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FRAX FINANCE: WHAT IT IS AND PRICE PREDICTIONS

Frax Finance (FRAX) is an algorithmic stablecoin partially backed by collateral. FRAX combines collateralisation with an algorithm to establish a collateral ratio, which varies over time. This collateral ratio defines what collateral ratio backs 1 FRAX to $1. FRAX is backed partly by USDC, the second largest stablecoin by market capitalisation, and partly by its government token FXS.

FRAX works similarly to how TerraUSD (UST) is backed by Terra (LUNA).

FXS benefits from seigniorage when minting FRAX. Seigniorage is the difference between producing a unit of FRAX (defined by the guarantee ratio) and the cost of minting the FXS to back its share of the guarantee ratio.

Since FXS can be minted at virtually no cost, it accumulates value over time with an expansion in the market capitalisation of FRAX. A very similar mechanism led to an increase in the price of LUNA as collateral for UST.

The FXS token also allows token holders to participate in governance and staking. Token holders can, for example, adjust the rules of existing collateral pools, add new asset types to the protocol or add new pools. They could also change the bonus fee paid to incentivise arbitrageurs to bring the FRAX price back in line when parity is broken. Users can earn FXS as liquidity providers for Frax Finance Uniswap groups.

The Frax protocol is multi-chain, meaning users can join canonical (native) FXS / FRAX or bridged FXS / FRAX for use on chains such as Fantom, Avalanche, Polygon, BSC, Harmony and Moonriver.

HOW DOES FRAX FINANCE WORK?
Frax Finance addresses the capital efficiency problem of stable currencies. Traditional stable currencies backed by collateral such as USDT are not decentralised and are an easy target for regulators. On the other hand, overcollateralised stables like DAI have proven to be stable, but are difficult to scale because they are capital inefficient ($150 in collateral needed to mint 100 DAI).

FRAX works with a dual token model that uses USDC and its governance token FXS to partially back its stablecoin with a variable collateral ratio. FRAX’s stability relies on the correct incentivisation of arbitrageurs. If FRAX breaks its peg to either side (up or down), it must be restored quickly due to the following incentive mechanisms:

FRAX breaks its peg to the upside and trades above $1. Arbitrageurs can deposit FXS and stable coin collateral worth $1 and mint FRAX. They then sell FRAX on the open market and pocket the difference until price parity is restored.
FRAX breaks its downward parity and trades below $1. Arbitrageurs exchange less than $1 in collateral to mint FRAX. Buying pressure on FRAX returns the price parity to $1 and arbitrageurs can pocket the difference.
The FRAX collateral ratio determines how much of the FRAX bid is backed by stablecoin collateral and how much by FXS. Say FRAX is priced below $1, Frax Finance’s collateral ratio has lost confidence and needs to improve. This triggers recolateralisation, which means that new FXS are minted and offered at a discount to USDC (0.2% at the moment). This mechanism improves the collateralisation ratio and triggers buying pressure on FRAX.

If, on the other hand, FRAX exceeds its parity, the new FRAX can be minted and used to buy and burn FXS. For example, at a collateral ratio of 84% (0.84 USDC per 1 FRAX), the protocol can mint $1.19 for each $1 of excess collateral ($1 divided by 0.84 USDC = $1.19). The excess collateral is the amount of the dollar equivalent of FRAX that can be sold on the open market to bring FRAX back down to $1.

Also, if you buy FRAX, you are not entitled to the same proportion of collateral that you initially deposited. Let’s say you deposited $80 in USDC and $20 in FXS to mint 100 FRAX (80% collateral ratio). You may receive a different proportion of assets if the ratio changes and you wish to redeem your FRAX.

UNIQUE FEATURES OF FRAX FINANCE
Several features distinguish Frax Finance from comparable stablecoin protocols.

veFXS
Frax Finance employs the system of proxy voting popularised by Curve Finance. Token holders can stake their FXS and receive veFXS in return, representing their share of the FXS wagered and their voting power on governance proposals. The longer the lock-in period for FXS, the more agricultural impetus users receive to wager their tokens. This incentivises longer wagering and a lower proportion of FXS in circulation. The veFXS balance decreases linearly towards the expiry date to incentivise betting.

Algorithmic Market Operations (AMO)
Frax Finance relies on several basic mechanics, such as:

Balancing the collateral ratio
Maintaining a healthy balance
Accumulating value for FXS
These mechanics are summarised as AMOs that ensure the stability and viability of Frax Finance. Other AMOs include:

Using the protocol’s stablecoin treasury to earn yield.
Depositing FRAX and USDC to provide liquidity in Curve Finance and Uniswap.
Hedging against potential drops in collateral prices.
Mint FRAX in the money markets to enable access to FRAX.
Price stability
Despite its novel and largely untested dual token model, FRAX has been trading within a stable 250 basis point band for almost its entire duration. This differentiates it from comparable projects such as Iron Finance and Empty Set Dollar, which tried (and failed) to achieve stable parity with an algorithmic stablecoin design.

Value accumulation
Another key aspect of FRAX is the seigniorage revenue to its FXS governance token. The buyback and recollateralisation mechanism aims to keep FRAX trading within a tight price band (so far successfully) and to channel value to FXS holders.

FRAX FINANCE TOKENOMICS
Frax Finance uses FXS as its utility and governance token. The tokenomics is as follows: total supply of 100 million FXS, and distribution of FXS tokens allocated to:

Agricultural rewards (60%): distribution by half every 12 months
Treasury (5%)
Team and investors (35%): 20% to team, 3% to advisors and early contributors, 12% to private investors.
FXS deposited in voting escrow can be locked in for up to four years, with a maximum 4x increase in voting power and agricultural rewards. Importantly, veFXS does not increase the issuance of bounties, but rather increases the allocation a protocol farming bounty holder receives. Approximately 60% of the token supply is wagered as FXS with vote escrow, with an equal proportion for short-term blocks (3 weeks), medium-term blocks (1-3 months) and long-term blocks (3-4 years).

PRICE OF FRAX FINANCE
FRAX is currently trading around $0.9992 to $1 as of March 27, 2022, and has traded between a high of $1.0682 to a low of $0.9642. The effectiveness of a stablecoin is determined by how well it holds its peg. Its 24-hour trading volume on exchanges is around $24 million, and its market capitalisation is around $2.8 billion.

FXS is currently trading around $20.93 as of 27 March 2022, down from its all-time high of $42 set in January 2022. Its 24-hour trading volume on the exchanges is around $40 million, and its fully diluted market capitalisation is around $2 billion.

PRICE FORECAST AND FUTURE OUTLOOK FOR FRAX FINANCE
FRAX has so far been a successful experiment in the growing stablecoin market. Its absolute and relative share of stablecoin market capitalisation has been growing, although the protocol has seen FRAX’s market capitalisation stagnate in Q1 2022. While not as successful as its closest competitor, UST, FRAX has traded within a tight price band, backed by sound economic design.

If FRAX can continue to forge partnerships with other protocols that broaden its application as collateral in decentralised finance, its market capitalisation will continue to grow. As a result, the price of the underlying FXS token would also grow. Provided the Frax Finance community properly manages its treasury, FXS may well see a return to all-time highs in the future.

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