Recently, we’ve seen a proliferation of algorithmic stablecoins with elastic supplies. Their design mechanics can vary drastically, ranging from completely uncollateralized to partial collateralization. Our friends over at Mechanism Capital recently published a great post on this topic that touches on the history of this sector and different design trade-offs. A permissionless, scalable, capital efficient, composable and price stable cryptocurrency has long been considered a holy grail in this space. The utility it could have in global commerce is self evident.
Frax Finance is a new algorithmic, partially-collateralized stablecoin protocol that launched towards the end of December. It implements a two-token economic model:
- FRAX – price stable token with an elastic supply that algorithmically adjusts based on market demand
- FXS – volatile governance token that accrues the value generated by the protocol and partially collateralizes FRAX
To fully understand this design, it’s vital that we start by discussing how exactly FXS partially collateralizes FRAX. If the mechanics prove resilient, and there’s appetite from the market, then FRAX should always be redeemable for $1 worth of value. The part that varies though, is what assets you receive during a redemption that sum up to $1 of value. Let’s walk through this with some data.
Right now, FRAX has an outstanding supply of ~133m tokens. At a price of $1 each, that equates to a total value of $133m. Importantly, there is not $133m of USDC backing the token as collateral. In the graphic below, we can see that FRAX is currently collateralized by ~$110m USDC, with the remaining ~$23m classified as “algorithmic”, which represents the FXS component. That part can be confusing because there isn’t actually $23m of FXS sitting in the collateral vault. The composition of the collateral backing, currently 83% for USDC and 17% for FXS, is also not static. In fact, when FRAX launched it was 100% collateralized by USDC.
For those points to make sense, let’s take a step back and discuss the most basic underpinnings of any algorithmic stablecoin – how it expands and contracts supply. In the tables below, we’ve provided a brief explanation of these mechanics and the incentives they rely on to function effectively.
Stablecoin supply expansions are triggered when the FRAX price >$1. When price breaks above its peg, it can b
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