The following is the first in Flywheel’s Frax 101 series which aims to provide the most comprehensive guide to the Frax protocol and how each of its stablecoins and subprotocols work. In this first issue, we take a deep dive into the protocol’s most well-known stable, FRAX.

What is FRAX?

FRAX is a dollar-pegged decentralized stablecoin. It was the first asset issued by the Frax protocol and it was launched in December 2020 after 18 months of development. At the time of publishing, FRAX’s history can be divided into two epochs, v1 and v2.

FRAX was created during a time when stablecoin options were limited, speculative and flimsy in architecture .

DAI was the primary stablecoin issuer, but it was over-collateralized by ETH. Every $1 of new DAI issued required $1.50 of collateral. The system was self limited by the amount of ETH available. There was no way to grow beyond the confines of ETH’s value. DAI later switched to a multi-collateral system and is now mostly backed by USDC.

On the other hand, many builders were experimenting with building algorithmic stablecoins with completely endogenous collateral, where all the value was contained within the token itself. Towards the end of 2020, earlier entrants like ESD, DSD, Basis, and others had all tried to build various systems to capture and store value, but they all failed and lost their peg eventually.

All of the algo-stables were playing with fire in hindsight. They wanted to inherit the core characteristics of Bitcoin, uncensorable, immutable, and decentralized, and implant them into a perfectly stable asset. At the same time, they sold this story of stability to investors who piled billions of dollars into the final algorithmic experiment of Terra/Luna.

Frax Founder Sam Kazemian decided to integrate ideas from both variants and Frax v1 was born based on two assumptions: first, 1 FRAX should always equal $1, and second, market forces should determine how much each Frax should be collateralized.

The idea was simple. If the market price of FRAX went above $1, people could mint FRAX with $1’s worth of collateral and sell it for more than $1, making a profit. If the market price of FRAX went below $1, arbitrageurs could buy FRAX for less than $1 and redeem it for $1’s worth of collateral, also making a profit. The question then becomes “what is the makeup of the collateral?”

At launch FRAX was 100% backed by USDC. 1 FRAX could be minted for 1 USDC. As demand grew, the protocol algorithm slowly lowered the collateralization ratio (CR) in 0.25% steps, so new minters would need a combination of USDC and FXS. Increased demand for FRAX lowered the CR, increasing the value of FXS. More demand for FRAX translated to more FXS burned to mint new FRAX. Ultimately, market forces would determine the CR at which investors would be comfortable.

“We believe that as FRAX adoption increases, users will be more comfortable with a higher percentage of FRAX supply being stabilized algorithmically rather than with collateral,” the team wrote in the Frax v1 whitepaper.

Collateralization and Death Spirals

The key parameter in FRAX v1’s design was how fast the protocol allowed the CR to be adjusted. At 100% CR, the value of each FRAX is fully dependent on USDC, as shown below.

But as the CR is lowered, the protocol is ever more dependent on its governance token FXS to retain value. Each FRAX will always be redeemable for $1 worth of assets made up of USDC and FXS. A lower CR means that a dwindling supply of FXS is needed to be burned to mint new FRAX, but additionally, an increased amount is created and sold into the market when the supply of FRAX contracts for every step down in CR. This model implants high natural volatility into FXS as a result and can lead to death spirals.

Death spirals for Frax v1 clones were common in 2021, the most notable being Iron Finance, which increased its TVL to over $1b while also rapidly decreasing the CR to the mid 70s in just a few weeks. The lower CR drove their governance token TITAN to sky high valuations, but it also ended up being their downfall.

In order to maintain the $1 peg once the CR is less than 100%, the value of each FRAX in the supply must equal the USDC held in the treasury plus the total market cap of FXS. As of writing the FRAX supply is at 1bn, while the FXS market cap is at 550m. With a current CR of 94.25%, the market cap of FXS must always stay above 57m to ensure the protocol can remain solvent.

Governance tokens like FXS derive their value from future expectations of the growth of the protocol. Their value is highly volatile and can swing rapidly in a short amount of time. Additionally, when shit hits the fan, liquidity providers will pull their capital in a flight to safety. You don’t want to be dumped on as people rush for the exit.

The problem with the CR is that every step down the protocol takes, the risks of rapid depeg grow larger. If at any point the value of FXS+USDC drops below the supply of FRAX, the protocol most likely will become unpegged.

Example: Arbitrageurs expect to redeem 1 FRAX for $1 worth of USDC+FXS. However, if the USDC+FXS only returns $0.95 of value, if the price of FRAX is still $1, it makes more sense to sell the stablecoin, rather than redeem. Increased selling of FRAX would outpace any redemptions as the gap for arbitrage becomes unprofitable.

Once the redemption channel breaks, two things happen, the supply of FRAX rapidly starts to shrink and FXS price would crater and exponentially expand. Traders run to the exits at the first sign of trouble, they swap their FRAX back to USDC or redeem for FXS and USDC. The supply of FXS expands as the protocol is designed to always return $1 worth of liquidity. As the price of FXS craters, the protocol must issue exponentially more supply to meet redemptions. As the supply shrinks the gap between the treasury assets+FXS and FRAX gets wider and wider.

Eventually, the FXS price would trend to zero and the supply would expand infinitely. You end up with a chart like the one below for Iron Finance’s token Titan.

These collapses are similar to a bank run, except with user deposits increasingly backed by the equity. It works wonderfully when prices are going up and supply is expanding, but its perilous in the contraction phase when traders are running for the exit.

What’s interesting about FRAX’s CR is that it bottomed well before the peak of its supply in February 2022. After the Iron Finance collapse, the DAO adjusted the risk parameters of the CR to be less aggressive, like it was during the first several months from launch. Whenever a fork collapses, it provides a lot of data into how it performed and what went wrong. IRON was no small fish either, with over 2 bn supply at its peak. The lessons learned provided FRAX a clear path towards making the CR more conservatively adjust.

Locked Liquidity

The only way that to prevent a death spiral with a CR of less than 100% is by extending the duration of deposits and liquidity through locking. There always needs to be a buyer of last resort for both FRAX and FXS for the protocol to survive. Frax was designed from the beginning with this in mind, as they included a locking mechanic for LPs.

Starting with FXS/FRAX, FRAX/WETH and FRAX/USDC, LPs could lock their tokens for up to 3 years for a 3x boost to their yield. For early supporters of the protocol, this meant massive triple digit yields in the first several months.

In its first 18 months of operation, the FRAX/FXS LP topped out with more than $150m in liquidity. During that time the price of FXS ranged from a low of $1.50 to a high of $39. It survived the Celsius, Terra, and FTX collapse only because LPs were locked in for years.

Without locked liquidity, FRAX would have suffered the same fate as Iron Finance. When Terra collapsed and the FRAX market cap decreased by a billion dollars in a week, the only saving grace was the myriad of locked LPs who helped weather the storm.

Eventually, in 2023, the DAO voted to increase the CR to 100%, as it became clear that the safest and most scalable way to grow a stablecoin was in this manner. CR was an important part of FRAX’s initial growth, it is no longer is needed in its more mature state once the protocol is fully collateralized. FRAX would still be more capital-efficient than its counterparts and “fractional” in nature due to how AMOs support both the swap facility and collateral backing.

Frax v2 aka AMOs

The biggest revelation for Frax after it's initial launch, was the implementation of Automatic Market Operations (AMO's). While the name might be a little confusing, the concept is simple. AMO's give Frax the ability to create new supply and then provide it into various decentralized applications, external to the protocol. This could be in the form of liquidity to DEX’s, lending platforms, or other yield generating opportunities.

A parallel of AMOs in the real-world is The Federal Reserve’s Open Market Operations (OMOs). The purpose of OMO’s is to keep the US dollar in check with inflation. One can look at the actions taken by the Fed in 2008 of opening new liquidity facilities as OMOs at work. Meanwhile, the purpose of AMOs are actions taken by the Frax protocol to keep FRAX pegged to a dollar. The largest AMO run by the Frax protocol is the Curve AMO which uses Curve’s stablecoin swap to maintain FRAX’s dollar peg.

Frax v1 had only one AMO, the core stability module that dynamically adjusted the CR to maintain a $1 peg.  The team writes in the docs

In Frax v1, the collateral ratio of the protocol is dynamically rebalanced based on the market price of the FRAX stablecoin. If the price of FRAX is above $1, then the collateral ratio (CR) decreases ("decollateralization"). If the price of FRAX is below $1 then the CR increases ("recollateralization"). The protocol always honors redemptions of FRAX at the $1 peg, but since the CR is dynamic, it must fund redemptions of FRAX by minting Frax Share tokens (FXS) for the remainder of the value. For example, at an 85% CR, every redeemed FRAX gives the user $.85 USDC and $.15 of minted FXS. It is a trivial implementation detail whether the protocol returns to the redeemer $.15 worth of FXS directly or atomically sells the FXS for collateral onchain to return the full $1 of value in collateral – the economic implementation is the same.

Through abstraction, four functions could be derived for Frax v1:

• Decollateralize - Lower the CR by some increment x every time t if FRAX > $1
• Equilibrium - Don't change the CR if FRAX = $1
• Recollateralize - Increase the CR by some increment x every time t if FRAX < $1
• FXS value accrual mechanism - burn FXS with minted unbacked FRAX, extra collateral, & fees

While these steps might seems complicated, the end goal was to adjust Frax’s balance sheet in response to the price of FRAX. The price of FRAX should always be equal to the supply in relation the collateral on its balance sheet.

As shown in the charts above, when the CR adjusts downward, the amount of USDC needed to maintain the peg is reduced. So long as the price of FXS + USDC is greater than or equal to FRAX, the protocol remains healthy (Equilibrium).

When new demand for FRAX is created, it will push the price of FRAX upwards above $1. Arbitrageurs can mint new FRAX for $1 worth of collateral and then sell it to pocket a low risk return. (Decollateralize)

When demand shrinks, FRAX is sold and the price drops below $1, Arbitrageurs can buy FRAX and redeem it for $1 of collateral.

In every instance, the protocol is algorithmically programmed to balance assets to liabilities to ensure FRAX always equals $1.

FRAX v2  and its AMOs were a natural extension of these rules. The protocol was able to implement any new balance sheet operations so long as they fit within the 4 functions and did not affect the peg. The new functions became:

• Decollateralize - the portion of the strategy which lowers the CR
• Market operations - the portion of the strategy that is run in equilibrium and doesn't change the CR
• Recollateralize - the portion of the strategy which increases the CR
• FXS1559 - a formalized accounting of the balance sheet of the AMO which defines exactly how much FXS can be burned with profits above the target CR.

AMO’s extended the capabilities of Frax outside of its own smart contract ecosystem and allowed the protocol interact with third party decentralized apps like Aave, Compound, Curve, etc. AMO’s give Frax superpowers that no other stablecoin has to create liquidity, generate yield and bootstrap growing protocols. This is done through “arbitrary FRAX monetary policy”

Lending AMO

As Frax grew during 2021, hundreds of millions of dollars of USDC flowed in as collateral to back FRAX. Instead of just sitting on the cash, Frax developed the Lending AMO to deposit the USDC collateral into various DeFi money markets like Aave and Compound to earn a yield.

This simple balance sheet operation swapped USDC for aUSDC and cUSDC.

Interest rates paid to lenders in these money markets helped generate revenue for the protocol, as over time the value of aUSDC and cUSDC would grow.

At certain time intervals, the revenues could be claimed, used to buyback FXS and then distribute it to veFXS. In the above example at Time 3, a total of $45,000 is available for this function.

Curve AMO

The Curve AMO has had the largest impact on Frax’s growth and liquidity. It enables Frax to create new unbacked FRAX and pair it with USDC in its own Curve LP. While the idea of issuing unbacked FRAX might seem dangerous at first glance, it’s just another balance sheet manipulation like we showed above.

The Curve AMO uses USDC collateral and pairs it with protocol issued FRAX. In the chart below, the USDC is transferred to Curve and paired with protocol issued FRAX. While this new FRAX is technically unbacked, it never enters circulation and so it doesn’t affect the value of the balance sheet.

As the Curve LP is protocol owned, the only way for it to enter circulation is buying or selling it. If someone were to buy $50,000 of FRAX, the circulating supply would increase and the CurveLPUSDC amount would increase equally, causing no effect on the peg. After the trade, the protocol could mint another 100,000 FRAX and add it as liquidity to the pool to rebalance the LP.

Conversely, if someone sold $550,000 FRAX into the pool, the circulating supply and USDC backing would reduce equally. Afterwards, the Curve LP would be heavily imbalanced with FRAX. As the protocol owns the liquidity, it can rebalance by removing 1,000,000 FRAX and burning it.

By placing FRAX+USDC into the Curve LP, Frax earns CRV rewards for the protocol treasury. Frax capitalized on this strategy dearly during 2021-2 to farm 20m CRV, making them the 2nd largest holder. When Convex debuted, Frax quickly jumped in, locking a sizable portion of its CRV as CVX, and is now the largest owner of CVX.

Where Are We Now: Stablecoin Maximalism and The Coming of Frax v3

After surviving several cataclysmic events whether it be the collapse of LUNA, fall of FTX, or depeg of USDC, FRAX stands as one of the most resilient and lindy stablecoins on-chain with today over $1 billion circulating. As mentioned, FRAX is currently climbing its way back to 100% collateralization, increasing its balance sheet to include revenue generating assets like frxETH and others which should increase the profitability of the protocol.

Frax v3 has been teased and recent hints of what it could look like can be seen in recent speeches and interviews by Sam Kazemian. In a telegram message, he stated that “Frax v3 is entirely a decentralized vision for FRAX whether the FMA happens or not. We're going to build the holy grail of a decentralized, scalable stablecoin whether the Fed part of the roadmap happens in 23-24 or not. Arguably, FRAX v3 is an even more important milestone for the stablecoin space depending on if you are more interested in an uncensorable stablecoin or a hybrid fiatcoin.”

Back in November 2022, Kazemian first presented the Frax team’s ambitions on Flywheel of attaining a Fed Master Account. Basically, in the same way you or I may have a savings account at a community bank, that community bank has an account at the Fed earning the risk-free rate of the US dollar which is quite literally the interest rates that JPOW and Federal Reserve Board determines. By getting exposure FMA or equivalent (such as a reverse repo agreement), Frax would be receiving the risk-free rate which is the lowest risk yield on their reference asset.

The risk-free rate of an asset is one of three parts that make up the structure of stablecoin maximalism. In his speech at ETH Denver, Kazemian proposed that on a long enough timeline almost all DeFi protocol will issue a stablecoin or have a stablecoin essential to its protocol and at scale at those stablecoins will look universally the same in structure. Just like how the laws of aerodynamics dictate how planes fly, the laws of economics drive protocols to adopt the same universal rules but for stablecoins.

The structure that this should look like is 1) the stablecoin, 2) the risk-free rate, and 3) the swap facility. For Frax v3, how this could potentially look like is 1) FRAX, 2) FMA, RRP, equivalent, 3) FRAXBP Curve Pool AMOs. From this graphic, it seems as if the hybrid fiatcoin that Kazemian talks about in his previous telegram message is “frxUSD” and the uncensorable stablecoin is “FRAX”.

More information about Frax v3 is yet to be officially released, but you can be sure that Flywheel will be there to cover it once there are further details. The Frax protocol’s mission is to build the most innovative decentralized stablecoins in crypto and beyond. In this series, we will cover each of how each of Frax’s stablecoins such as frxETH and FPI work, how subprotocols Fraxlend, Fraxswap, and Fraxferry operate, as well as tutorials and anything else that is in the Frax ecosystem along the way.