An Analysis of the Design Mechanism and Risks of the Algorithmic Stablecoin Frax

This article is from DeFi Master.

In late January, the fourth-generation algorithmic stablecoin Frax experienced its first death spiral since its launch. Ultimately, Frax lived up to expectations and successfully "crossed the tribulation," with its price firmly holding at one dollar (see the chart below), making it the undisputed most stable algorithmic stablecoin.

Moreover, Frax has a strong self-sustaining ability, with the current protocol revenue (minting fees, redemption fees, and some trading fees) reaching 2.1 million dollars in just five weeks. This data will be displayed on Frax's Dashboard in the future, and the ample capital reserves will help Frax better achieve stability and application.

In today's post, DefiMaster will first review the mechanism of Frax for newcomers, then analyze Frax's performance and risk points during the death spiral, compare it with the unfortunate collapse of Pegs, and finally look forward to its future development and explain how to participate.

1. Design of Frax

There are two types of tokens in the Frax ecosystem: one is the stablecoin Frax, pegged to one dollar, and the other is the governance token FXS. Unlike completely uncollateralized algorithmic stablecoins, Frax intends to start with fully collateralized stablecoins, gradually reducing the collateralization ratio, ultimately achieving a partially algorithmic, partially collateralized stablecoin. Its name also comes from the word fraction.

Initially, minting Frax required a 1:1 collateralization with USDC. If Frax's price exceeds one dollar for a period, the protocol will lower the collateralization ratio; conversely, if Frax's price falls below one dollar for a period, the protocol will raise the collateralization ratio. Suppose at a certain point the collateralization ratio is 97%, the minting and redemption scenarios are as follows:

Minting: It requires 3% FXS + 97% USDC to mint FRAX. For example, to mint 100 Frax, one would need 97 USDC and FXS worth 3 dollars; FXS will be burned during minting.

Redemption: When redeeming 100 Frax, the system will provide the user with FXS worth 3 dollars (newly issued) and 97 USDC.

2. Death Spiral Test

From the mechanism, we can see that Frax's design maximally ensures the stability of Frax, placing the risk exposure on the holders of FXS.

When the demand for Frax increases, users continuously buy FXS and burn it, causing the price to rise rapidly. Conversely, when the demand for Frax decreases, the price of FXS drops quickly, and its total supply increases rapidly, amplifying the decline.

Theoretically, regardless of the fluctuations in FXS, Frax holders do not need to worry about losing their principal. They can always exchange for USDC and FXS worth one dollar and quickly sell the FXS. However, as the price of FXS continues to decline and its total supply increases, the system will face two critical tests.

(1) Exhaustion of Governance Token Liquidity

As the price of FXS continues to drop, rational investors will immediately stop providing liquidity and tend to sell their FXS quickly to prevent further depreciation. This will lead to a continuous decrease in FXS liquidity. When Frax holders redeem their Frax, the portion of FXS they receive may not be easily sold or may face significant slippage, leading to principal losses.

The true collapse of Frax's imitation Pegs began at this moment. After that, pusd could not be exchanged for an equivalent dollar value. Therefore, when Pegs dropped from 18 dollars to 1 dollar, PUSD still stabilized around 0.98 dollars. However, when the liquidity pool of PEGS fell below 500,000 dollars, PUSD could no longer maintain stability and began to decline.

DefiMaster's previous post was issued when the liquidity of PEGS significantly dropped, urging everyone to withdraw from PUSD mining, because if the liquidity pool of Pegs continued to decline, the portion of PEGS that PUSD holders redeemed would not be easily sold.

Recently, Frax also faced this issue, but Frax designed a mechanism to lock LP tokens and increase reward coefficients. This ensured ample liquidity in the pool. As shown in the chart below, although the liquidity of FXS also experienced a significant drop, there was no risk of exhaustion.

Additionally, the protocol's sufficient revenue and strong backing have ensured people's confidence, preventing further large-scale redemptions of Pusd. FXS stabilized, successfully crossing the tribulation, and Frax still tightly held onto 1 dollar, with price fluctuations not exceeding 3%.

(2) Bad Debts from Excessively Low Collateralization Ratios

Even if the liquidity of governance tokens is exhausted, users may lose at most 10-20% of their principal. However, a more frightening situation lies ahead. Taking Pegs as an example, when PUSD is greater than one, the collateralization ratio rapidly decreases, meaning less USDC is needed for minting. However, when PUSD is less than one, the collateralization ratio rapidly increases, and users redeem too much USDC, leading to a decreasing amount of USDC in the system. Eventually, the remaining PUSD has increasingly low real collateral, ultimately becoming bad debts.

These bad debts killed Pegs. As the price of USDC in the system continued to drop, the price of PUSD plummeted, eventually falling to 0.01U. There are still 400,000 dollars of bad debts in the system, and the massive bad debts have rendered PEGS unable to recover, with no one willing to take over.

In Frax's design, there is an arbitrage mechanism to address this issue. When the collateral USDC is insufficient, users can deposit USDC to exchange for FXS at a rate 0.75% higher than the market price. However, when the price of PEGS continues to fall, no one is willing to engage in this arbitrage, leading to the accumulation of bad debts.

Fortunately, Frax did not reach this point. However, the Frax team has also noticed this issue and will design a more stable collateralization ratio adjustment mechanism in future updates to prevent systemic risks caused by rapid changes in collateralization ratios.

3. Outlook

Ample liquidity, rich revenue, and strong consensus ensure the stability of Frax. The various future applications are highly anticipated.

Stablecoins are a very profitable business. In addition to the current minting fees, redemption fees, and trading fees, Frax has nearly 100 million dollars of USDC as collateral. In the future, this money may be invested in protocols like Curve and Compound to earn interest. Even at an annualized rate of 5%, it would bring significant revenue to the protocol. Furthermore, after achieving stability, the realization of functions such as collateralization, lending, and payments will naturally follow.

In terms of participation, Frax-USDC liquidity mining has the lowest risk. After undergoing a significant test, people's confidence in Frax has further strengthened. Additionally, the price of FXS has significantly retreated, making it relatively lower risk compared to when it was 20 dollars. Those optimistic about the algorithmic stablecoin sector can cautiously participate in small amounts, but due to the high number of private placements, risks should still be noted.