On Frax Finance
Exploring A Multi-Tier Valuation Framework For A Rising Decentralized Algorithmic Central Bank (02/13/2022).
Adapted from an internal Frax memo drafted in September 2021. For a primer of Frax Finance, I recommend Messari’s February 2022 high-level analysis.
The Rise of Algo Stablecoins
Global stablecoin market capitalisation has now surpassed $180B indicating that the combination of traditional-asset stability with digital-asset flexibility and efficiency has already become a powerful combination.
The stablecoin market continues to be largely dominated by fiat-backed assets like USDC and USDT which together account for 80%+ of the market.
Being a centralized issuer of stablecoins comes with certain regulatory scrutiny where very recently the US Treasury and Congress have been considering new policies for stablecoin issuers, particularly around verification of reserves and redemption.
As this scrutiny has intensified over the months, we have seen the growing dominance of algorithmic stablecoins including FRAX and UST. In December 2020, fiat-backed stablecoins market capitalization was 21x that of algorithmic. Today, that ratio is just 5x.
You don’t have to look far to find the plausible drivers of this momentum shift. On October 26th 2021, the SEC secured authority to propose legislation to oversee the stablecoin market and their centralized issuers. This event arguably represented just the start of long-haul legislation building and formal agency oversight.
One algorithmic stablecoin that has see impressive adoption since that announcement has been FRAX where its stablecoin supply has seen 5.6x growth and a 50% average MoM growth rate over the last 6 months.
Founded in 2020, Frax Finance is the world’s first fractional algorithmic stablecoin which is partially backed by collateral and partially stabilized algorithmically.
Frax can be best thought of as an on-chain central bank that can alter its monetary policy based on market conditions around its stablecoin, FRAX. Specifically, the collateral ratio is continuously moved up or down relative to supply/demand of FRAX as measured according to its peg to USD.
If the system needs to re-collateralize, FXS is minted to ensure 1-1 during a redemption call.
Despite being able to loosen or tighten monetary policy, the golden rule within the system is that 1 FRAX can be minted or redeemed for $1 within the system.
We can define this mathematically at the point of FRAX minting:
where F is the units of newly minted FRAX. Collateral units (Y) multiplied by the price of collateral Y (Py) requires a certain market value of FXS to be burned (where Z is the units of FXS burned where Pz is the price in USD of FXS). The FXS value burned is determined by the collateral ratio of the system (Cr).
Likewise for redeeming, FXS may be minted for re-collateralization events based on the collateral ratio itself:
Therefore all FRAX tokens are fungible regardless of collateral ratio they were minted at.
During periods of high FRAX demand (expansion), the collateral ratio falls providing a higher ‘efficiency ratio’. Conversely, periods of lower relative demand for FRAX (contraction), the collateral ratio increases to re-build confidence in its peg.
We can see the system working as intended. With FRAX being mostly in an expansionary period (peg often >$1), the ‘central bank’ has loosened monetary policy beyond its collateral or ‘protocol value’ (PV).
More recently, the system has seen a lower efficiency ratio as it modulates back to an appropriate threshold due to the market conditions.
A Multi-Tier Valuation Framework
Frax uses a two token system: FRAX the stablecoin and FXS as the governance token. FXS controls the core system parameters, controls the protocol revenue flowed to both the treasury and FXS holders.
FXS is therefore the only asset that captures the protocol’s value from FRAX’s adoption. Looking at simple cash flows may make understanding the value of FXS may seem intuitive at first but digging deeper into the Fraxs’s mechanics demanded a more nuanced picture.
A valuation framework for FXS needed to incorporate the following key factors:
The value of monetary supply (Cryptonetwork Governance As Capital)
The protocol value expressed via its collateral (Book value)
Future revenue directed back to FXS holders
Different cryptoasset call for idiosyncratic valuation methodologies. Specifically, one type of network within a niche may have idiosyncratic value drivers to another network within another niche.
For an algorithmically dynamic system like Frax, it is worth considering how the lens of which we apply valuation methodologies become dynamic too depending on the state of the network itself.
Given Frax can control a monetary supply larger than its protocol value during times of expansion, it is reasonable to expect the value placed on governing that monetary supply to proportionally increase.
However, a valuation framework here should consider a reduction in the system’s efficiency particularly when the system is stressed tested by wider market movements.
In this case, a primary valuation could then be the book value of the system itself. After all, 1 FRAX can always be created or redeemed for $1. The book value is always important but it’s what the market will pay attention to primarily in these scenarios.
The above framework forecasted that FRAX’s monetary supply (MS) would generally guide FXS valuation with future monetary expansion. Since the start of 2021, this appears largely true with FXS often using FRAX’s MS as a valuation floor.
During periods of stalled MS growth, lower system efficiency, or wider market drawdowns, Frax’s PV appears to be a useful north star for FXS’ market valuation, often bottoming or recovering much closer to its ‘book value’.
More recent catalysts have now pushed FXS higher from its lows back on par with its MS. Of course, time will tell how these dynamics play out longer term.
Given revenue is controlled and shared by FXS holders, cash flow-based methodologies should be weaved in to create a more holistic and composite overall valuation.
Today, the Frax treasury is earning an average of ~$360k of income daily (~$131m annualized) through its AMOs and mint/redeem fees. Cumulative revenue through AMOs has now surpassed $70m.
Another consideration is how much value is placed by the market on governance weight over other protocols. For example, Frax holds 19% of the CVX supply that can be used as proxy governance via the veCRV token.
All these may reasons why we see (and will likely to continue to see) FXS trading at a 100%+ premium to both its MS and PV.
Note - one of the problems with DCF models is identifying the often unclear terminal values of cryptoassets but this may become clearer over time.
FPI And The Need To Re-Iterate Valuations
The long-term vision of Frax is to offer a crypto-native consumer price index (CPI) called the Frax Price Index (FPI). A first decentralized, permissionless native unit of account which aims to stabilize the costs living standards.
Details around FPI are limited but the new unit of account will ultimately be governed by FXS holders. Therefore, a new composite valuation framework for FXS should be adjusted for future vertical integrations including for FPI. This may include new PVs and revenue streams controlled by FXS holders.
As networks evolve and iterate over time, value captures for their respective cryptoasset need to also evolve and iterate in turn.
This also means that seemingly unrelated headlines may now be key drivers of attention from both users and investors.
Frax, which was once well positioned as a direct response to regulatory pressures on stablecoins, is now being positioned to respond to the macroeconomic concerns at play - stretching from the US, UK, France, and all the way to Japan.
Catalysts evolve just as much as the valuations themselves.
Finally, it’s worth zooming out and understanding where we are heading at a higher level.
As we all navigate through the ‘cocktails of worries’ on the global stage, DeFi is already re-defining the financial system and its services.
Protocols like Frax are quickly becoming decentralized on-chain central banks that will offer CPI-pegged assets for any user, anywhere. Its value flows, algorithms, balance sheets, and parameters are all fully transparent and auditable in real time.
For the poetically inclined - that’s something.
Now let’s push the boundaries for how we value them.
In full disclosure, entities managed by Decentral Park Advisors LLC and its affiliates ("Decentral Park") do own or have invested in positions discussed in this article.
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