Frax Finance

Frax Finance

Introduction

Many stablecoin protocols have entirely embraced one spectrum of design (entirely collateralized) or the other extreme (entirely algorithmic with no backing). Collateralized stablecoins either have custodial risk or require on-chain overcollateralization. These designs provide a stablecoin with a fairly tight peg with higher confidence than purely algorithmic designs. Purely algorithmic designs such as Basis, Empty Set Dollar, and Seigniorage Shares provide a highly trustless and scalable model that captures the early Bitcoin vision of decentralized money but with useful stability. The issue with algorithmic designs is that they are difficult to bootstrap, slow to grow (as of Q4 2020 none have significant traction), and exhibit extreme periods of volatility which erodes confidence in their usefulness as actual stablecoins. They are mainly seen as a game/experiment than a serious alternative to collateralized stablecoins.

FRAX can always be minted and redeemed from the system for $1 of value. This allows arbitragers to balance the demand and supply of FRAX in the open market. If the market price of FRAX is above the price target of $1, then there is an arbitrage opportunity to mint FRAX tokens by placing $1 of value into the system per FRAX and sell the minted FRAX for over $1 in the open market. At all times in order to mint new FRAX a user must place $1 worth of value into the system. The difference is simply what proportion of collateral and FXS makes up that $1 of value. 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. In a 97% collateral ratio, every FRAX minted requires $.97 of collateral and burning $.03 of FXS, and so on.

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. At all times, a user is able to redeem FRAX for $1 worth 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. In a 97% collateral ratio, every FRAX can be redeemed for $.97 of collateral and $.03 of minted FXS.

The FRAX redemption process is seamless, easy to understand, and economically sound. During the 100% phase, it is trivially simple. During the fractional-algorithmic phase, as FRAX is minted, FXS is burned. As FRAX is redeemed, FXS is minted. As long as there is demand for FRAX, redeeming it for collateral plus FXS simply initiates minting of a similar amount of FRAX into circulation on the other end (which burns a similar amount of FXS). Thus, the FXS token’s value is determined by the demand for FRAX. The value that accrues to the FXS market cap is the summation of the non-collateralized value of FRAX’s market cap. This is the summation of all past and future shaded areas under the curve displayed as follows.

All FRAX tokens are fungible with one another and entitled to the same proportion of collateral no matter what collateral ratio they were minted at. This system of equations describes the minting function of the Frax Protocol.