Frax Finance is a fractional-algorithmic stablecoin protocol that uses both collateralization and algorithmic processes to create its decentralized stablecoin, FRAX.
The collateral ratio, which is the ratio of collateral needed to back $1 of FRAX, varies with time and is solely determined by market forces. Only stablecoins are currently accepted as collateral by the protocol, with plans to accept more volatile collateral like wrapped BTC as the protocol is increasingly adopted.
Before Frax launched in 2020, stablecoins that existed at the time were either collateral-backed or were minted and burned algorithmically. Collateralized stablecoins are not capital-efficient, while fully algorithmic stables are intrinsically fragile and are vulnerable to breakage in erratic market conditions. Frax Finance brings together the best of both worlds, eliminating their issues to produce the first fractional-algorithmic stablecoin protocol.
The project, which started in May 2019, was formerly called Decentral Bank and is founded by Sam Kazemian, Travis Moore, and Jason Huan. Since its launch, FRAX has had its supply partially backed by collateral and the rest of the supply left floating. The amount of supply that is backed is based on the collateral ratio of the protocol.
Frax Finance is a two-token protocol made up of FRAX the stablecoin and Frax Shares which is its governance token. This structure is optimised to maintain the fiat peg stability, accrue seigniorage fees, and empower community members with governance rights. The protocol also makes use of a pool contract that holds USDC collateral. Further to the two-token model, the algorithm behind the minting and redemption of FRAX relies on interacting with the FXS token. For example, a collateral ratio of 75% would mean a newly minted FRAX of $1 value will be backed by $0.75 in a stablecoin asset, and $0.25 of Frax Shares will be burnt. At all times, the amount of FRAX minted would always be equivalent to the amount of value committed to protocol, either as collateral or by interacting with FXS.
Frax v1 is the first iteration of the fractional algorithm used to create FRAX. The protocol uses fully on-chain oracles to obtain the prices of FRAX, FXS and collateral. The Uniswap oracle provides the time-weighted average prices of ETH, USDT and USDC while the Chainlink oracle provides the USD price. The v1 algorithm is essentially a banking algorithm that adjusts its collateral ratio (akin to a bank's balance sheet ratio) according to market forces, evidenced by arbitrage trades that occur on the FRAX and FXS tokens.
In March 2021, Frax v2 was launched, introducing the concept of Algorithmic Market Operations controllers (AMOs) as lego pieces to build and enact fully autonomous monetary policies on the Frax protocol. These AMOs would run on the foundation of the base stability mechanism conceptualized in Frax v1. At the time of writing, four AMOs are fully implemented and currently utilize the protocol's capital assets more efficiently, thus accruing even more value to FXS holders. Two more AMOs are currently in development and have to pass through the protocol's decentralized governance process before implementation.
Frax's founder, Sam, has announced the development of a crypto native Consumer Price Index (CPI). The proposed CPI will have its own native stablecoin (Frax Price Index) and governance token (Frax Price Index Shares). The new product will enable FRAX to break free of the USD peg and become the first truly decentralized and permissionless crypto native unit of account. Holders of the new FPI token will experience an increase in the dollar-denominated value of their holdings every month. Hence, the FPI also seeks to serve as a hedge against inflation.