1 Frax is supported by 0.85 dollars of USDC and 0.15 dollars of FXS. The higher the demand, the lower the CR, and vice versa. Since Frax is always pegged to 1 dollar, when the peg is out of balance, arbitrageurs intervene, along with the protocol's algorithm.
FRAX is currently in its V2 version, which utilizes multiple Automated Market Operations (AMOs). Essentially, AMOs are smart contracts that execute open market operations (i.e., minting, burning, deploying FRAX) to maintain FRAX's peg to 1 dollar. In V1, the protocol only used one AMO, the core stable module, to dynamically adjust the CR to maintain the 1 dollar peg. AMOs are one of the core mechanisms that have led to Frax's success. The underlying concepts will be elaborated in the next section.
It is worth noting that in 2023, the DAO voted to raise the CR to 100%, as this is the safest way to continue FRAX's expansion. While the CR provides greater flexibility and capital efficiency, the DAO has decided that, given Frax's mature state, it is no longer necessary, while the use of AMOs can still maintain high capital efficiency for FRAX.
4.1.2 FPI
The Frax Price Index (FPI) is the second stablecoin released by the protocol. Its design aims to maintain purchasing power by being tied to real inflation, as defined by the US All Urban Consumers Consumer Price Index (CPI-U). Frax uses a dedicated Chainlink oracle to obtain and report the inflation rate from the US federal government and applies that rate to the redemption price of FPI. Since the peg of FPI is closely related to the inflation rate, the redemption price of FPI will rise (or fall) with inflation (or deflation), meaning that users exchanging other assets for FPI are predicting that the purchasing power of CPI will grow faster than the assets they are selling.
The motivation behind FPI is to create the first on-chain stablecoin that can be used to represent transactions, value, and debt. Using FPI as a benchmark helps determine the value of treasury or income relative to the ever-growing inflation, which can be very useful for DAO operations or similar activities.
4.1.3 frxETH
Frax Ether (frxETH) is the third stablecoin released by Frax. It is pegged to ETH and earns zero staking rewards. Users can stake frxETH to receive sfrxETH, thereby earning all staking rewards. Each un-staked frxETH contributes to the yield of sfrxETH. Therefore, the staking rewards earned by each sfrxETH are higher than those of ETH, which is why sfrxETH's yield is higher than all other LSDs. Users can provide fexETH-ETH liquidity for Curve pools and earn trading fees and launch rewards. Because Frax holds a large amount of $CRV and $CVX, it can guide substantial rewards for the pool, incentivizing liquidity provision.
The launch of frxETH/sfrxETH represents Frax's strategic expansion into the LSD narrative and deepens its influence in the DeFi ecosystem. Frax has cleverly leveraged its significant position in the Curve War to successfully erode the market share of blue-chip LSDs like stETH and rETH. With the upcoming launch of the V2 version of Frax Ether, another wave of adoption growth is expected.
4.2 Core Infrastructure
4.2.1 AMOs
For stablecoin protocols like Frax, maintaining stability is crucial. Unlocking not only undermines user confidence but can also lead to a chain reaction that tears the protocol apart. Algorithmic Market Operations (AMO) are smart contracts that execute various monetary operations to maintain the stability of FRAX. Frax Finance has evolved from a single AMO in V1 to four main AMOs in V2. While each has slightly different operations, all AMOs share three common attributes: de-collateralization - the strategy portion that lowers the CR, market operations - the strategy portion that operates in balance without changing the CR, and re-collateralization - the strategy portion that increases the CR.
4.2.2 Fraxswap
Fraxswap is the first constant product market maker (CPMM) combined with time-weighted average market making (TWAMM) to optimize the execution of long-term orders, such as order pools and aligning order expirations, and efficiently handle large orders. The purpose of Fraxswap is to enable the protocol to effectively execute its monetary policy for its stablecoins. More specifically, Frax will use Fraxswap for the following operations:
Use AMO profits to buy back and burn FXS
Mint new FXS to buy back and burn Frax
Mint Frax to purchase hard assets through minting taxes
Fraxswap is completely permissionless, allowing other protocols and DAOs to utilize it for monetary policy. Fraxswap V2 is also in development, which will support concentrated liquidity (the current version is based on Uniswap V2) and further expand its functionality by combining with related asset liquidity.
4.2.3 Fraxlend
Fraxlend is Frax Finance's native money market, supporting lending activities using ERC-20 pairs. Each pool is over-collateralized and independent, protecting the protocol from counterparty risk and bankruptcy threats. As a stablecoin protocol, Frax's primary goal is to naturally expand the use and adoption of its stablecoin, with Fraxlend being an important component in achieving this goal. By allowing users to have CDPs (debt positions) in FRAX, it increases the use of FRAX as currency in DeFi. Notably, Fraxlend adopts a no-fee model as an incentive for adoption. Like other infrastructures, Fraxlend also has v2 plans, which may introduce low-collateral loans to the platform.
4.2.4 Fraxferry
Frax Finance launched Fraxferry to achieve a seamless bridging mechanism for the protocol's multi-chain expansion. Fraxferry bridges user assets in a slower but safer manner, aiming to maximize security. A v2 version is also on the way, which will further decentralize the mechanism.
The functionalities of bridging through Fraxferry are as follows:
Users initiate the process by sending tokens to the ferry contract.
The designated "captain" checks and batches the transactions.
There is a 24-hour waiting period before the transfer occurs, allowing for further verification.
Upon execution, the system ensures transaction validity by comparing hashes.
5. Token Economics
Frax Share ($FXS) is the staking and governance token of Frax Finance, with all revenues and utilities concentrated on $FXS. More specifically, to enjoy all benefits, users are encouraged to lock their $FXS to receive $veFXS, which is similar to Curve's veToken model. $veFXS holders enjoy voting rights, yield farming boosts, and cash flow from AMOs, Fraxlend loans, and Fraxswap fees. Currently, 37.484M $FXS are locked, accounting for 50.88% of the circulating supply and 37.6% of the total supply. Notably, after FIP-256, whenever $FXS falls below $5 and $4, the protocol will conduct buybacks, a proposal aimed at reinforcing the tokenomics by signaling the implied valuation basis for the token.
6. Growth Drivers
Due to its diverse business areas, Frax Finance has several upcoming upgrades, making it well-suited for different major narratives that could become significant drivers of its future growth. This section will review them and explore their prospects.
6.1 FRAX V3
Although not much detail has been released yet, FRAX V3 aims to eliminate reliance on $USDC and create a new decentralized stablecoin mechanism designed to significantly enhance the robustness of the protocol. According to Frax co-founder Sam Kazmien, FRAX V3 will abandon the current pegging mechanism and will not rely on fiat currency. However, more details are pending release from the Frax team. Another highlight of v3 is the expansion into the RWA space. A nonprofit entity named FinresPBC has been launched to leverage attractive yields from US government bonds. FinresPBC can facilitate off-chain transactions of US government bonds, and users can participate through Fraxbond (FXB), which can be exchanged for $FXS. RWA is a major narrative in the current DeFi market, and this expansion may reflect the success of MakerDAO, whose token price has performed quite well recently due to its RWA operations. Combined with a more robust stablecoin mechanism, this could drive FRAX adoption to new heights.
6.2 frxETH V2
Regarding frxETH, users' ongoing complaints have centered around the centralization of the mechanism, where the protocol relies on its internal validators. In response, frxETH V2 is set to launch, aiming to decentralize the mechanism while providing users with the same or higher yields. At its core, frxETH V2 includes two innovations: usage-based interest rates and a decentralized lending market. Frax views the LSD market as a borrowing (stakers) and lending (validators) market, prompting these modifications.
Through a peer-to-pool model, anyone can provide collateral and borrow ETH from stakers to become a validator. Interest rates are dynamically determined based on utilization. Ultimately, LSD borrowers and lenders will have a dynamic market that promotes the growth of Frax LSD.
6.3 FraxChain
Three months ago, in a podcast with FlyWheel DeFi, Sam revealed that the protocol would launch its own EVM-compatible L2 called Fraxchain. Although not much detail has been disclosed yet, this upcoming L2 has two highlights. First, it will be a hybrid rollup using an Optimistic architecture but also integrating ZK technology to enhance security. Second, frxETH will be used as the fuel fee. The significance of frxETH as a fuel token lies in the fact that as demand increases, the supply of frxETH will decrease, thereby increasing the yield of sfrxETH and further expanding its LSD market share. Fees will flow to $veFXS holders, and combined with other income sources already flowing to $veFXS, the value accumulation of $FXS will be significantly enhanced. The launch of Fraxchain is scheduled for the end of this year, and with the L2 narrative brought by the Cancun Upgrade, market interest may surge.
7. Growth Potential
The aforementioned growth drivers could significantly boost performance in their respective areas. To further illustrate Frax's potential, this section will conduct a simple comparative analysis of the LSD market (one of Frax's main business areas) to provide insights into the growth prospects of the protocol.
In terms of LSD market share, Lido, Coinbase, and Rocket Pool are leading. For this analysis, we will use the top three LSDs as a representative sample. Currently, the top three LSD protocols have approximately 10.85M staked ETH, collectively accounting for 90.72% of the market share. Frax's current staked ETH amount is about 0.26M. Conservatively assuming that the current figures of the top 3 LSD protocols represent Frax's target, and setting 50% of Rocket's number, the median of the top three, and the average trading volume of the top three as our bear, baseline, and bull market scenarios, we can roughly estimate the potential growth upside for Frax LSD.
While this basic comparison highlights the potential of Frax LSD, it must be recognized that reaching the staking numbers of the top 3 protocols is not necessarily a straightforward process and is influenced by various factors. However, this analysis clearly underscores Frax's potential, and combined with the upcoming V2 updates, the future is undoubtedly bright.
(This analysis is a simplified approach to estimating the potential growth of Frax LSD, using top protocols as a baseline and their staked ETH numbers as targets. More detailed predictions would require considering several additional factors, meaning this analysis should only be viewed as a rough measure of Frax Ether.)
8. Conclusion
Starting as an algorithmic stablecoin protocol, Frax Finance has successfully transformed into a robust DeFi stack encompassing every core area of the ecosystem. The team's ongoing efforts are the primary reason for Frax's current state and support its future growth. Its mechanisms and products are cleverly designed, creating a strong synergy that could trigger a positive flywheel effect for the protocol's growth and the value accumulation of $FXS. Looking ahead, it is advisable to closely monitor FRAX V3, frxETH V2, and Fraxchain, as these will be key developments determining Frax's future.
References
https://docs.frax.finance/?source=post_page-----9c23b056d46c--------------------------------
Disclaimer: This report is an original work completed by contributor @GryphsisAcademy @BC082559. The author is solely responsible for all content, which does not necessarily reflect the views of Gryphsis Academy or the organization that commissioned the report. Editorial content and decisions are not influenced by readers. Please be aware that the author may hold cryptocurrencies mentioned in this report. This document is for informational purposes only and should not be considered as investment advice. It is strongly recommended that you conduct your own research and consult with a neutral financial, tax, or legal advisor before making investment decisions. Please remember that past performance of any asset does not guarantee future returns.
