5 minutes to understand Monetary Policies by Algorithmic Market Operation with Frax V2
This article targets an audience with prior knowledge of cryptocurrency and finance. This article is a follow-up to the one on Frax V1.
Introduction
Frax V2 introduces the revolutionary concept of Algorithmic Market Operations (AMO). Behind this strange name, there is an autonomous module composed of several smart contracts that performs market operations to ensure the stabilization of the FRAX price at $1 as well as the money supply management.
We have seen in the previous article which mechanisms allow the V1 protocol to manage the FRAX monetary policy. We can summarize them in 4 main mechanisms:
- Decollateralization: Lower the Collateral Ratio (CR) if FRAX > $1
- Equilibrium: Do not change the CR if FRAX = $1
- Recollateralization: Increase the CR if FRAX < $1
- FXS deflationism: Burn of FXS tokens when FRAX money supply increases
FRAX V2 promotes a “Turing-complete stability mechanism” that automates FRAX V1 through the AMO module, so we have:
- Decollateralization: Market operations that lower the CR if FRAX > $1
- Equilibrium: Market operations that do not modify the CR if FRAX = $1
- Recollateralization: Market operations that increase the CR if FRAX < $1
- FXS deflationism: Optimized burn of FXS tokens when the FRAX money supply increases
We will see the different modules of the AMO and how they allow to stabilize FRAX and make FXS Tokenomics relevant.
1/ The Collateral Investor
The Collateral Investor is a module of the AMO that invests a part of the collateral supply on DeFi protocols such as Aave or Yearn.
So we have:
- Decollateralization: Yield-generating DeFi strategies that lock collateral so CR decreases
- Equilibrium: Yield-generating DeFi strategies that do not require a locking period. The CR is therefore not lowered and liquidity is provided in case of need for recollateralization
- Recollateralization : Withdrawal of DeFi strategies to provide liquidity as collateral
2/ The Liquidity Provider
A key challenge for protocols is to ensure the liquidity of its token. It is generally costly for a project, because its often needed to create economic incentives for third parties to become liquidity providers on decentralized exchanges.
Since it has USDC liquidity with its collateral, the Frax protocol is able, via the AMO, to deploy its own pool, be the main liquidity provider, and manipulate the money supply via FRAX token minting.
Moreover, on Curve, liquidity optimization mechanisms allow Frax to sell FRAX tokens massively without changing the price by more than $0.01. For example, assuming a TVL of $330m and an equilibrium of the tokens balance on the Curve pool, the protocol can sell $39.2m of FRAX tokens without changing its price.
We therefore have:
- Decollateralization: Increase the pool size via FRAX token mint and collateral use
- Equilibrium: DeFi strategies to increase the yield on the pool (particularly the boost strategies via StakeDAO for Curve) without changing the money supply
- Recollateralization: Decrease of the money supply by withdrawing FRAX tokens and then USDC tokens to provide liquidity as collateral
3/ The Lender on decentralized lending markets
Another AMO module mints FRAX tokens to lend them on decentralized lending markets.
Since the loan markets require over-collateralization for the borrower, the Frax CR does not decrease.
Moreover, the quantity of minted tokens is managed by the protocol. Therefore, it is able to control its interest rate in the lending markets, unlike other stablecoins protocols.
So we have:
- Decollateralization: Increase of the money supply via the mint of FRAX tokens
- Equilibrium: Yield generated by FRAX tokens lending
- Recollateralization : Decrease of the money supply via the withdrawal of FRAX tokens
4/ FXS1559 : FXS to the moon ?
FXS1559 (whose name is a tribute to EIP1559) is the AMO module that uses the profits generated on the other modules to buy back FXS tokens on the markets. These FXS are burned to decrease the amount in circulation, which tends to increase its value.
FXS1559 determines the absolute value above the CR, issues FRAX, buys FXS with the issued FRAX, then burns the FXS.
For example, assuming 100m FRAX token supply at 86% CR, the AMO generates $20,000 in revenue, so the CR is now 86.023%. Instead of buying the FXS directly with the $20,000, it is optimal to issue FRAX i.e. 20,000/0.86=23256. Thus the FRAX money supply increases, the CR returns to equilibrium, and more FXS are burned.
5/ The Gauge
The Gauge is not a AMO module but the voting system that controls the monetary policies of FXS and FRAX tokens.
To vote, FXS need to be staked for a period from 10 days to 4 years to obtain veFXS. Staking FXS also allows to get a multiplier on the different DeFi strategies with FRAX tokens, which creates an incentive to participate in the governance of the protocol.
Thus, voters decide on which protocols new minted FXS will be allocated.
This voting system is a key challenge, especially in the desire to move away from USDC as the unique source of collateral towards more decentralized and fluctuating assets, such as Ethereum.
Conclusion
The Frax V2 protocol has achieved to create a under-collateralized stablecoin with a stable value, which generates revenue for its users, and whose governance token, the FXS, is very relevant in terms of Tokenomics.
Moreover, the protocol is really innovative. We can mention the bridging mechanisms that allow the emergence of a “chain-agnostic” protocol or the collaboration with the Tornado Cash protocol that authorizes private transactions via the zk-SNARK technology.
However, the protocol has still many challenges to face, such as integrating collateral with floating prices or increasing the decentralization ratio. We can also fear a systemic risk with the strong interdependence of the protocol to the DeFi ecosystem (Aave, Uniswap, Curve, Stake DAO…) since a major problem on one of these protocols can create a devastating domino effect.
Disclaimer: None of the content in this article is investment advice. The author of the article has no partnership with the projects presented.
