FRAX: Will it Hold It’s Peg?
The recent by of fall Terra’s $UST token shook the whole of DeFi. Trust for algorithmic stablecoins is at an all-time low, and there has been much more scrutiny towards the surviving stablecoins, particularly FRAX.
People have been drawing parallels between UST-LUNA and FRAX-FXS. So is the token in danger of depegging and following the same fate as $UST?
Let’s break it down.
(Note: If you need a refresher on FRAX mechanics, our Codex writer BowTiedBart has two excellent articles for you here and here)
Protocol Owned Liquidity
FRAX owns ~ 51% of the total $FRAX supply, most of which is in the AMO (Algorithmic Market Operations Controller). Most of the LUNA liquidity was on Terra and paired against UST. This pairing exacerbated the UST collapse.
The peg stability of FRAX is maintained through deep liquidity pools. The largest of these is the FRAX3CRV pool on Curve Finance. Of the 2.5B FRAX total supply, 1.55B of that currently sits in this pool.
The Curve AMO, implemented as part of Frax v2, furthers the stability of FRAX by automatically supplying excess collateral plus FRAX from the Frax protocol to the FRAX3CRV pool to ensure this deep liquidity remains.
Even if we assume the 1B FRAX in circulation got dumped simultaneously, that would barely move the price of FRAX below $0.997.
Collateralization
Frax is an agnostic protocol and allows the market to determine the collateralization ratio it will settle over the long term. FRAX is collateral-backed and not a full algorithmic stablecoin like LUNA. The “collateral ratio” is constantly being adjusted. At the time of this writing, the collateral ratio of FRAX is 89.25%. Each FRAX is backed by $0.89 in USDC and the rest in FXS.
When $FRAX is at or above $1, the protocol lowers the collateral ratio by 0.25% per hour. When the price of $FRAX is below $1, the protocol increases the collateral ratio by 0.25% per hour.
During downturn periods or times of high volatility, FRAX can also increase the collateral ratio to maintain higher investor confidence.
Use Case
There needs to be strong use cases for why users or other protocols would buy a stablecoin outside of farming itself. UST is minted by burning LUNA and was primarily used for farming on the Anchor protocol, which attracted investors by offering 20% APY for staking UST, among the highest yields offered in all of DeFi for staking stables. But there was little exogenous use for UST outside of this.
FRAX, on the other hand, has no shortage of partners and is constantly innovating and expanding into new territories. Introduction of Frax v2, veFXS, Convex partnerships, and recently released $FPI token are only a few examples of FRAX achievements.
The Risks
A concern that is often raised is that FRAX is only partially backed. But it is wise to remember FRAX’s history. At genesis, FRAX was 100% collateralized with USDC, and it was only through many small design decisions and careful step-changes that they managed to build up to becoming fractionally collateralized. Ultimately, FRAX makes no assumptions about what collateral ratio the market will settle on in the long term. If the market doesn’t believe a pure algorithmic stablecoin is viable, $FRAX can quickly go back to being backed by a centralized stablecoin.
Speaking of centralized stablecoins, the flipside argument is that FRAX has a custodial risk in that it has all its eggs in one basket - $USDC. What happens if USDC fails? Or if USDC decides to block FRAX? The protocol is very aware of this and has been slowly fine-tuning the algorithmic side of the coin and experiment with other types of collateral. For example, having FRAX backed by $1 in other tokens or $1 of LP token value (i.e., $1 value of the FRAX-ETH LP token can be used to mint $1 of FRAX. This means that liquidity is backed up with ETH, but the liquidity token is not as volatile as ETH. The volatility is “softened”)
Conclusion
FRAX has one of the most flexible designs, and their step-change approach to improving the protocol has worked wonders for them. The fact that their peg barely moved in the face of the UST collapse is a testament to their stability and security.