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Exploring Frax Finance, the FRAX Token, and the FXS Token

Frax Finance is a “fractional-algorithmic” stablecoin protocol that uses a combination of algorithmic backing and collateral backing. Most stablecoins tend to use either collateral or algorithmic backing. However, Frax Finance offers a solution that changes between the two types of backing to reflect market confidence. The FXS token is the native utility and governance token. The protocol automatically buys FXS tokens and burns them to control the supply. Furthermore, the FRAX token is the native stablecoin of the Frax Finance ecosystem. The only way to mint FRAX tokens is by locking up value within the protocol.

In this article, we’re going to dive deep into the Frax Finance platform. We’ll discuss the FRAX token, the FXS token, and the veFXS token. Also, we’ll explore Algorithmic Market Operations (AMOs), governance, minting, and redeeming.  

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What is Frax Finance?

Frax Finance is a decentralized cross-chain “fractional-algorithmic” stablecoin protocol. The aim of Frax Finance is to establish a scalable, open-source currency with a flexible supply. The native FRAX token is a stablecoin backed algorithmically and by collateral, making it the first stablecoin of its kind. 

The Frax Finance ecosystem comprises two primary assets. The first is the FRAX token, a dollar-pegged stablecoin. The second is the FXS governance and utility token, which enables holders to earn fees and excess collateral value. Plus, holders can vote on proposals to make changes to the protocol.

Rather than pursuing a single avenue for backing (i.e., 100% algorithmic or collateralized) like many stablecoins, Frax Finance offers a highly scalable, “ideologically pure” stablecoin system. The ratio of collateralized and algorithmic backing is determined by the market price of the FRAX token. When the FRAX token trades under $1, the Frax Finance protocol increases the collateral ratio. Conversely, when the FRAX token is trading above $1, the collateral ratio decreases.

The vision of the project is to become the first crypto native consumer price index (CPI), which FXS token holders will govern. Currently, the FRAX token is price-pegged to the US dollar. However, in the future, the project aims to support multiple currencies and become a worldwide permissionless unit of account. Also, more volatile cryptocurrencies such as ETH and WBTC may be under consideration as collateral as the velocity of the Frax Finance system increases.

The FRAX Token

The FRAX token is the native stablecoin of the Frax Finance ecosystem. Because anyone can mint and redeem the FRAX token at any time, supply and demand are balanced by arbitrageurs on the open market. Accordingly, when the price of one FRAX token exceeds the price target of $1, users can use $1 of value to mint FRAX tokens that can be sold at a higher value.

The only way to mint FRAX tokens is by locking up value. However, the backing of the FRAX token varies during different phases. During the collateral phase, the FRAX token uses 100% collateral. However, during the fractional phase, part of the value entering the system for backing comes from FXS tokens, which the protocol then burns and removes from circulation. 

For example, a 98% collateralization ratio would require $0.98 of collateral and the burning of $0.02 of FXS. During the 100% collateral phase, all of the value the protocol receives from redeeming FRAX tokens is collateral. Also, part of the value leaving the system during FRAX token redemption goes towards minting new FXS tokens.

Minting and Redeeming FRAX Tokens

Redeeming FRAX tokens during the 100% collateral phase is straightforward to execute. During the fractional-algorithmic phase, FXS tokens are burned whenever FRAX tokens are minted. Plus, FXS tokens are minted whenever FRAX tokens are redeemed. The demand for FRAX does not determine the value of the FXS token. Instead, the value accrual of the FXS market cap reflects the non-collateralized value of the FRAX token market cap.

The process of minting and redeeming FRAX tokens helps maintain the price stability of the stablecoin. Accordingly, the more people using the protocol, the more stable the FRAX token becomes. Furthermore, the demand for FRAX tokens influences the price of the FRAX token and can create arbitrage opportunities. 

To reach the target price of $1, new FRAX tokens must be minted. An upturn in demand for the platform increases the market cap of the FRAX token via an increase in price or expansion of the circulating supply. Moreover, the FXS market cap is directly linked to the demand for FRX tokens, as the number of FXS tokens burned depends on the demand for FRAX tokens. In the future, the protocol may opt for an auction-based minting process. 

Collateral Ratio

The Frax Finance protocol automatically alters the collateral ratio during periods of expansion and contraction of the FRAX token supply. When the supply expands, the collateral ratio reduces so that more FXS tokens must be deposited to mint new FRAX tokens. However, during periods of supply retraction, the collateral ratio increases. 

Furthermore, the protocol amends the collateral ratio by 0.25% every hour at genesis. As such, whenever the value of the FRAX token exceeds $1, the collateral ratio decreases. Similarly, the collateral ratio increases when the price of the FRAX token falls below its price target.

Frax Finance is agnostic towards the collateral ratio. It is up to the community to decide what the long-term collateral ratio will be. It is only when the confidence in the protocol remains high that this ratio will drop. Moreover, the protocol could be completely collateralized or algorithmic if the community decides this to be the correct course of action. As such, Frax Finance provides a “deterministic and reflexive” service that efficiently measures the market confidence in a stablecoin without backing.

The FXS Token

The Frax Share token (FXS) is the governance and utility token of the Frax Finance ecosystem. Frax Finance uses a minimal approach to protocol governance with a similar ethos to that of Bitcoin. Rather than using a traditional decentralized autonomous organization (DAO) model like many popular decentralized finance (DeFi) protocols, Frax Finance opts for a governance model with less active management. Resultantly, FXS token holders have fewer protocol parameters to disagree about changing. These parameters include the addition of new collateral pools and adjustment to existing ones. Also, FXS token holders can vote on proposals to make changes to fee structures and “the rate of the collateral ratio”.

The initial FXS token supply is 100 million. However, the FXS token will likely implement a deflationary model as the demand for minting FRAX tokens grows. At the time of writing, the FXS token is trading at around $33.20, with a market cap of $1.17 billion, according to CoinGecko. Moreover, as the market cap of the FXS token increases, the FRAX token benefits from greater stability. This dual-token model facilitates maximum value accrual while preserving the stability of the stablecoin protocol. Staking the FXS token enables holders to participate in platform governance. Additionally, stakers receive yield farming boosts and veFXS token rewards.

The veFXS Token

The veFXS token model is a “vesting and yield system” that takes inspiration from the Curve Finance veCRV mechanism. By locking up FXS tokens, holders receive veFSX in return. The number of veFXS tokens that a staker receives is proportional to the duration of their stake. For example, locking up 100 FXS tokens for four years would return 400 veFXS tokens.

The veFXS token is non-transferable and cannot be traded on liquid markets. Instead, the veFXS token works like an “account based point system” that reflects the duration of a vesting period relating to the locked balance of FXS tokens for a specific wallet address. These balances decrease linearly as the FXS lockup expiry date approaches. This approach aims to encourage long-term staking.

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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.

Farming

Frax Finance will also provide liquidity programs and staking incentives via liquidity pools on the Uniswap decentralized exchange (DEX). These liquidity pools will feature novel pairs, each with individual incentives and emission rates. Furthermore, the veFXS token will entitle holders to farming boosts in these liquidity pools. In turn, these boosts will provide additional rewards for external farming and staking opportunities that are proportional to each veFXS balance. In turn, the veFXS token helps to allocate voting power to long-term FXS token holders while incentivizing staking. 

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.

The first iteration of the Frax Finance protocol featured a single AMO. However, the current version will feature multiple implementations of modular AMOs to create a “Turing-complete design space of stability mechanisms” that do not affect the underlying base stability mechanism of the protocol. Moreover, these AMOs will enable frictionless upgrades and optimizations without compromising the user experience.

FXS1559

Taking inspiration from the EIP-1559 Ethereum improvement proposal, the FXS1559 mechanism evaluates the amount of excess value within the Frax Finance protocol. It uses this value to purchase FXS tokens for burning during block production. In turn, this helps to minimize transaction fees. Plus, FXS1559 “binds FXS value capture on the AMO level” by minting new FRAX tokens to buy and burn FXS on FRAX-FXS automated market maker (AMM) pairs.

Collateral Investor

The Frax Collateral Investor AMO puts idle USDC collateral to work using some of the top decentralized finance (DeFi) protocols. Current DeFi protocols include Aave, Uniswap, Compound Finance, and Yearn Finance. However, protocol governance facilitates the addition of new protocol integrations.

Buybacks and Recollateralization

The protocol features two novel swap functions to buy back FXS tokens and reach the collateral ratio. This expedites the redistribution of value to FXS token holders and increases collateral. The recollateralize function monitors the total collateral value. Anyone can call this function when the collateral value is below the target to enable the protocol to reach the target collateral ratio by minting new FXS tokens at an advantageous rate. 

Arbitrageurs have an incentive to buy these tokens at a discount, which eventually closes the gap. Alternatively, any FXS holder can call the buyback function when the collateral value exceeds the value necessary to maintain the target collateral ratio. When an FXS token holder calls the buyback function, they exchange the surplus collateral value for FXS tokens that the protocol burns. Essentially, this mechanism operates like a share buyback system for the FXS token.

Exploring Frax Finance, the FRAX Token and the FXS Token – Summary

Most stablecoin projects tend to favor 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.

If you want to take your DeFi game to the next level, check out the DeFi 201 course at Moralis Academy! This course teaches students about yield farming, liquidity pools, and crypto hedge funds. Plus, we show students how to take advantage of crypto arbitrage opportunities! There has never been a better time to learn about blockchain and cryptocurrency. Kickstart your blockchain education the right way with Moralis Academy! Also, don’t forget to follow us on Twitter @MoralisAcademy! We’d love to hear your thoughts about Frax Finance, the FRAX token, and the FXS token!

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Written by Ivan on Tech

January 7, 2022

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