FRAX: The Fractional Solution to a Stable Future
— By Ibrahim Quabboua
The path toward ‘’the stable coin’’ that will be used in the decentralized world we are creating is far from over.
Algorithmic stable coins are inherently fragile. Uncollateralized digital assets, which attempt to peg the price of a reference asset using financial engineering, algorithms, and market incentives, are not stable at all but exist in a state of perpetual vulnerability. Iterations to date have struggled to maintain a stable peg, and some have failed catastrophically. Aka iron finance.
Overcollateralized stable coins are not that lovely either. Forcing us to lock up to 1.5x more times than we want to mint not knowing the amount of leverage we take on our daily trades to gain more pennies. (Yes Mr. 50x leverage, yes, I am mentioning you)
I’m not going to mention USDTether, since is always 100% backed by ‘’ our reserves ‘’, and by our reserved they mean shitty commercial papers belong to shitty companies (beloved EVERGRANDE)
So, geeky colleagues, what is the solution?
Frax is the first fractional-algorithmic stable coin protocol targeting a tight band around $1/coin. Frax is open-source, permissionless, and entirely on-chain — currently implemented on Ethereum and other chains.
The end goal of the Frax protocol is to provide highly scalable, decentralized, algorithmic money in place of fixed-supply digital assets like BTC.
What I love about this is that it simply balances between the real collateral and the floated collateral in response to the trust gained by the people in the FRAX.
As FRAX adoption increases, users will be more comfortable with a higher percentage of FRAX supply being stabilized algorithmically rather than with collateral. The collateral ratio refresh function in the protocol can be called by any user once per hour. The function can change the collateral ratio in steps of .25% if the price of FRAX is above or below $1. When FRAX is above $1, the function lowers the collateral ratio by one step and when the price of FRAX is below $1, the function increases the collateral ratio by one step.
II. FRAX SHARES (FXS)
The Frax Share token (FXS) is the non-stable, governance, utility token in the protocol.
Some of the parameters that are up for governance through FXS are adding/adjusting collateral pools, adjusting various fees (like minting or redeeming), and refreshing the rate of the collateral ratio.
The FXS token has the potential of upside utility and downside utility of the system, where the delta changes in value are always stabilized away from the FRAX token itself.
FXS supply is initially set to 100 million tokens at genesis, but the amount in circulation will likely be deflationary as FRAX is minted at higher algorithmic ratios. The design of the protocol is such that FXS would be largely deflationary in supply as long as FRAX demand grows. And we will explain how he happens in the net part.
III. Collateral Ratio (CR)
The collateral ratio is defined as =
Real Collateral / (Real Collateral + Floated Collateral)
The protocol adjusts the collateral ratio during times of FRAX expansion and retraction. During times of expansion, the protocol collateralized (lowers the ratio) the system so that less collateral and more FXS must be deposited to mint FRAX. This lowers the amount of collateral backing all FRAX.
During times of retraction, the protocol is collateralized (increases the ratio). This increases the ratio of collateral in the system as a proportion of FRAX supply, increasing market confidence in FRAX as its backing increases.
At genesis, the protocol adjusts the collateral ratio once every hour by a step of .25%.
When FRAX is at or above $1, the function lowers the collateral ratio by one step per hour and when the price of FRAX is below $1, the function increases the collateral ratio by one step per hour. This means that if FRAX price is at or over $1 a majority of the time through some time frame, then the net movement of the collateral ratio is decreasing. If FRAX price is under $1 a majority of the time, then the collateral ratio is increasing toward 100% on average.
IV. Minting FRAX
Minting new FRAXs requires a simple calculation for you dear trader to identify how much USDC and FXS you have to provide.
For example, if you want to Mint FRAX at a collateral ratio of 80% with 120 USDC ($1/USDC price) and an FXS price of $2/FXS.
150 FRAX are minted in this scenario. 120 FRAX are backed by the value of USDC as collateral while the remaining 30 FRAX are not backed by anything. Instead, FXS is burned and removed from circulation proportional to the value of minted algorithmic FRAX.
V. Redeemingng FRAX
Redeeming the process will let you redeem your initial deposits, as given in these two formulas:
Example: Redeeming 170 FRAX at a collateral ratio of 65%. Oracle price is $1.00/USDC and $3.75/FXS.
Redeeming 170 FRAX returns $170 of value to the redeemer in 110.5 USDC from the collateral pool and 15.867 of newly minted FXS tokens at the current FXS market price.
To be noted that :
- The minting and redemption fees are set between 0.20% and 0.45%
- There is a 2 block delay parameter (adjustable by governance) on withdrawing redeemed collateral to protect against flash loans. (smart, I know)
VI. Stability of FRAX
FRAX can always be minted and redeemed from the system for $1 of value. This feature allows arbitragers to balance the demand and supply of FRAX in the open market.
Let’s take this example, If the market price of FRAX is above the price target of $1 for example, then there is an arbitrage opportunity to mint FRAX tokens by placing $1 of value into the system per FRAX and selling the minted FRAX for over $1 in the open market.
So, When FRAX is in the 100% collateral phase, 100% of the value that is put into the system to mint FRAX is collateral. As the protocol moves into the fractional phase, part of the value that enters into the system during minting becomes FXS (which is then burned from circulation). For example, in a 98% collateral ratio, every FRAX minted requires $.98 of collateral and burning $.02 of FXS
If the market price of FRAX is below the price range of $1, then there is an arbitrage opportunity to redeem FRAX tokens by purchasing cheaply on the open market and redeeming FRAX for $1 of value from the system.
The difference is simply what proportion of the collateral and FXS is returned to the redeemer. When FRAX is in the 100% collateral phase, 100% of the value returned from redeeming FRAX is collateral. As the protocol moves into the fractional phase, part of the value that leaves the system during redemption becomes FXS (which is minted to give to the redeeming user). For example, in a 98% collateral ratio, every FRAX can be redeemed for $.98 of collateral and $.02 of minted FXS.
VII. Personal Thoughts
This ‘Frax dance’ is always happening and uses AMM game theory to test different ratios of collateralization, incentivize collateralizing through arbitrage swaps, and redistribute excess value back to FXS holders through a buyback swap. The protocol starts at a 100% collateral ratio at the genesis and might or might not ever get to purely algorithmic.
The novel insight is to use market forces itself to see how much of a stable coin can be algorithmically stabilized with its own seigniorage token so that it keeps a tight band around $1 like fiat coins.
Its most likely the Frax protocol can become a foil to Bitcoin’s “hard money” narrative by demonstrating algorithmic monetary policy to create a trustless stable coin that all of the crypto community can embrace.