Under-Collateralized & Fully Backed?

Investigating FRAX’s Collateralization Ratio

Bobby J. Shilla
Bobby J. Shilla
July 11, 2022
Under-Collateralized & Fully Backed?

In our first piece, we laid out the framework for the creation and success of an automated stablecoin. Moving forward, we investigate FRAX’s mechanisms for two core purposes:

  1. Determining whether it sufficiently meets the necessary conditions for success
  2. Finding incremental opportunities for improvement of underlying technology

Of the numerous underlying factors battling to regulate stablecoin price, there were two previously identified as especially important for protocol health- a flexible and agnostic collateralization ratio and sustainable yield economics.

This paper will focus on FRAX’s unique floating collateralization ratio (CR). Optimizing this technology remains the single most important factor for long-term protocol success; if the correct variables are chosen, even the most violent bank runs will be met by a fully redeemable backing.

Justice is Blind

“For a partially-collateralized stablecoin to succeed, it must remain functionally over-collateralized through a combination of backing, trust, and revenue generation. Trust is earned, not created; at this point, given historical precedent and the nascent stage of the industry, assume value in trust to be approximately zero. Therefore, through a combination of trusted assets and revenue streams a partially-collateralized stablecoin could be both undercollateralized and pegged to $1.”

- Bobby J. Shilla

As discussed prior, to allow a partially-collateralized stablecoin to succeed, it must have a flexible Collateralization Ratio that allows its balance sheet to adjust as a factor of mint & burn flows. Additionally, the CR must be market agnostic, and should make no underlying assumptions about its ‘fair’ value. Other attempts (IRON, UST) failed to meet these conditions, and collapsed in periods of low confidence.

To create a stablecoin capable of surviving major bank runs during periods of low confidence it must always have sufficient collateral to ensure all liquid tokens are redeemable at 1:1. This should be achieved through collateral management, ensuring the maintenance of a balance sheet in equilibrium.

Practically, we’ve seen three different major models evolve:

  1. Stablecoins that use volatile assets like ETH & BTC as backing (e.g. DAI). This requires efficient liquidity management, ensuring that capital is available to meet liquidation demands during spirals down. To provide breathing room from underlying volatility, these stablecoins must generally always remain overcollateralized, causing opportunity cost of capital to increase.
  2. Stablecoins that use other, less leveraged, stablecoin models as collateral (e.g. MIM using USDC). This creates leverage loops that can be difficult to untangle, and assess risk effectively.
  3. Stablecoins that use a combination of widely-trusted collateral and their governance token (e.g. FRAX, kind of LUNA). This method has been widely thrown out by the general DeFi populace as unsustainable, but I want to focus on this subcategory. While maligned, when structured properly such a model could use seigniorage generated by the governance token as an effective replacement for traditional backing.

Breaking down what’s happening is pretty straightforward. There are two major components- the first is a traditional non-volatile asset backing, like USDC. The second would be a governance token, like FRAX, that earns fees passed through from open-market operations on FRAX via AMOs. Effectively, rather than assuming the price of the token to be its value, you instead assume its lowest common denominator.

The final key component remains the ‘agnostic’ part of the collateralization ratio. That is, as market conditions and protocol revenue per dollar change, CR should adjust accordingly. This brings us back to the formula we proposed in the first piece to define the CR of a seigniorage-collateralized stablecoin:

Collateralization Ratio Stablecoin = 1 - Protocol Profit Ratio

Assets Deposited = CR*(Backing Asset) + 1-CR*(Seigniorage Token)

Current FRAX Mechanisms

The current FRAX structure ticks many (but perhaps not all) of the boxes for thorough risk management in high stress periods, which is likely a part of its recent resilience amid market turmoil.

Let’s start by looking at the successful methods FRAX currently uses to manage peg and collateralization risk- an agnostic collateralization ratio and managing liquidity.

One of the key foundational mistakes made by other algo-stables was the use of a standardized CR. Regardless of market conditions and investor risk tolerance, the same amount of trusted collateral was demanded. FRAX, on the other hand, makes no assumptions about where market equilibrium stands. Instead, the protocol adjusts the ratio as a function of secondary market demand for FRAX changes. If current demand is above current supply, secondary market price of FRAX rises, and CR shifts down encouraging new mints. In down markets, supply will likely exceed demand, causing prices to temporarily drop below $1.00. That would cause CR to shift upward, requiring additional trusted backing to mint new FRAX, and restricting the flow of new mints.

Another key risk management technique is the use of a PIDController to control collateral ratio, as a factor of FXS, helping to avoid feedback loops (e.g. UST-LUNA spiral).

Docs - Source

Without re-inventing the technical wheel, the growth ratio is used to measure the spread between existing FRAX mints and current FXS circulation. For those who remember, a major concern leading into UST’s upheaval was the narrowing of the relative spread between the market cap of UST and LUNA. In the event of a mass bank run, a huge number of investors would simultaneously redeem FRAX for underlying assets.

If collateralization ratio is set too low, the following feedback loop will occur:

  1. Investors redeem FRAX for stables and FXS
  2. Low CR leads to greater amount of FXS vs. stables
  3. Investors sell large quantities of FXS, driving price down
  4. Non-stable backing per FRAX falls

Through use of the growth ratio, FRAX can automatically ensure that CR is rising in periods of high-stress, causing pressure on FXS to be minimized. Effectively, the greater the market cap of FXS is, relative to the market cap of FRAX, the lower the sell pressure.

The final safety mechanism worth addressing actually falls within FRAX’s Curve AMO. While we plan to do a deeper dive on AMOs at a later date, this functionality serves as more of a risk measure than a revenue-generating opportunity. Due to FRAX’s deep liquidity through a long-time partnership with Curve and Convex, the protocol is actually able to control TVL through its own Curve pool. While Curve serves as the arena where the deep liquidity is placed, the role Convex plays in this trilateral relationship is to efficiently incentivize it via its large position of the CRV token. Through careful monitoring of the  pool, the AMO is able to know exactly how much algorithmic FRAX can be market sold before price shifts more than $0.01, and limit circulating supply to below that amount.

Currently, FRAX is primarily paired with the Curve 3pool which consists of USDC, USDT, and DAI and serves as the base pool in which all stablecoins are traded against. Recently, a Curve governance proposal passed that created a new meta-pool, FRAXBP, which consists of only FRAX and USDC. Stablecoins that pair to FRAXBP will be matched dollar for dollar with the Curve AMO. For example, if Abracadabra decides to supply $250 million worth of MIM to the pool Frax will inject $250 million worth of freshly minted FRAX and idle USDC collateral into FRAXBP. The ramifications of FRAXBP will be explored in future essays.

Conclusion & Thoughts

FRAX’s current mechanisms are significantly more robust than competing algorithmic stablecoins. This relative resilience has been reflected in recent price action across the stablecoin space.

However, one assumption is still currently being made around price during the minting process that could be improved to ensure backing. Specifically, as noted, FRAX uses a combination of FXS and trusted stables as backing. By taking FXS price as the underlying component of collateralization, FRAX is exposing itself to governance token volatility. In the event of a genuine black-swan event, FXS could be aggressively market sold (despite growth ratio safeguards) leaving FRAX undercollateralized.

Fortunately, this problem is easily solvable. As mentioned, in an ideal scenario, seigniorage yield generated by the governance token (rather than token price) would be the collateral used as a deposit. For this to work, FRAX would need to develop additional data on the protocol / AMO profit per additional FRAX minted.

Armed with that information, they would have a live feed to set collateralization ratio. If the protocol is able to sustainably earn $0.10 on every $1 of FRAX minted through AMOs, and 100% of fee-generation is passed through to FXS holders, then the protocol could ostensibly use a portion of expected profit on minting activity to fund undercollateralized minting. This is only achievable through smart-contracts, which allow efficient pass-through of fees as well as a transparent verifiable account of such action.

This change would allow the protocol to remain functionally over-collateralized, even in periods of high stress, and would also help create a true ‘fair-market’ value for FXS.

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