Note: The crypto industry will see a reduction in Bitcoin production next year. Hot Air Balloon predicts that the best time for capital allocation may be the end of this year, so it launches the "High-Quality Crypto" series to analyze and explore the potential currencies in each track of the next cycle and make preemptive layouts.
In this issue, we will focus on DeFi's veteran blue chip and the "LSD newcomer" Frax Finance.
Background of the project
basic situation
Frax Finance was launched in 2020. It was originally an algorithmic stablecoin system based on a partial collateral mechanism. The ecosystem included the non-stable fee token FXS and the stablecoin FRAX.
As we all know, the solutions for stablecoins can be roughly divided into three categories:
Fiat-pegged stablecoins, represented by USDT, appeared the earliest and currently have the largest market share, but they sacrifice centralized issuance and are still unable to escape the question of 100% asset reserve support.
Although asset-backed stablecoins such as DAI have achieved decentralization to a certain extent, they cannot avoid the problems of over-collateralization and low capital utilization.
Algorithmic stablecoins represented by UST establish a monetary system through market supply and demand, achieving "decentralization" to the greatest extent and liberating the upper limit of capital utilization, but their own "spiral deflation and inflation" volatility is too large and it is difficult to escape the Ponzi fate;
The stablecoin FRAX was originally based on the "hybrid algorithmic stablecoin" mechanism, which aims to maintain a 1:1 anchor to the US dollar through algorithms and collateral. It has the characteristics of both algorithms and collateral:
Compared with the over-collateralized DAI and LUSD stablecoins, FRAX is issued using a partial collateralized mechanism, meaning that the collateralized assets behind it are less than 100% in most cases.
Compared with the purely algorithmic AMPL and UST, FRAX has hard currency assets, mainly USDC, as a certain degree of guarantee, which can retain the basic intrinsic value in extreme cases;
However, after the collapse of UST in 2022 led to the collapse of the entire stablecoin track, FRAX was also affected. So this year, Frax Finance mainly made two business adjustments:
On the one hand, we finally chose to abandon the algorithmic stablecoin factor and turn to a fully collateralized stablecoin that is completely similar to DAI;
On the other hand, it also shifted its focus from stablecoins to the liquidity staking (LSD) track, and used the voting weights of CVX, CRV, etc. accumulated from supporting the stablecoin FRAX to its own LSD product frxETH, with fruitful results.
Up to now, Frax Finance's user network and business volume have begun to take shape, and it is developing from a single currency protocol to a DeFi matrix centered on stablecoin (FRAX), with LSD (frxETH) as an important tool, and combining DEX (FRAXSwap), lending (FRAXLend), etc.
Frax Finance's previous competitive advantages mainly came from a more capital-efficient monetary mechanism and a flexible monetary policy based on the AMO module. Now its product line covers lending, Swap, stablecoins, and LSD, which are all highly innovative in DeFi projects. The synergy effect may constitute a long-term moat for the project.
development path
Start with a stable foundation and move to full mortgage
As of the time of writing (July 7, 2023), FRAX's market capitalization is $1 billion. It has remained relatively stable over the past year, with no increase or decrease in circulation. It is currently ranked 6th among all major stablecoins (USDT, USDC, DAI, BUSD, TUSD), and second only to DAI (US$4.3 billion) among decentralized stablecoins.
Before April 2022, FRAX continued to connect to most of the mainstream public chains other than Ethereum, with a market value of nearly $3 billion at its peak. In addition, FRAX has another feature, which is to actively apply for the Federal Reserve's main account, making FRAX the closest thing to a risk-free dollar:
The Federal Reserve master account can achieve direct access to the wholesale payment system and related Federal Reserve payment services without the need for banks to act as intermediaries. Simply put, Frax Finance can hold US dollars itself and trade directly with the Federal Reserve without worrying about the risk of USDC being affected by the collapse of Silicon Valley Bank.
Stephen, one of the project initiators of Frax Finance, was also nominated by Trump as a member of the Federal Reserve Board of Governors, so he actively embraces supervision.
However, FRAX still uses its own ecological cycle as its main application scenario, and its usage scenarios are extremely limited compared to USDT\USDC\UST\BUSD.
After April 2022, Terraform Labs released a new proposal, planning to launch UST, FRAX, USDC, and USDT 4pool on Curve, aiming to replace the 3pool (USDT, USDC, DAI) at the core of the stablecoin market with decentralized algorithmic stablecoins.
In Terraform Labs' vision, Terra and Frax Finance, as the two largest protocol holders of CVX, can influence Curve's incentive policy through huge bribes of vlCVX, thereby maintaining deep liquidity in the 4pool pool, making 4pool the most liquid and frequently used cross-chain stablecoin pool.
This means achieving the subversion of 3 pools by 4 pools, but the collapse of UST/Terra in May 2022 caused a huge shock in the algorithmic stablecoin track. The idea came to an abrupt end, and the size of FRAX shrank rapidly, halving to US$1.5 billion in just one month, and then gradually fell to around US$1 billion, and has remained stable for a year.
Starting from the first half of this year, FRAX has gradually increased its collateral ratio (CR) back to 100%, which means that FRAX has completely abandoned its stable property and is gradually approaching the full collateralization or even over-collateralization model of MakerDAO and DAI.
As of the time of writing (July 7, 2023), FRAX's CR has gradually recovered and stabilized at around 95%, basically getting rid of its stablecoin properties and turning into a fully collateralized stablecoin.
LSD
While adjusting the properties of its own stablecoin FRAX, Frax Finance is also exploring new business directions.
Combining the time window of last year's The Merge and this year's Shanghai upgrade, Frax Finance selected the Ethereum Liquidity Staking (LSD) track as the focus of its new business:
Frax Finance launched the Ethereum liquidity staking product frxETH. Similar to Lido's stETH, frxETH is a liquidity staking token provided by Frax Finance for users who stake Ethereum.
Business Mechanism
Arbitrage balance between frxETH and sfrxETH
Understanding Frax Finance's business mechanism mainly lies in its emerging LSD business.
The business mechanism of Frax Finance in the LSD track is mainly the arbitrage balance design between frxETH and sfrxETH:
Unlike stETH, which directly distributes staking rewards to stETH users through rebase, frxETH users cannot directly obtain staking rewards - if frxETH users want to obtain Ethereum staking income, they need to stake frxETH again as sfrxETH.
The only difference is that the way to accumulate staking rewards is still frxETH. However, since not all users choose to stake frxETH again as sfrxETH, sfrxETH will accumulate more frxETH over time.
This means that when sfrxETH users exit, they can participate in the division of the entire frxETH reward pool, thereby obtaining a higher rate of return than similar products. For example:
Assuming that there are a total of 100 ETH staked as frxETH in the Frax contract, and only 30 of them are minted as sfrxETH through secondary staking, then these 30 sfrxETH will share the staking rewards of the 100 ETH (in the form of frxETH) in proportion.
In short, users who did not choose to re-stake frxETH as sfrxETH transferred their share of the staking rewards to sfrxETH users.
Dynamic Balance of Secondary Staking
The reason why some frxETH users do not choose secondary staking and are willing to transfer their income to sfrxETH users is because Frax Finance provides frxETH users with another income option - depositing frxETH into Curve's frxETH/ETH liquidity pool to reap LP income.
From the user's perspective, Frax Finance actually provides two profit paths for frxETH:
First, pledge ETH as frxETH, then deposit it into the frxETH/ETH liquidity pool to earn Curve income, while giving up your own frxETH pledge income;
First pledge ETH as frxETH, and then pledge it again as sfrxETH. In this way, while obtaining your own staking income, you can also obtain the additional frxETH staking income transferred by the first part of users;
Theoretically, choosing Curve's frxETH/ETH liquidity pool (frxETH) and choosing secondary staking (sfrxETH) will gradually form a dynamic arbitrage balance due to the difference in yields, thereby keeping the yields of the two different options in the same range.
According to data from Frax Finance’s official website, as of July 7, the yields of the two were indeed quite close: Curve’s frxETH/ETH liquidity pool (frxETH) was 4.67%, and the secondary pledge (sfrxETH) was 5.29%, and the proportions of the two were basically close.
latest progress
frxETH is fast
Since Frax Finance holds the most CVX governance tokens locked in Convex (21.2%), and Convex controls more than half of Curve’s voting rights (veCRV), this gives Frax the possibility to use the huge exchange rate to influence Curve’s reward emission and create higher returns:
By adding the Curve pool, you can form an LP pledge with ETH to add a liquidity pool, and then use the voting rights of CVX and CRV to tilt the emission rewards toward the frxETH/ETH liquidity pool, and then get more rewards in the form of CRV and CVX, which is much higher than the income from simply staking Lido's stETH.
This is the underlying logic of Frax Finance increasing the incentive weight for a specific transaction exchange pool by participating in the Curve War.
In general, Frax Finance, through its influence on Curve, has found a differentiated competitive advantage for frxETH that is different from similar products such as stETH - a higher-yield option under the arbitrage balance between frxETH and sfrxETH, and behind it lies complex product logic such as the frxETH/ETH anchoring adjustment.
From October 21, 2022 to date, in more than 250 days, frxETH has grown from 0 to over 235,000, worth approximately US$446.5 million. According to DeFillama data, frxETH's current staked amount is second only to Lido (7.58 million), Coinbase (1.13 million) and Rocket Pool (810,000).
Become crvUSD collateral
As the Ethereum staking market got on track after the Shanghai upgrade this year, the Ethereum Liquid Staking Token (LST) market has grown rapidly. Its current market value is nearly US$20 billion, accounting for about 10% of the entire market value of Ethereum. According to DeFiLlama data, it is already the DeFi category with the largest TVL, becoming the largest potential market in DeFi.
Before the emergence of LSD, the market value of both pledged stablecoins and algorithmic stablecoins would not exceed the underlying asset itself (such as Ethereum), which was actually a limitation. At the beginning, whether it was DAI or other algorithmic stablecoins, they actually relied on the substantial growth of stablecoins linked to fiat currencies such as USDT and USDC to drive their growth.
This includes wrapping USDC in MakerDAO and "changing its skin" to DAI, which can further meet the decentralized needs of some users who are exempt from KYC. Only with this anchor can the development of stable computing be promoted.
The emergence of LSD allows users to use liquid staked tokens as collateral to mint fully collateralized stablecoins, which can be further incentivized on Curve and Convex Finance, providing users with additional income such as transaction fees, CRV, CVX and PRISMA.
frxETH cooperated with crvUSD, the native stablecoin launched by Curve, and became the first to become the collateral of crvUSD (earlier than leading projects such as stETH and WBTC).
According to data from the Curve website, as of July 7, the number of Curve's native stablecoin crvUSD minted exceeded 55 million, of which 41.21 million were based on wstETH, 8.12 million were based on sfrxETH, approximately 6.78 million were based on WBTC, and 726,000 were based on ETH.
Configuration reason
Valuation space
For Frax Finance, the current valuation space of its main utility token FXS mainly relies on its traditional "stablecoin" (FRAX) and emerging "LSD" (frxETH) narrative empowerment.
In terms of stablecoins, the minting of FRAX requires pledging the corresponding USDC + destroying the corresponding FXS based on the current system's collateral ratio (CR).
For example, as mentioned above, the current CR is 95%. If a user wants to mint 100 FRAX, he needs to pledge 100*95%=95 USDC and destroy FXS worth 5 US dollars to obtain the corresponding FRAX. In addition to the above expenses, the user also needs to pay a minting fee of 0.2%.
Redemption is the reverse operation of the above process. Users provide 100 FRAX and can get back 95 USDC and 5 USD worth of FXS newly minted by the system based on the current CR value of 95%. Similarly, in addition to providing 100 FRAX, users also need to pay a redemption fee of 0.45%.
It is also important to note that FRAX will only be allowed to be minted and destroyed when its price is outside the stable range. For example, during the Silicon Valley Bank turmoil in the first half of this year, the depegging of USDC and the resulting depegging of FRAX triggered this condition.
This means that as CR continues to increase, the destruction rate of FXS itself is actually decreasing. Therefore, the empowerment of FXS at the "stablecoin" level is mainly due to the 0.2% minting fee income and 0.45% redemption fee income caused by the subsequent growth of FRAX volume.
On the LSD side, the upcoming frxETH v2 is expected to further strengthen its overall value creation and capture capabilities, where users provide some small ETH collateral (or other collateral approved by veFTX holders in the future) and borrow validators, and the withdrawal address and all custody are decentralized and immutable, just like the DeFi lending market. Interest is paid directly from the user's ETH+PoS cash flow.
The interest rate is determined by the market and utilization. If it is cheap to borrow a validator, the node operator can verify, pay interest to the lender and maintain the spread/MEV, etc. For experienced node operators, the profit will be relatively lucrative, but this part still needs to be observed after the business is launched.
In summary:
At the stablecoin level, the current market value of FRAX has been maintained at around US$1 billion for a long time, which is less than 1/4 of DAI, while the current total market value of MKR is about US$1 billion;
At the LSD level, Lido Finance’s Ethereum pledge volume is $14.3 billion, Frax Finance’s is $445 million, and LDO’s current total market value is about $2 billion;
From this perspective, the upper limit of Frax Finance in the LSD track should be greater than or equal to Lido Finance. Currently, the mortgage scenario of stETH is almost synchronized with frxETH, but the income of stETH is not affected by Curve. Therefore, as long as the growth of frxETH can be maintained stably, it is expected to continuously erode the market share of Lido Finance.
The upper limit of Frax Finance in the stablecoin market is, on the one hand, the existing size of FRAX (which has remained at $1 billion for nearly a year), and on the other hand it is directly linked to the amount of crvUSD minted using frxETH as collateral. One month after its launch, crvUSD has exceeded $55 million, and the collateral usage of frxETH is second only to wstETH, almost evenly matched.
Comparing the ceiling projects in the two dimensions, the total market value added is US$3 billion, while FXS’s current market value is US$670 million, leaving about 4.5 times of room for growth.
Configuration Window
Although it cannot be simply added together, the most important thing to note is the flywheel effect that may be caused by the high yield of frxETH - since its launch, the returns that frxETH can provide have always been higher than the yield of Lido's stETH (the former is 5.29% and the latter is 4% as of the time of writing).
The growth of protocol flow and protocol revenue is a positive flywheel. If the yield of frxETH is greater than that of stETH, more people will choose to deposit ETH in Frax, especially after Lido opens withdrawals. The growing share of frxETH will bring more protocol revenue, which will flow to veFXS stakers. The yield of veFXS stakers will increase, the demand for FXS will be greater than the supply, and the price will increase.
So when will be the best time to pay attention to Frax Finance and allocate FXS? It mainly depends on the actual market share progress of Frax Finance in the second half of this year, especially at the end of the year:
On the one hand, DAI has almost halved from over US$7 billion at the beginning of the year to US$4.3 billion today. With the passive approach of the market size of DAI and FRAX, the two leading players in the decentralized stablecoin narrative have become a catalyst for the valuation convergence of MKR and FXS.
On the other hand, frxETH's market share is still about 4 times that of Rocket Pool. Once it maintains the growth momentum of the first half of this year and surpasses Rocket Pool, Frax Finance will become the leading decentralized liquidity staking project after Lido Finance, and its valuation space will be completely opened up.
In this way, Frax Finance has firmly grasped the composite narrative of LSD + stablecoin, and has also taken the initiative to lay out the liquidity unlocking opportunities of the LSD market with a market value of hundreds of billions, especially the cooperation with Curve. In addition to the LSD profit bonus, it may also complete the construction of a new stablecoin structure with crvUSD in addition to its own FRAX native stablecoin, opening up new currency protocol imagination space after the calculation is stable.
