Analysis: The Frax Stablecoin Thesis

*The following article is an op-ed from Zhou YeMen, an investment analyst at DWF Labs.

What is Frax Finance?

Frax Finance was initially a hybrid algorithmic stablecoin protocol that proved itself over several years of operation, but it came into the spotlight at the beginning of 2023 with its Liquid Staking Derivative (LSD) product frxETH. With the LSD narrative running rampant, Frax benefited as one of the clear winners due to its innovative two-token system. What frxETH illustrates is how Frax is ultimately a stablecoin protocol with the goals of increasing the monetary premium of its family of stablecoins (FRAX, frxETH, FPI). These stablecoins would be aided in adoption by Frax’s “holy trinity” of DeFi primitives such as Fraxswap and Fraxlend. Most recently, Frax voted to have its flagship stablecoin 100% collateralized, marking the end of an era of partial-collateralization.

How did Frax build its ecosystem?

FRAX Stablecoin

FRAX’s backing is primarily made up of its AMOs which put its idle USDC collateral to work. Currently, the largest AMO operating today is the Curve AMO which has hundreds of million of dollars in TVL.  While the collateral ratio of FXS backing is determined by market forces, Frax’s AMO adjusts supply of FRAX to maintain price stability. This is akin to a central bank conducting open monetary operations for their economy.

• AMOs: There are several AMOs that are in charge of different operations. The Liquidity and Curve AMOs deploy idle USDC collateral and mint FRAX into different DEX’s to create liquidity and tighten the peg. Thus, Frax earns trading revenues generated from the LP position and also the rewards emitted to the pool. Currently, Frax owns 99.9% of the Frax-3CRV pool and 58.5% of the Frax Base Pool (FRAXBP) on Curve. These are two of the largest stablecoin pools on the DEX, with only 3pool relative in size.. This allows Frax to have a strong reserve of Protocol Owned Liquidity (POL) and a continuous revenue source. With this model, FRAX has yet to depeg against USDC, even during the UST crash.

• Convex AMO and farming flywheel: Frax’s investor AMO owns 3.55M CVX tokens, approximately ~6.5% of all locked CVX tokens. This allows FRAX to direct CRV incentives to Frax selected pools and deepen liquidity for FRAX and any FRAX-denominated trading pair. As Frax owns the majority of the Frax-3CRV and FRAXBP pool, they earn CRV & CVX rewards that are emitted. Frax also bribes vlCVX holders,  as each $1 of vote incentives brings  to $1.11 (As of 12/2/23) in emissions. This is a flywheel that only Frax can achieve due to its POL and AMOs.

  

  Frax’s net gain is highly dependent on the price of CRV, CVX and FXS. The peak net gain coincided with the peak price period of the 3 tokens in Jan 2021. In recent months, net gain has been at break even, but it is still net positive for the protocol as they are basically bribing the pools for free (free liquidity). Thus, this farming flywheel allows Frax to bribe consistently and farm back the rewards. 
  

• Frax Base Pool (FRAXBP): Frax was able to secure a Curve meta pool, one of two total, which consists of FRAX-USDC and can be used to pair with other assets similar to how 3CRV (USDT/ USDC/ DAI). Frax incentivizes protocols to work with them through bribes using Frax’s CVX/CRV holdings to increase incentives for pool based on their proportional size to the total FRAXBP TVL. This increases the use cases and demand for FRAX as more trading pairs are created with FRAXBP. Thus, FRAXBP helps Frax build its moat and establish itself as the central liquidity hub on Curve.

Liquid Staking Derivatives (LSD)

Frax uses a two-token model, frxETH and sfrxETH, to provide a unique LSD offering. frxETH acts as a stablecoin pegged to ETH and does not earn any yield, whereas sfrxETH receives all yield from staking.

• Superior Token Model: The two-token model that Frax employs ensures that sfrxETH earns a higher staking yield as compared to other LSD protocols. This works as frxETH holders forgo their staking yield, instead deploying into the Curve liquidity pool to earn the rewards. Curve LPs have earned 7-10% APR for the past 3 months while sfrxETH earned 6-8% APR. Based on the current frxETH supply, 1 sfrxETH earns an equivalent staked APR of 1.974 ETH, which is why staking ETH with Frax offers a much higher yield. In just four months, this system helped propel Frax into the top rankings for LSDs. Frax is able to execute this strategy sustainably because of its Curve and Convex holdings used to direct incentives to the frxETH-ETH pool. Last, Frax fees for operating the LSD are 10%, 8% goes to veFXS holders and 2% goes to the insurance fund.

• frxETH Minter: frxETH withholds a percentage of all ETH swapped into frxETH (Frax holds 17.617% of total frxETH). These funds are added to the Curve liquidity pool to increase liquidity depth. Additionally, Frax earns rewards emitted from the pool that it bribes and seeds liquidity into. It's a similar flywheel to the Curve and liquidity AMOs.

Frax uses $549.5K per month to incentivize the Curve liquidity pool while emitting $750K of rewards, including $382.3K of FXS. While Rocketpool’s native token emissions are slightly more efficient , this is due to Aura’s bootstrapping phase. Frax will soon start to bribe Aura gauges, reducing FXS emissions, as bribing on Aura produces higher rewards currently. Thus, Frax can reduce its Votium bribes as liquidity increases on Balancer (reducing FXS selling pressure).

Tokenomics

Frax’s governance token FXS uses Curve’s ve token lockup model, dubbed veFXS. Currently, 41.22% of the supply is locked up. Like Curve, FXS gauges can be bribed. However, current bribe amounts are negligible. veFXS holders are entitled to 100% of AMO revenue and frxETH revenue (not distributed at this time). The current yield for veFXS holder is 1.83% APR. This should increase sharply once Frax beings to distribute frxETH fees.

Considerations

• Low traction on other products: The TVL for Fraxswap and Fraxlend is negligible as compared to direct competitors (Aave and Curve). However, this is understandable as these products were mainly built to suit Frax’s specific needs as a stablecoin protocols. Currently, sfrxETH can be used as collateral to borrow FRAX and build staking yield leverage. This allows Frax to capture lending fee revenue, unlike Lido which outsources it to AAVE. As Frax continues to grow, Fraxswap and Fraxlend will be key infrastructure. These products will be offered to more public-facing users, where FRAX liquidity might be deeper on Fraxswap as compared to Curve and Uniswap.
• Incentive split: As Frax launches more products, it will split incentives for the whole protocol and it will be tougher to attract liquidity. However, Frax’s Convex holdings might be significant enough to offset any growth.
• Regulatory concerns: FRAX is currently backed 92% by USDC which is a centralized stablecoin, regulated by the US government. There might be implications on FRAX if regulators enforce rules against USDC. However, almost all of Frax’s USDC is distributed amongst various DeFi applications and cannot be differentiated from other deposits. Thus, it will be challenging for regulators to enforce any actions through USDC.
• Up-and-coming competitors: Curve and Aave have each announced the launch of their own stablecoins, which might challenge FRAX as one of the top decentralized stablecoins. However, Frax views these protocols as potential collaborators that will eventually pair against FRAXBP and frxETH.
• Depeg: After the UST crisis, no stablecoin can fully mitigate depeg risks, even centralized stablecoins like USDT and USDC. The AMOs previously mentioned will help Frax to maintain its peg and the worst-case scenario for Frax is where users are only able to redeem USDC collateral, returning 92 cents on the dollar.

Potential catalysts

• Ethereum Shanghai upgrade will lead to more ETH staked with Frax and higher fees for the protocol.
• Lido’s ETH staking dominance threatens Ethereum’s security ecosystem and leads to users flocking to other LSD protocols.
• Frax’s core mission is to build stablecoins and will soon launch frxBTC.
• Frax plans to replace WETH with frxETH as the primary ETH pairing for LPs.
• When Frax starts distributing the 8% sfrxETH fees to veFXS holders, it will increase yields significantly.

Comparatives for LSD

The table above is the current P/S ratio of the top 4 LSD protocols. Frax performed the worst due to its high FDV. However, it should be noted that Frax not only offers LSD services, but it has other products under its belt with $1.51B in stablecoin issuance. Frax is the only protocol to have a revenue-sharing model with the native token, where veFXS holders are entitled to 8% of the staking yields. With frxETH’s impressive growth to obtain 1.49% market share in a mere 4 months, it is clear that frxETH will continue to grow so long as its yields are higher than its competitors.

Let's look at a projection for LSD Protocols over the next 2 years.

LSD P/S protocol projections in terms of ETH

The highlighted P/S ratio for frxETH is a conservative estimate that frxETH might achieve. At the end of 2023 and 4% market share, Frax’s P/S ratio is 1/4  as compared to the current P/S ratio and a value much closer to its competitors. RocketPool has the best P/S due to its high market share and fees, but with Distributed Validator Technology (DVT) being added soon, it seems that the  Rocketpool model of decentralized staking might become obsolete. With the potential catalyst mentioned, I am confident that Frax might even outperform the 2024 & 2025 conservative estimates as more products are built out using frxETH.

Thesis (The Stablecoin issuer)

LSD protocols received their fair share of attention during January, but the narrative was cut short due to AI and ZK narratives quickly gaining popularity. Due to the PvP market environment that we are in, LSD protocols were dumped for the next narrative making the rounds on Crypto Twitter. LDO, FXS & RPL underperformed the market during this time. Thus, this might be a good chance to accumulate FXS before the LSD narratives come back in full swing.

As Shanghai approaches, all eyes will be on ETH and all of its LSD protocols as the direct beta for the event. Currently, many users are not staking ETH due to the lock-up and peg deviation of staked ETH. Only 14% ETH is staked, while other L1s have greater than 30% staked. With Lido dominating ~30% of the staked ETH supply, it will pose a potential risk that many Ethereum watches have flagged. So while frxETH is the highest-yielding LSD, it could be an attractive choice for many making the switch after Shanghai. The frxETH-ETH LP will be able to handle any outflows immediately after the upgrade, and should scale with future inflows (frxETH Minter). This in turn generates more fees for Frax from both staking and LPing.

Frax being the primary stablecoin issuer for ETH and BTC is its biggest bullish factor as to why it will outperform ETH. To replace WETH, Frax will have to create trading pairs with frxETH and incentivise protocols to pair up with frxETH. Frax has the assets (CVX) and a strong reserve of Frax stablecoin that they can fall back on. Using the FRAXBP as ~$700M TVL or the Frax liquidity AMO can mint Frax based on the protocol collateralization ratio to create a flywheel as follows:

Once frxETH gets paired with tokens, the above flywheel will play out, resulting in a net positive for the Frax ecosystem.

Most importantly, Frax views other LSD protocols as collaborators and has announced the WETHR program for other LSD on Curve. For frxBTC, there isn't any information but a possible effect on Frax is the increase of demand for FRAX or FRAXBP and potential integrations of it into Frax’s flywheel.

Replacing WETH and WBTC is an extremely tough job, but the Frax team always delivers, as seen from their full suite of products. Betting on FXS is equivalent to betting on the DeFi ecosystem as a whole (FRAX, frxETH, Fraxswap, Fraxlend, Fraxferry (Bridge), FPI). All these products and primitives are part of the Frax ecosystem and will help expand its foothold to other networks.

All in all, the main factor why FXS can outperform ETH is due to the attention from Shanghai upgrade and the broader LSD narrative. As frxETH accumulates more market share, Frax will have a healthy source of income, solidifying FXS as a revenue-generating token.

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Disclaimer: This is a guest post and does not represent the views or opinions of Flywheel DeFi Not financial or tax advice. This article is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. This post is not tax advice. Talk to your accountant. Do your own research.