Frax’s reserves comprise Curve and Uniswap v3 LP tokens (~79%), USDC (~3%), non-native cryptocurrencies (~12%) and FXS (~6%). Frax can redeem the LP tokens for underlying pool assets.
Unlike most stablecoin issuers, Frax deploys most collateral assets in liquidity pools to generate yield, instead of keeping them idle for future redemptions. By concentrating most of its liquidity on Curve pools, the protocol can ensure that FRAX’s peg is strictly maintained for a prolonged period, despite under-collateralization. This works most of the times but isn’t failure-proof. If FRAX were to experience a bank-run like event, the following would occur:
FRAX holders deposit their FRAX in liquidity pools and swap out other paired stablecoins, causing a severe pool imbalance. Consequently, Curve pools increase slippage, eventually breaking 1:1 swaps. Soon, FRAX starts trading outside the protocol’s target price band 0.9933~1.0033.
When FRAX trades below 0.9933, the protocol’s direct redemption mechanism kicks in. FRAX holders may now redeem FRAX through the Frax App and receive a combination of USDC and FXS (based on the Collateral Ratio).
FXS issued against FRAX redemption gets sold in the market. This selling pressure drives down the price of FXS rapidly. In turn, the protocol would need to issue exponentially more FXS for subsequent FRAX redemptions as price continues to spiral down.
Eventually, the protocol runs out of USDC to carry on redemptions and / or FXS’s price crashes to $0. In both cases, the protocol incurs significant bad debt due to under-collateralization.
For these reasons, we treat endogenous collateral such as FXS as worthless for determining the protocol’s ability to wind down safely.
Frax’s Collateral Ratio
As per FRAX
Stable collateral = $228.7
Crypto collateral = $43M
Total collateral = $271.7M
Outstanding FRAX = $288.8M
Collateral Ratio = 94%
FRAX is under-collateralized because it uses a partial seigniorage shares model.
As per Bluechip
(A) Stable collateral = $228.7M
Crypto collateral = $43M
(B) Adjusted value of crypto collateral for 220% LTV = $17.48
(Note: 15% discount applied to all non-ETH/non-BTC crypto)
(C) Third-party liquidity locked in LPs for more than 1 year = $51M
(TVL of Locked Liquidity / 2, assuming balanced pools for simplicity)
(D) Adjusted Total Collateral (A) + (B) + (C) = $297.2M
(E) Outstanding FRAX = $288.8M
Adjusted Collateral Ratio (D)/(E) = 103%
Stablecoin liquidity locked by third-party investors is functionally the same as Frax-owned liquidity. As long as locked stable liquidity exceeds the algorithmic value of FRAX (represented by FXS), FRAX can be considered fully collateralized.
That said, locked liquidity is only a temporary solution to FRAX’s under-collateralization problem. In our view, FRAX’s semi-algorithmic model is fragile to redemption shocks or panic-induced bank runs.
84% of Frax’s reserves are held in third-party smart contracts (Curve and Uniswap v3) and the remaining assets are in team-controlled Multisigs (13%) and the protocol’s own smart contracts (3%). Users are advised to note that the use of third party smart contracts can expose Frax to significant risks. For example, during the Rari Capital exploit in April 2022, Frax suffered a loss of ~$13M as a result of its attempts to generate yield using its reserves.
Frax segregates its treasury assets from protocol-owned assets earmarked for backing FRAX’s peg.