How stETH is frxETH’s New Best Friend + What is the Optimal LP Ratio

Frax’s strategy eyes new frontiers as it approves the stETH/frxETH Curve AMO. Here’s why it matters.

Samuel McCulloch
Samuel McCulloch
July 3, 2023
How stETH is frxETH’s New Best Friend + What is the Optimal LP Ratio

In a landmark vote, the Frax DAO approved to add an AMO for the stETH/frxETH Curve LP. The vote allows for the AMO to allocate up to 50% of frxETH to the stETH Curve pool. Since launch, the frxETH/ETH Curve LP has been the primary venue of AMO activities.

In last week’s edition of “This Week in Frax” we mentioned the recently proposed FIP-257. It surprised us how a proposal of this calibre slipped under the radar so quietly. Now that it’s passed, frxETH can further extend its liquidity into other protocols, slowly but surely becoming the new wETH on Curve.

The vote signals a new chapter for the frxETH Curve AMO strategy. While the frxETH/ETH LP will remain the cornerstone of the AMO, the inclusion of LSDs pools such as stETH to the mix will increase volume and revenue for the protocol as well as positively align incentives.

What is an AMO?

For those unfamiliar, algorithmic market operations, better known as AMOs, are the onchain activities that the Frax protocol does in order to keep their stablecoins pegged. AMOs were first introduced as a part of Frax v2 in 2021 and have been essential to Frax’s peg performance and profitability since. In the case of frxETH, 10% of its backing is made up of the frxETH Curve AMO and acts as the “swap facility”. By having part of frxETH’s AMO exposure as stETH, the protocol can count the largest LSD on the market as part of it’s balance sheet.

The stETH/frxETH Curve LP currently has the second highest TVL of all the frxETH pools with $15m, which is only eclipsed by the flagship frxETH/ETH pair.

Why it Matters

Frax adding stETH to the Curve AMO provides several key benefits. The first obvious one is that by growing the liquidity pot for all protocols, Frax makes them more useful. The added liquidity will mean that traders should receive the best execution prices when swapping to and from stETH.

Second, higher trading volumes should flow through the pair as its increased liquidity should be able to compete with the ETH/stETH Curve LP. Aggregators naturally will route their trades through the Frax pool to find the best execution price.

Third, protocol revenues will increase, as Frax’s protocol-owned-liquidity (POL) earns revenues from the stETH yields. Once the AMO goes live, Frax will start adding frxETH to the Curve pool, and over time, a portion of those assets will be swapped by traders into stETH. All of the yield earned by Lido is rebased directly back into the supply, and Frax will earn as well. Revenues will be passed back to sfrxETH, increasing their yield.

Curve LP Ratios

With the AMO approved, Frax can now deploy frxETH into the pool single sided to create new LP assets. By imbalancing the pools heavily with frxETH, Frax increases its POL, and thus protocol reward yield revenues. The optimal ratio for each pool depends on the A factor and the type of Curve pool.

For stable pools like frxETH/ETH, the mechanics allow for a high imbalance. Currently the ratio sits at 70/30, however for the past several weeks, it had been at 80/20. We covered the discussion between Sunomono and Sam Kazemian in last week’s edition of This Week in Frax.

A highly skewed pool is normally uncommon for Curve LPs. For other assets like the 3pool, an imbalance signifies market deterioration and potential depeg risk. Post-Luna, any time 3pool appears on the brink of disintegration, PTSD laden threadooors start mashing xanax as fast as they can mash their keyboard with Cheetos stained hands. Wild amounts of hand wringing in the press and on the timeline rapidly boils into a frenzy as the Very Smart People question the ontological inclusion of “The-Soon-to-Be-Failing-Asset-of-the-Day” in our market structures.

Although it’s unintuitive, the imbalance of Frax LPs is intentional in its design and actually opens profitable opportunities of the AMO. As the scale tips over towards doom, Frax AMO revenues start to shoot through the roof. So Frax intentionally imbalances every pool the AMO operates through to maximize protocol revenue. Obviously there is a hard limit, depegging on the asset price, that prevents 100% skew towards a singular asset.

How much Frax can push the ratios is determined by the type of Curve pool and its A value. There are two types of Curve pools, stableswap (Curve v1) and cryptoswap (Curve v2).

Most LSD pools are stableswap, but not all. eETH/frxETH and cbETH/frxETH are both cryptoswap, while stETH pools are stableswap. Stableswap pools allow for a higher imbalance before price depegs. Both the steth/frxETH and frxETH/ETH pools are both stableswap.

The A parameter, also known as the amplification coefficient or amplification factor determines the shape of the pool's bonding curve, which governs how prices change as liquidity is traded. By modifying the bonding curve, protocols can choose how much slippage and efficiency the pool has. If two assets are pegged 1:1, like the frxETH/ETH LP, the A value can be high… and the higher the A value, the more Frax can exploit the imbalances with its POL to farm revenue. It’s a virtuous cycle.

The new AMO for the steth pool has an A value of 200 and is a stableswap pool. While the wstETH price does rise slowly as it accrues yield, the stableswap pool adjusts incrementally to maintain pricing. Prices smoothly adjust as the pool remains imbalanced for long periods of time.

The A value is what has the largest effect on slippage and ratios. The stETH LP has an A value of 200, which is relatively high. The stETH/ETH LP, which has a TVL of close to $1bn in assets, only has an A value of 30. (I asked a couple of Curve insiders and they said that they stETH pool probably could have a higher A value) In comparison, the frxETH/ETH LP has an A value of 1200 and 3 pool 2000. So while the stETH/frxETH LP is designed to be more efficient, it has to have a lower A value to account for the slowly rising price.

Based on Frax’s other pools, the stETH/frxETH pool most probably will be imbalanced somewhere between 60/40 to 70/30. Currently there is approximately 24000 ETH set aside to pair with a ratio corresponding amount of frxeth by the AMO. If 25% is moved to the stETH/frxETH LP, Frax will earn 5% on 6000 ETH via stETH or 300 ETH annually. The Curve AMO will also create 9-12000 additional frxETH to pair with the stETH, increasing pool liquidity by 2-300%. The total TVL of the pool should break $50m once the AMO operations are complete, raising it from its current levels of $15m.

A New Partnership Brewing?

Sam Kazemian has always made it clear that he doesn’t think the LSD wars are winner take all. Lido is a giant, but there’s always room for innovative products like frxETH, which bolsters stETH’s liquidity. Lido’s incumbency is not threatened by Frax, as the protocol is building a radically divergent ecosystem of products that support its mission to become the dominant stablecoin issuer on ETH.

The addition of the stETH AMO is the first piece towards greater integration. One notable market which is missing is a stETH Fraxlend pair, where users can use stETH as collateral while borrowing frxETH or sfrxETH. With this new deep liquidity source, a Fraxlend pool could now handle several million in liquidations.

We’re all very excited to see the growth of Frax and Lido together and this is a first step in that direction.

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