Exploring Frax Finance
The crypto world has undergone rapid innovations and developments in recent years. Among all the advancements, stablecoins have definitely caught the eyes of many crypto enthusiasts. Stablecoins are digital tokens pegged to the value of stable currencies, for example, the US dollar.
Most stablecoins are either backed by collateral or algorithmic. But there is a distinctive stablecoin that combines two backing mechanisms.
This is Frax. Let’s take a look at the peculiarities of Frax and the innovations it’s introducing to DeFi.
What is Frax Finance?
FRAX is the first stablecoin with a dual collateral-backed and algorithmic peg mechanism.
Frax Finance (FRAX) is an algorithmic stablecoin partially backed by collateral. FRAX combines collateralization with an algorithm to establish a collateral ratio, which varies with time.
This collateral ratio defines what ratio of collateral backs 1 FRAX to $1. FRAX is backed in part by USDC, the second-largest stablecoin by market capitalization, and in part by its FXS governance token.
FRAX functions in a similar way to how TerraUSD (UST) is backed by Terra (LUNA). FXS benefits from seigniorage when minting FRAX. Seigniorage is the difference between producing one unit of FRAX (defined by the collateral ratio) and the cost of minting the FXS to back its share of the collateral ratio.
Unique’s Features
1. Price Stability
The Frax protocol achieves price stability using a two-token mechanism made up of FRAX and its governance token, Frax Shares (FXS). As a fractionally-collateralized stablecoin, its ratio of collateralization depends on the market’s pricing of the FRAX stablecoin.
If FRAX is trading above peg (>$1), then the protocol will decrease the collateral ratio. If FRAX is trading below peg (<$1), the protocol will then increase its collateral ratio.
2. Algorithmic Market Operations (AMOs)
The Frax Finance Algorithmic Market Operations (AMO) controller is a framework for “composable, autonomous central banking legos”. An AMO module is a series of smart contracts that enact “arbitrary monetary policy”. This enables AMO controllers to carry out algorithmic market operations without affecting the fractional-algorithmic stability of the FRAX token.
Frax Tokenomics
Frax Finance uses FXS as its utility and governance token. The tokenomics are as follow: total supply of 100 million FXS, and token distribution of FXS allocated to:
- Farming rewards (60%): distribution halving every 12 months
- Treasury (5%)
- Team and investors (35%): 20% to the team, 3% to advisors and early contributors, 12% to private investors.
FXS Risks
As for the risks, FXS suffers from potential volatility, which can arrive if the FRAX stablecoin changes its distance from the focused $1 price point. As previously explained, arbitrageurs profit by keeping FRAX in line, and at both ends of the spectrum (buying and selling), FXS is either sold or bought.
Such an environment creates massive fluctuations for FXS, which can occur if FRAX moves too far. For investors, this can turn into a nightmare if FXS constantly ranges at a certain price level. However, we are fairly certain that active traders will have a good time buying the lows and selling the highs.
Governance
Frax Finance uses a minimal governance model that is a fork of the Compound Finance governance structure. Holders must stake the FXS token to vote on proposals to make changes to the protocol. By locking FXS tokens, users receive veFXS tokens, which are essential for casting votes.
Bottomline
Most stablecoin projects tend to favour either collateral or algorithmic backing. However, Frax Finance takes a novel hybrid approach that enables market confidence to determine the type of backing that takes precedence. This model aims to future-proof the platform while providing flexibility to users.
Frax is certainly not without its faults. Its overreliance on USDC is one: relying too much on a centralized stablecoin to mint and back a “decentralized” one is not the most desirable model for any protocol that strives to be truly decentralized and censorship-resistant.
