Go2Mars Research

As AladdinDAO's latest work, the f(x) protocol decomposes ETH into two new derivative tokens: fETH and xETH. fETH is a low-beta near-stablecoin with little price volatility and no reliance on centralized risks, which can effectively meet the needs of decentralized finance (DeFi).

xETH is a high-beta leveraged long-term ETH perpetual contract that provides a powerful decentralized on-chain trading tool. Both tokens are issued and redeemed entirely based on ETH as collateral, thus maintaining the decentralized and Ethereum-native characteristics.

Simply put, the f(x) protocol allows users to use ETH to generate fETH and xETH, and then use these two tokens to enjoy different degrees of ETH price changes. The price of fETH will only follow 10% of the change in ETH price, which means it has a β coefficient of 0.1. The price of xETH will reflect the ETH price changes that fETH does not reflect, which means it has a β coefficient greater than 1. In this way, fETH is equivalent to a floating stablecoin, and xETH is equivalent to a leveraged long-term investment tool.

AladdinDAO

AladdinDAO is a DAO composed of DeFi experts, aiming to screen high-quality DeFi projects and provide high-yield investment opportunities for community members. In the Curve War, a war for CRV voting rights, AladdinDAO launched two new tools: Concentrator and Clever, to help users win more profits and influence.

Through these two tools, AladdinDAO not only provides users with an opportunity to easily obtain high returns, but also provides a solution for DAO to manage treasury funds without the multi-signature process. At the same time, these two tools also enhance Convex’s voice in Curve War, thereby influencing the development direction of Curve’s ecology.

Since the USDC crisis, the core members of AladdinDAO have re-examined the shortcomings of the current stablecoins in the market and proposed a new solution, the f(x) protocol.

Stablecoins

Before discussing the f(x) protocol, let’s first review the definition of stablecoins:

A stablecoin is a digital currency whose value is pegged to another currency, commodity or financial instrument to reduce price fluctuations compared to other more volatile cryptocurrencies such as Bitcoin.

The main role of stablecoins is to provide liquidity and stability in the cryptocurrency market as a store of value and medium of exchange. Most stablecoins are anchored to the US dollar or other fiat currencies, which makes them easy to interact and exchange with the traditional financial system. However, from a crypto-native perspective, if the crypto world continues to develop and grow, stablecoins will be relatively inflated because they cannot capture the appreciation of cryptocurrencies relative to fiat currencies. Therefore, stablecoins may lose their appeal and competitiveness, and more people will seek an asset that can follow the development of the crypto market.

There are three main types of stablecoins at present: legal currency-backed, partially algorithmic stablecoins, and CDP algorithmic stablecoins.

Purely algorithmic (uncollateralized or insufficiently collateralized) stablecoins, such as Terra's UST, are the most obvious risk type because they are difficult to guarantee safety and reliability and are not suitable as a long-term option. It then divides existing stablecoins into three major categories:

1. Fiat-backed stablecoins (such as USDC, USDT), which rely on third-party institutions to maintain fiat currency reserves, but also face the risk of centralization.

2. Algorithmic, but partially or fully fiat-backed stablecoins (e.g. DAI, FRAX), which are also subject to the centralization risks of fiat-backed stablecoins.

3. Fully decentralized CDP algorithmic stablecoins (such as LUSD), which only accept decentralized collateral, but have room for improvement in scalability and capital efficiency.

Therefore, the goal of the protocol is to create stable assets that can improve capital efficiency and scalability while maintaining low volatility, thus introducing two assets, fETH and xETH. In traditional finance, β is a measure of the volatility of a given security or portfolio. Compared to the market. Since fiat currency is the denominator of these measures, cash has β = 0, and a portfolio with β = 1 will perfectly reflect market returns (such as the S&P 500 ETF). A portfolio that moves in the same direction as the market but with a relatively small amplitude has β < 1, while a portfolio that moves in the same direction as the market has β > 1.

In the f(x) protocol, the price of ETH is defined as the market, and beta is a measure of the volatility of a given cryptocurrency relative to ETH. ETH itself has a beta of 1, while a perfect stablecoin has a beta of 0. Asset X targets a beta of 0.5, meaning it only reflects 50% of changes in the price of ETH.

How the protocol works

The invariant f(x) is maintained by adjusting the NAV (Net Asset Value) of fETH and xETH, namely:

The protocol then calculates the new NAV of xETH based on the f(x) invariant:

This way, xETH captures all ETH price movements that are shielded by fETH, providing leveraged returns.

Fractional ETH — Low Volatility Asset/“Floating” Stablecoin

At the beginning of the protocol, the price of fETH was set to $1. The protocol controls the volatility of fETH by adjusting its NAV so that it only reflects 10% of the change in ETH price (i.e. β_f = 0.1). When the price of ETH changes, the NAV of fETH is updated according to the following formula:

Where rETH is the rate of return of ETH between time t and t-1.

The advantages of stablecoins are mainly reflected in low price volatility, low inherent risk, and deep liquidity. fETH is a low-volatility asset with a beta of 0.1, which means that its price change is only one-tenth of the change in ETH price. In this way, fETH can avoid centralization risks while capturing part of the growth or decline of the ETH market.

Compared to traditional stablecoins, fETH is issued based on market demand rather than CDP demand, and is only limited by the supply of xETH (xETH is a token that can absorb fETH fluctuations and provide leveraged returns), so it has higher scalability and capital efficiency. fETH can be seen as a way to anchor to ETH, but it does not maintain a fixed or near-fixed ratio like traditional anchoring methods, but adjusts according to β = 0.1.

In general, fETH, as a store of value and medium of exchange, provides liquidity and stability in the cryptocurrency market while also retaining some of the market's growth potential.

Leveraged ETH

Leveraged ETH, also known as xETH, is a decentralized, composable leveraged long ETH futures contract with low liquidation risk and zero funding cost (in extreme cases, xETH minters can even earn fees), designed as a companion asset to fETH. xETH holders bear most of the fluctuations in fETH supply, and traders can change their positions at will by using f(x) minting and redemption modules or ready-made on-chain AMM liquidity pools.

fETH can be minted and redeemed based on immediate demand, as long as there is enough xETH supply to absorb fETH volatility. xETH leverage is variable, so a relatively small amount of xETH can support a large amount of fETH.

Calculation of leverage ratio of xETH

Determined according to the following formula:

If the amount of fETH minted is 0, then $$\lambda_f=0,L_x=1$$, and xETH becomes a perpetual contract with a one-time long position on ETH.

The actual effective leverage of xETH tokens changes over time as the relative supply of xETH and fETH is minted and redeemed. The higher the supply of xETH relative to fETH, the lower the effective leverage of xETH, as the excess volatility of fETH is spread across more tokens. Conversely, a larger supply of fETH concentrates volatility on fewer xETH tokens, resulting in higher effective leverage.

System stability

Since xETH is used as an asset to hedge fETH, the more xETH there is, the more stable the system is. If we regard the total ETH reserve as the collateral of the CDP and the total fETH supply as the borrowing amount, we can use the Colletral Ratio similar to the CDP system to monitor the health factors of the system. For the f(x) protocol, we can define CR as follows

Whether it is minting fETH or xETH, or adjusting the net asset value of the two tokens, it will affect the CR value. If the system CR falls by 100%, it means that the value of xETH is zero. At this time, the beta value of fETH is 1, which means that it will be fully exposed to the price fluctuations of ETH and no longer exist as a low-volatility asset. Therefore, f(x) has designed a four-level risk management module to carry out risk control.

Wind control

The risk control system of f(x) is a four-level module that is used to take corresponding measures to maintain the low volatility of fETH and the positive net asset value of xETH when the system's collateral ratio (CR) drops to a certain threshold, thereby increasing the CR. These measures include:

Stable mode: When CR is lower than 130%, fETH minting is prohibited, fETH redemption fees are cancelled, xETH redemption fees are increased, and xETH minters are given additional rewards.

User balance mode: When CR is lower than 120%, users are encouraged to increase the system’s collateral ratio by redeeming fETH, and additional rewards are given to redeemers.

Protocol balance mode: When CR is lower than 114%, the protocol automatically uses ETH in the reserve to purchase and destroy fETH in the market to increase the system's collateral ratio.

Recapitalization: In the most extreme case, the protocol has the ability to raise ETH to recapitalize by issuing governance tokens, either by minting xETH or purchasing and redeeming fETH.

income

The f(x) protocol earns its revenue by charging fees for the minting and redemption of fETH and xETH. These fees are an operational parameter that will be determined at launch. In addition, when the risk management module is activated, fETH holders will also need to pay stability fees, which will be distributed to other users or the protocol itself to help balance the system.

β - the key parameter for regulating volatility

In order to better understand the impact of β on assets, we will analyze and evaluate the change of β from 0 to 1 from three different perspectives: value storage, transaction medium, and crypto-native. These three perspectives cover the main functions and characteristics of assets, as well as their status and role in the cryptocurrency market.

Store of Value

From a value storage perspective, as β goes from 0 to 1, the value stability of assets gradually decreases because they are increasingly affected by market fluctuations. Stablecoins (β = 0) can maintain the same purchasing power as fiat currencies, while ETH (β = 1) will increase or decrease as the market rises and falls. fETH (β = 0.1) is in between, which can retain some of the market's growth potential while limiting volatility.

Medium of exchange

From the perspective of a medium of exchange, as β increases from 0 to 1, the liquidity and scalability of assets gradually increase, as they increasingly conform to the needs and characteristics of the cryptocurrency market. Stablecoins (β = 0) can be easily exchanged with fiat currencies, but there are also centralization risks and trust issues. ETH (β = 1) is a fully decentralized and Ethereum-native asset, but there are also high volatility and price uncertainty. fETH (β = 0.1) is somewhere in between, it avoids centralization risks while maintaining low volatility and high liquidity.

Crypto Native

From a crypto-native perspective, as β goes from 0 to 1, assets become more decentralized and innovative as they increasingly embody the spirit and value of cryptocurrencies. Stablecoins (β = 0) are assets anchored to fiat currencies, and they rely on the support and regulation of traditional financial systems and institutions. ETH (β = 1) is the native asset of the Ethereum network, a leader and innovator in the cryptocurrency space. fETH (β = 0.1) is a new type of asset created based on the f(x) protocol, a low-volatility, decentralized, scalable, Ethereum-native asset paired with xETH, a high-volatility, leveraged, perpetual contract token.

Assumptions for extreme market scenarios

Let’s explore the performance of fETH in extreme market conditions and compare it to the centralized stablecoin USDT. If you are looking for a short-term safe-haven tool that wants to maintain low volatility, then USDT may be more suitable because it can maintain a fixed exchange rate with fiat currency. However, if you are looking for a long-term store of value, fETH may be more suitable. The relationship between fETH and ETH is relatively stable, and it can grow with the cryptocurrency market without being affected by the depreciation of fiat currency. Importantly, fETH has a certain degree of resilience, and even in the case of drastic fluctuations in ETH prices, it can maintain low volatility through the risk management module to achieve its β=0.1 target.

Let's use a practical example to illustrate: Assume that the current price of ETH is $2,000 and the price of fETH is $1 (that is, the NAV of fETH is equal to $1). If the price of ETH drops to $900, the price of fETH will drop by about 10% to $0.9. Despite the depreciation relative to fiat currency, fETH still maintains its low volatility characteristics. If ETH is expected to rebound in the long term, or if fiat currency continues to depreciate, fETH can be used as a mild deflationary currency to store value. In contrast, although USDT can maintain a fixed exchange rate with fiat currency, it cannot resist the risk of fiat currency depreciation, and there are centralization risks, such as banking crises or regulatory intervention. Therefore, fETH and USDT each have their own advantages and disadvantages, and you need to choose according to your needs and expectations.

Summarize

In general, the position of fETH and xETH in the Ethereum ecosystem and their future development direction do not exist in isolation, but will be closely affected by market demand and trader behavior. Market demand is determined by a combination of factors, such as Ethereum's price trend and the overall cryptocurrency market situation. Trader behavior is determined by their expectations of market trends, risk tolerance, and their understanding and emphasis on the value of decentralization and composability. These factors are intertwined and jointly shape the role and development prospects of fETH and xETH in the Ethereum ecosystem. Therefore, to predict and understand the development trends of fETH and xETH, it is necessary to deeply explore the changes in market demand and trader behavior, and understand how they interact and jointly affect the position and development direction of these two assets in the Ethereum ecosystem.