Over the last year the crypto markets have taking a beating, not just from the malicious actions of Sam Bankman-Fried, Celsius, Genesis and other companies that engaged in fraud, but also from rising interest rates, which dampened investor's risk appetites.
The biggest indicator of the effect of rising interest rates is the total market capitalization for stablecoins, which has dropped by almost $40 billion since April 2022. Only USDT has been able to escape any dramatic downward supply decrease, with its circulation at $83 bn, the same level it was before the collapse at Luna. Tether benefited at the cost of every other major stablecoin; BUSD was shut down by the Feds, USDC supply is down by 53%, DAI -60%, and Frax -80%. It's carnage all around.
This slow bleed of stablecoin TVL is bound to continue so long as interest rates continue to rise. Investors simply do not want to hold non-yield bearing assets when dollar-denominated inflation recently peaked near double digits. Additionally, without SBF using customer funds to bid crypto asset prices higher, the yields provided by DeFi at scale have collapsed to less than the "risk free rate" provided by short term treasuries. With no respite in sight and interest rates at their highest levels in two decades, new solutions were needed to restart stablecoin demand in crypto.
Last week Staked Frax (sFRAX) was added as the latest product to the Frax ecosystem. sFRAX is the first implementation of Frax's Real World Asset (RWA) strategy to use DAO treasury capital to return yield from off-chain sources care of its off-chain partner Financial Reserves and Asset Exploration Inc (FinresPBC). The public benefit company was enabled by the Frax DAO with FIP-277 to "provide the Frax Protocol access to safe cash-equivalent assets and near Fed rate yields for the benefit of all without seeking to make profit from this relationship or charge fees (other than to pay for minimum costs related to serving its mission)." Finres is authorized by the Frax DAO to invest treasury funds into short-dated T-bills, Repos, dollar deposits in a Fed Master Account and select money market mutual funds.
Since its launch, sFRAX has absorbed 40m FRAX, with yields starting at the capped maximum of 10% and declining towards the Federal Reserves IORB rate at full capacity.
Final Stablecoin
sFRAX is one part of Frax v3, the latest upgrade for the FRAX stablecoin, which Frax Founder Sam Kazemian calls "The Final Stablecoin."
In the wake of Luna/UST and one of the fastest interest rate rises in history, it was clear that Frax v2 was inadequate for long-term safety of the protocol.
Over the past several years, we've learned a lot about how stablecoins should be designed and should function. Luna/UST showed us that fully algorithmic stablecoins are prone to instability leading to rapid depegging.
In February of this year, the DAO voted to eliminate the algorithmic backing by raising the collateral ratio to 100% or greater. This would end the nearly 2 year experiment of letting market forces determine Frax's collateral backing. We ultimately learned that the CR is highly responsive downwards during bull markets, but increasing it the midst of a massive global downturn in risk assets has taken longer than expected.
Time after time we've seen algoritmic stablecoins lose the peg once the market sniffed they didn't not have enough collateral backing to satisfy demands. Just this past week we saw the collapse of Tangible, a real estate backed "stablecoin" with a 30% reserve buffer. The price of its stablecoin USDR collapse to .50 after its DAI buffer was drained.
Tangible's downfall shows just how fragile on-chain stablecoins can be if their treasuries contain a capital shortfall or illiquid assets. We can confidently say that at this point only stablecoins with fully liquid backing, or enough locked liquidity to buffer illiquid assets, can survive.
And now in this high rate environment, we're learning that stablecoins also need a way to provide safety when economic conditions are weakening. Sam Kazemian told Flywheel in a recent interview that stablecoins need "to function extremely well in a high rate environment and really well in a low rate environment." What Sam's saying here is that for a stablecoin to succeed, it needs to track the four prices of money: par, interest rates, exchange rate, and price levels.
By pegging a stablecoin to the dollar, the asset needs at a minimum match the actions of the issuer, the Federal Reserve. Negating exchange risk and relative pricing, while maintaining par is easy, the underlying backing must only be dollars or dollar denominated debt.
Tracking interest rates on-chain is a trickier task. There is no feasible way to access minimum IORB rates without an off-chain KYC'd entity. FinresPBC was setup explicitly for this purpose, as its run by members of the Core Dev Team, who are aligned with the Frax DAO, and can act as beneficial owners.
Other protocols are employing multi-entity RWA strategies which allocate capital to several for-profit entities to invest on behalf of the DAO. While it has been successful at large, it increases default risk and complicates exposure analysis.
Frax's v3 model transform it into an "All-Weather Stablecoin" able to navigate any market condition.
The goal with sFRAX is simple, allow deposits of FRAX into sFRAX and the authorize the FraxDAO to allocate funds to FinresPBC, who will then purchase a variety of yield bearing assets. These assets are limited in scope and Finres is committed to providing a level of transparency unparalleled in finance.
How does sFRAX work?
The model for sFRAX is simple. When a user deposits FRAX into the sFRAX ERC-4626 vault contract, the DAO authorizes a similar amount of stablecoins held in the treasury, USDC or USDP, to be off-boarded to Finres' account with Circle or Paxos. Finres then swaps the stablecoins for cash and invests in approved short duration assets.
Finres purchases interest bearing assets through Kansas City-based Lead Bank and plans to expand to other service providers. Recently they announced a partnership with Ondo Finance to acquire its USDY, its tokenized note secured by short-term US Treasuries and bank demand deposits.
Once a week, the yield earned by Finres is transferred back to DAO control and then queued up into the sFRAX contract for linear deployment over the next weekly epoch. According to the Frax v3 docs:
Every Wednesday at 11:59:59 UTC the Frax Protocol adds newly minted FRAX stablecoins into the sFRAX vault. This newly minted FRAX is one-to-one proportional to the earnings of the Frax Protocol over the prior week and thus fully backed at 100% CR. Each sFRAX epoch is 1 week and identical in length and start time as the FXS gauge and sfrxETH epoch.
The sFRAX contract is governed by the DAO through the frxGov module, who can set specific parameters, such as the maximum yield cap. Currently, the maximum yield is 10%. There is no minimum yield. In this first epoch 50,000 FRAX is slated as yield rewards. If a whale deposited $100m, the yield would trend towards 0% for the current epoch. Rates would readjust the next week. This lagging reward model is similar to sfrxETH, where staking rewards are only updated every 2 weeks. As TVL grows in sFRAX, reward volatility should decline and settle around the IORB rate.
The yield model sFRAX employs is similar to MakerDAO's sDAI, which also offered a high initial yield that declines towards a terminal rate. However, MakerDAO's rate offering was a one way street, once the yields declined, they would never be raised. sFRAX yields are responsive to the total supply deposited into the pool, if users unstake, the yield increases for all participants and could potentially rise to 10% again.
Final Thoughts
With the release of sFRAX, the All-Weather Stablecoin is transforming into its "Final" form, adaptable and nimble to navigate any market conditions. In a low interest rate environment, we'll again see the bullish speculation at the end of the risk curve like we saw in 2020-21. In high rate environments, Finres will act on behalf of the Frax DAO to bring income to the protocol. It's a win-win in both situations. Frax can now grow into the billions with sFRAX and v3.
Deposit into sFRAX today and start earning native FRAX yields.
