In 2020, the crypto market was at a critical point with a massive influx of external funds, leading to a flurry of new cryptocurrency launches and a rapidly expanding market cap. Besides contract-based altcoins, many application-based cryptocurrencies emerged. However, the traditional field of algorithmic stablecoins also made a breakthrough that year, with FRAX becoming the world’s first fractional algorithmic stablecoin.

What is FRAX?

Frax Finance is a decentralized stablecoin protocol featuring two primary tokens: $FXS, the governance token, and $Frax, a stablecoin pegged to USD 1.

Unlike over-collateralized stablecoins like $DAI and $USDC, FRAX uses a partial collateralization model. However, unlike UST, which relies heavily on algorithms, FRAX employs a hybrid approach, making it a “hybrid algorithmic stablecoin.”

The $Frax token is algorithmically generated, leading to rapid protocol growth and increased risks. However, FRAX is backed by assets like USDC, providing a safety net that helps maintain its intrinsic value, even in extreme situations.

The FRAX protocol aims to offer a highly scalable and decentralized algorithmic currency that could eventually replace mainstream digital assets like BTC. The governance token Frax Shares (FXS) was launched in 2020, with a total supply of 100 million tokens.

The Origins of FRAX

In 2019, American software developer Sam Kazemian founded Frax Finance and introduced the concept of a fractional algorithmic stablecoin. Before this, he co-founded Everipedia, an online encyclopedia, in 2014 with Theodor Forselius.

Other key members of Frax Finance include Travis Moore and Jason Huan. Travis Moore, the CTO of Frax Finance, is also a co-founder and CTO of Everipedia, making him a long-term collaborator with Kazemian. Jason Huan, who studied computer science at UCLA, co-founded a student-run blockchain community there, focused on blockchain technology and applications. This experienced team, with strong blockchain expertise, laid a solid foundation for FRAX’s development.

About the FRAX Token FXS

FXS represents the value and governance of the entire Frax protocol, as all algorithmic processes are executed through FXS. The Frax management team designed the economic model with a degree of centralization, focusing FXS’s functions on adjusting collateral pools, fees, and collateral ratios. This approach minimizes conflicts within the community regarding FXS’s application.

Although FXS has a theoretical supply of 100 million tokens, the circulating supply is likely to decrease due to the high FXS ratio required for minting FRAX. As demand for FRAX grows, the supply of FXS will diminish.

Additionally, FXS has a linear and cliff-style unlocking process. Initially, 65% of the tokens were released, with the remaining 35% allocated to the team and private placements. Since FXS and FRAX form a dual-token economic system, FXS plays a crucial role in maintaining FRAX’s value stability. The key functions of FXS include:

• Governance: Granting token holders the right to manage collateral asset pools, set minting/redemption fees, and update collateral ratios.
• Staking: Earning rewards by staking in various pools with an attractive annual yield.
• Minting and Redemption: Burning FXS to mint FRAX and minting FXS to redeem FRAX.
• Rewards: Users who deposit Uniswap LP tokens into specific incentive pools can earn FXS rewards.

Initially, FRAX was 100% collateralized, requiring only collateral to mint FRAX. In the partial collateralization phase, minting FRAX requires collateral and burning FXS. FRAX’s stability relies on the various functions of FXS, with minting and redemption at the core.

FRAX’s Operational Model

FRAX is a hybrid stablecoin supported by both collateral assets and algorithmic technology, making it the world’s first fractional algorithmic stablecoin. FRAX is always pegged to $1, with its collateral ratio adjusted based on market demand to keep its price stable at $1, rather than sticking to a fixed ratio. When FRAX trades above $1, the platform reduces the collateral ratio by 0.25%. When it falls below $1, the collateral ratio is increased.

How FRAX Maintains Price Stability

FRAX’s price stability is maintained through two key mechanisms: minting and redemption. To mint FRAX, an appropriate amount of algorithmic components is added to the system. When FRAX is fully collateralized, users can mint new FRAX simply by depositing collateral into the minting contract.

As FRAX moves into a fractional collateral phase, minting FRAX requires a mix of collateral and burning some FXS tokens. A FRAX is created through a combination of these two components.

For example, with a 98% collateral ratio, minting one FRAX would require $0.98 in collateral and $0.02 in FXS. This fractional approach helps maintain FRAX’s value stability.

FRAX can always be minted or redeemed at a stable value of $1, helping balance supply and demand in the crypto market. If FRAX trades above its $1 target price, arbitrageurs and users can mint FRAX at $1 and sell it for a higher price on the market.

Similarly, if FRAX drops below its $1 target price, arbitrageurs and users can purchase FRAX at a lower price on the market and redeem it on the platform for $1. It’s important to note that when redeeming, users receive a combination of collateral and newly minted FXS tokens.

(Image source: docs.frax.finance)

These mechanisms ensure FRAX’s price stability and its strong market performance has demonstrated the effectiveness of this fractional algorithm system.

Building on the FRAX protocol, the team has expanded into new areas. Fraxswap and Fraxlend are standout examples of applications integral to the FRAX ecosystem.

Fraxswap is designed to function within the FRAX protocol’s key systems through TWAMM orders. The goal of Fraxswap was to create a unique Automated Market Maker (AMM) with features like algorithmic stablecoin monetary policy, forward guidance, and large, continuous market orders. These features help stabilize an asset’s price over the long term by reducing its supply or acquiring specific collateral.

Fraxlend, on the other hand, is less tool-focused compared to Fraxswap. It is an official lending platform that provides lending services between ERC-20 assets. Fraxlend allows anyone to participate in lending activities, enabling lenders to deposit ERC-20 assets and receive interest-bearing fTokens (credentials used on the Fraxlend platform).

FRAX Version Evolution

Each version of Frax has its distinct positioning and strategy, representing either a new development or adding new features, rather than simply enhancing a single function. Understanding the past versions is essential to grasping Frax Finance’s future strategic direction.

• Frax v1: Launched as an algorithmic stablecoin.
• Frax v2: Shifted from reducing the collateral ratio of algorithmic stablecoins to increasing it, transforming it into an over-collateralized stablecoin, and introduced AMOs and other services to improve capital efficiency.
• Frax v3: Integrated Real World Assets (RWA) to further enhance capital efficiency, ultimately aiming to become an on-chain bank.

Here is a brief overview of the positioning of each version:

FRAX V1: Algorithmic Stablecoin

FRAX V1 was the initial version of the FRAX protocol, created to offer a stable cryptocurrency pegged to the US dollar. This version introduced a partially collateralized stablecoin model, combining algorithmic stability with collateral backing. It allowed users to generate FRAX tokens by collateralizing other cryptocurrencies and used market mechanisms to maintain price stability. This version marked FRAX’s debut in the stablecoin market and set the stage for future developments.

FRAX V1 entered the market with a unique Fractional Algorithmic model. The Frax protocol consists of two tokens: the stablecoin FRAX and the governance token FXS. FRAX’s value is supported by a mix of collateral, mainly USDC and FXS, with the proportion of USDC referred to as the collateral ratio (CR). The protocol’s core function is to control the price of FRAX by adjusting the collateral ratio.

• When FRAX trades above one dollar, the collateral ratio is lowered
• When FRAX trades below one dollar, the collateral ratio is increased

The protocol’s collateral ratio refresh function can be triggered once an hour by any user. If FRAX’s price deviates from one dollar, this function adjusts the collateral ratio by 0.25% per refresh. The refresh rate and adjustment parameters can be modified through governance, allowing the market to automatically balance the price.

FRAX V2: Multi-Protocol Value

FRAX V2 introduced significant improvements, building on V1 by focusing on enhanced stability and scalability. This version introduced an automated contract called the Algorithmic Market Operations Controller (AMO), which automatically invests idle funds within the Frax protocol, thereby increasing capital efficiency. For instance, the Collateral Investor AMO can stake funds in AAVE and Compound to earn returns. V2 also expanded support for multiple assets, allowing users to collateralize a broader range of cryptocurrencies to generate FRAX. Additionally, FRAX V2 optimized algorithmic stability by improving the governance process, enabling the community to have a more active role in decision-making, further enhancing the ecosystem’s overall stability and sustainability.

Community members can design various AMOs to execute different market strategies, provided they adhere to the established rules and do not compromise the original collateral mechanism. The main AMOs currently include:

1. Curve AMP: Invests funds in the FRAX3CRV pool to earn returns.
2. Uniswap AMO: Invests funds in Uniswap liquidity pools to earn returns.
3. Collateral Investor AMO: Stakes funds in AAVE and Compound to earn returns.
4. Fraxlend AMO: Lends FRAX in the Fraxlend market to earn interest.
5. RWA AMO: Starting from v3, invests funds in US Treasury bonds and other RWAs to earn returns.

The profits from these AMOs are used to buy back and burn FXS tokens through the FXS-1559 mechanism, thereby returning value to token holders. However, these earnings are primarily used to maintain a 100% collateral ratio.

(Note: FXS-1559 is an economic strategy designed to enhance token value and maintain protocol health through a buyback and burn mechanism.)

FRAX V3: Comprehensive Ecosystem

FRAX V3 is the most recent version, further enhancing the capabilities and efficiency of the FRAX protocol. This version aims to create a decentralized stablecoin pegged directly to the US dollar, fully backed by external reserves (with a collateral ratio of 100% or more). V3 focuses on issuing stablecoins without requiring collateral and uses more advanced algorithms to achieve full decentralization. This version significantly lowers users’ entry barriers and broadens the FRAX application. Additionally, V3 integrates a more robust governance mechanism, enabling community members to participate more effectively in the protocol’s development, driving continuous growth of the FRAX ecosystem.

Frax Finance will leverage internal and external protocols to achieve these goals, including its internal Fraxlend, Fraxswap, and the newly launched sFRAX, as well as external protocols like Curve and upcoming RWA purchases.

RWA Purchase Process and Facilities

FRAX’s collateral ratio will be determined based on the value of the external collateral held by FRAX and will achieve a 100% or higher collateral ratio in V3, making it a fully externally backed stablecoin. This transition from an algorithmic stablecoin to a collateral-backed stablecoin will be realized through AMOs and Frax community governance, which will decide which AMOs to operate. By earning value from internal and external protocols, the FRAX stablecoin will maintain a collateral ratio of at least 100%.

In addition to earning profits through AMOs from internal and external protocols, FRAX can also purchase low-risk RWAs, such as short-term US Treasury bonds, to improve the capital efficiency of the FRAX ecosystem. In combination with the newly proposed deposit protocol sFRAX, external partners approved by governance will use FRAX stablecoins to purchase and hold RWAs to increase revenue sources, making it easier to achieve the goal of fully external reserves.

FRAX V3 users can deposit FRAX stablecoins into the sFRAX staking pool to earn interest rates close to the Interest Rate on Reserve Balances (IORB), similar to Maker’s DAI savings system. The profit-sharing design of sFRAX will attract more users to invest, facilitating the achievement of a 100% collateral ratio.

Unless approved by community governance, the Frax team will only purchase the following assets as RWAs:

1. Short-term US Treasury bonds
2. Overnight reverse repurchase agreements
3. US dollars deposited in Federal Reserve Bank master accounts
4. Mutual Funds

FRAX V3 partners (custodians) will primarily purchase the above assets as RWAs and must report monthly on their custody, broker, banking, and trust arrangements. FIP-277 designates FinresPBC as FRAX V3’s first RWA partner, with no fees except for some regulatory costs.

(Note: FIP-277 aims to strengthen FRAX V3’s financial stability and yield while reducing operational costs by introducing FinresPBC as a partner.)

FRAX Will No Longer Be Redeemable

It is important to note that FRAX will no longer be redeemable for collateral in the future. Instead, it will rely on the market mechanisms, various AMOs, and related protocols mentioned above to achieve its dollar-pegged valuation. The team considers this the “ultimate stablecoin,” although its feasibility remains proven. Additionally, FRAX will introduce FRAX Bonds (FXB), allowing users to purchase them at a discount and redeem them for FRAX on a specific date. This service is another method to enable FRAX to purchase RWAs more efficiently. (All efforts in Frax V3 aim to raise the collateral ratio to 100%.)

Conclusion

Frax Finance is an innovative decentralized stablecoin protocol that has successfully established a significant presence in the crypto market with its unique approach of combining partial collateralization with algorithmic stability. From the inception of FRAX and the introduction of the FXS governance token to the iterative evolution of its various versions, Frax Finance has shown a strong ability to adapt to market changes and technological advancements. The release of FRAX v3 represents a major step towards becoming a fully decentralized stablecoin, setting a strong foundation for FRAX’s future growth by incorporating external partnerships and advanced algorithms.

Frax Finance has consistently improved its governance mechanisms and incentive programs, including the FXS-1559 buyback and burn strategy and the FIP-277 partnership initiative. These efforts have strengthened FRAX’s value stability and offered significant rewards to token holders and community members. Furthermore, FRAX’s diverse applications, such as Fraxswap and Fraxlend, have broadened its ecosystem, providing users with a rich array of financial services and use cases.

As FRAX v3 continues to evolve and partnerships expand, Frax Finance is poised to play a more prominent role in the stablecoin market, offering a secure, efficient, and scalable digital currency solution for users worldwide. Through ongoing technological innovation and adaptability to market needs, Frax Finance is making steady progress toward its ambitious goal of becoming an on-chain bank and the next-generation financial ecosystem.