A brief analysis of the design highlights of Frax

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Frax is an interesting currency experiment that strikes a new balance between price stability, capital utilization, and resistance to scrutiny.

Original title: “A Brief Introduction to FRAX-Partial Algorithmic Stable Coins”
Written by: Alexis Direr
Translation: Login Community

FRAX (Fractional-Algorithmic Stablecoin Protocol) is a decentralized, partially mortgaged stablecoin launched on the Ethereum network and pegged to the US dollar. It was initially fully mortgaged, and its purpose was to gradually transition to a fully algorithmic stablecoin protocol.

This article briefly introduces the FRAX stablecoin, its operating mechanism, coinage model and ability to deal with financial shocks.

Operating mechanism

Anyone can create FRAX by providing two tokens: mortgage token (currently USDC) and agreement equity token FXS. The ratio of the two tokens is determined by the mortgage ratio. For example, a ratio of 60% means that USDC of 0.60 and FXS of 0.40 can be used to mint 1 USD of FRAX:

A brief analysis of the design highlights of FraxFRAX mortgage rate is 60%

1 FRAX can always be redeemed for 1 USD. Continuing with the example of a collateral ratio of 60%, each can be exchanged for $0.60 collateral and $0.40 FXS:

A brief analysis of the design highlights of FraxFRAX redemption-mortgage rate is 60%

FRAX is secured by USDC as a mortgage, but contrary to stable coins such as DAI, FRAX is designed as a partial mortgage guarantee. The USDC reserves held in the agreement are less than the number of circulating FRAX coins.

FRAX’s two-way conversion can ensure pegging with USDC:

  • When 1 FRAX <$ 1, arbitrageurs will buy FRAX, redeem USDC and FXS with FRAX, and make a profit by selling FXS. The purchase demand for FRAX will restore the exchange rate.
  • When 1 FRAX> $1, arbitrageurs will use USDAC and FXS to create FRAX and sell FRAX to make a profit. Selling pressure will prompt the exchange rate to recover.

The FRAX protocol currently provides incentives for three liquidity pools (FRAX/USDC, FRAX/WETH and FRAX/FXS), casting and distributing FXS to liquidity providers.

A brief analysis of the design highlights of FraxFXS rewards liquidity providers

Seigniorage

The FRAX agreement proposed the original model of seigniorage. FXS is required to cast FRAX. Stablecoins have value because of the anchoring of the US dollar, so FXS is also very valuable. The total amount of seigniorage is the market value of FXS in circulation.

FXS holders benefit from the price increase (seigniorage). When casting a new FRAX, FXS will be burned in proportion to the unsecured portion. Continuing the previous example, the mortgage rate is 60%, and casting 1 FRAX means burning $0.40 of FXS:

A brief analysis of the design highlights of Frax

This reduces the number of FXS in circulation, thereby pushing up its price. In addition, when the agreement reduces the collateral ratio (CR: collateral ratio), casting the same amount of FRAX will burn more FXS. This will also generate more buying of FXS, which benefits FXS holders.

Liquidity providers in the FRAX pool will also benefit from seigniorage. By providing FRAX in three incentive pools, they can obtain FXS. The smaller the mortgage ratio (that is, the higher the seigniorage tax), the more FXS they will get. From 100% mortgage ratio to 0% mortgage ratio will increase the FXS issuance rate by 2 times.

The price of FXS basically depends on the supplier. On the one hand, stable FXS is minted and distributed to liquidity providers, expanding the circulation supply and exerting downward pressure. On the other hand, with the increase in usage and adoption rate, more FRAX is minted than redeemed, which means that a large amount of FXS will be burned in the process and withdrawn from circulation.

In order to understand the numbers, it is assumed that the supply of FRAX will expand from 50M to 300M in 2021, which is a reasonable forecast. Assuming that the mortgage ratio is 50%, it means that the additional FXS required is 0.5 x 250M = 125M. At the same time, the release of FXS is about 1.5 x 18M = 27M (taking into account the 50% mortgage ratio) + 35M = 62M of the team/founder/investor’s shares that are gradually released. The mismatch between supply and demand is by design and an important factor in price increases.

risk

If FRAX supplies increase and the agreement becomes more algorithmic, holding FXS will help. But there are some risks. Recall:

  • If 1 FRAX <$ 1, arbitrageurs buy FRAX and redeem them in exchange for USDC and FXS and “sell” FXS.
  • On the contrary, if 1 FRAX> $ 1, the arbitrageur buys F XS, uses USDC and FXS to mint FRAX and sells FRAX.

In both cases, maintaining the peg to the U.S. dollar is accomplished through the transmission of price fluctuations to FXS holders, and greater demand fluctuations may occur. In particular, if the demand for FRAX contracts falls, the price of FXS may fall. In a rare black swan event, this may trigger a large-scale redemption of FRAX bank operations.

In order to deal with the strong contraction phase, the system is protected by three types of protective measures. First, in the contraction phase, the agreement adjusts the system mortgage rate. FRAX redeemers get more collateral and less FXS. As the asset mortgage rate increases, this will increase market confidence in FRAX.

Second, control the FRAX:FXS ratio (called growth rate). It is the number of FRAX in circulation divided by the fully diluted market value of FXS. The larger the market value of FXS, the smaller the price drop of FXS for a certain amount of FRAX sold in the market. A low ratio means that the system is more resilient. The supply of FRAX (as of January 2, 2021) is 74M. The total market capitalization of FXS is 686M, with a ratio of 10.8%. However, please keep in mind that in the short/medium term, the circulating market value of FXS is low (currently 16M).

Third, the issuance of FRAX bonds (not yet online) can relieve the FXS selling during the contraction phase by incentivizing holders to purchase bonds through pledged FXS.

All in all, FRAX is an interesting ongoing monetary experiment that strikes a new balance between price stability, capital utilization, and counter-censorship. After the agreement ran for a week, it worked well. What remains to be seen is whether stability remains when reducing the mortgage ratio, and how far it can go on the road to removing asset pledges.

Relevant information:

Frax documentation:
https://docs.frax.finance/

Frax code:
https://github.com/FraxFinance

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