This report will briefly explore past developments, examine the project's current status, and offer insights into upcoming developments that have bolstered our confidence in Frax Finance.

This is a long read, so you’ll need to find a comfortable spot and settle down to digest how the past has shaped Frax Finance’s present state and what the future holds for this project. 

Ready for an update? 

Let’s go!!!👇 

TLDR📃

• Past developments: Frax Finance weathered the Curve exploit, showing resilience. Fraxlend averted a crisis by swiftly handling a potential bad debt situation.
• Present state: FRAX stablecoin's market cap declined due to shifts in the macroeconomic environment. frxETH, a liquid staking token, thrived with competitive yields.
• Financial position: Frax Finance boasts a strong balance sheet with $63 million in assets after liabilities deduction, positioning it well in a bear market.
• Frax's prospects: FRAX V3 aims to revolutionise stablecoin backing. frxETH V2 focuses on decentralisation, and FraxChain consolidates products into a unified hub, promising a DeFi super hub.

 

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Disclaimer: This is not financial or investment advice. Any capital-related decisions you make are your full responsibility and yours only. The information made available in this report is NOT for replication. The purpose is to share the thought process behind our decision-making for entertainment purposes only.

The past 🕰️

Since our 12x investment thesis on Frax Finance, much has transpired within the Frax ecosystem, the most recent of which is the Curve exploit in July 2023.  Let’s quickly travel down memory lane to help you catch up.

How the Curve exploit impacted the Frax ecosystem 📰

In July 2023, hackers pulled off the  Vyper/Curve exploit to net a $69 million payday. Many DeFi protocols, including Frax Finance, were affected by this exploit – either because the hack extended to them or due to their affiliation with the Curve ecosystem.

As mentioned, Frax Finance, with its long history of involvement with Curve, got it as well. In the aftermath, the price of its FXS token dropped by more than 20%. 

It sounds like Frax had a bad Q2, but if we take a step back to look at the situation, how significant was the impact of the hack on Frax Finance? That's exactly what you are about to find out. 

Did the exploit have a direct impact on Frax?

Once the news of the hack broke and people remembered the relationship between Frax and Curve, one of the primary concerns was whether the exploit impacted liquidity pools involving assets from the Frax ecosystem.

For context, Frax Finance, with its AMO (Algorithmic Market Operations Controller), had $404.316 million of its reserves in these liquidity pools inside Curve. This significant amount at stake raised concerns about the potential impact on the backing of the FRAX stablecoin.

Fortunately, none of Frax’s Curve LPs were affected by the exploit. And despite the initial FUD, the fact is that the actual exploit itself had no direct impact on Frax Finance.

Fraxlend swiftly averted a crisis of bad debt

However, beyond the direct impact of the hack, the Frax ecosystem had another risk lurking in the shadows. 

Here are the specifics: Curve’s Co-Founder Michael Egorov had taken a massive $100M CRV loan against his CRV position. Some $19.5 million of that loan was from Fraxlend (Frax Finance’s lending protocol), and it was at risk of liquidation due to the substantial decline in the CRV price.

While this looked like a major pain point, it turns out that Fraxlend features a robust design that solved the problem. 

Long story short, interest rates on Fraxlend are designed to escalate significantly when borrowers face liquidation risks. This rapid escalation compels borrowers to repay their loans promptly. And that is precisely what happened.

Egerov sold off some of his CRV position to raise the funds needed to pay off a substantial portion of the debt, securing his position. In contrast to protocols like Aave, which adopt a more passive approach to handling liquidations, Fraxlend's aggressive interest rate hike prompted the Curve Founder to settle his debt.

Overall, this crisis underscored the resilience of Fraxlend's design –  a design choice that protected Frax Finance from the aftermath of the Vyper exploit. 

The present ⌛

So, a review of the recent developments suggests that Frax is resilient. But where does Frax Finance stand now? To review the current state of Frax Finance, we examine the product – there’s no Frax Finance without its core products. 

Starting with Frax Finance’s products

Currently, Frax has two key products:

1. FRAX stablecoin: The FRAX stablecoin is the foundation for the Frax ecosystem. 
2.  frxETH: a liquid staking token that has quickly found product-market fit. 

Now, what’s happening with these two products?

FRAX stablecoin's market cap decline 📉

Since May 2022, FRAX's market cap has steadily declined, now ranking 7th with a market cap of $671,247,972. This trend prompts an exploration of the factors behind this downturn.

Transitioning from Algorithmic stabilisation

Initially, FRAX adopted a partially backed stablecoin model, with 80% value supported by crypto assets and algorithmic stabilisation. In the exuberant bull market of 2021, this approach was hailed as innovative. However, the collapse of UST and operational issues with Terra revealed the unsustainability of FRAX's original design. 

Swiftly, in February 2023, Frax Finance pivoted away from this model, recognising that algorithmic stablecoins weren't the path to mass adoption.

Collateralization Ratio and Brand Perception: The collateralization ratio has climbed steadily to 94%, but the historical association with algorithmic stablecoins still affects FRAX's adoption. Frax Finance is actively working towards full collateralization while rebranding efforts are underway to dispel lingering misconceptions.

Evolving macro environment

Another significant factor contributing to FRAX's decline is the changing macroeconomic environment driven by surging interest rates. 

This shift aligns with the decrease in FRAX's market cap. With interest rates at 5.33%, individuals opt for safer assets like U.S. treasuries, providing competitive yields. This leads to liquidity flowing away from stablecoins like FRAX towards these alternatives.

An overreliance on USDC as collateral

FRAX uses the USDC as collateral, but this relationship creates stability risks. Case in point, Silicon Valley Bank's bankruptcy affected Circle, leading to problems for USDC, which, in turn, spells downstream stability trouble for FRAX. Therefore, there’s a need to diversify FRAX’s collateral base beyond USDC.

In addition, while USDC heavily collateralises FRAX, Frax Finance cannot access juicy US Treasury yields because it all goes to Circle, the company USDC. Frax Finance acknowledges this challenge and is actively working on FRAX V3, aiming to enhance the stablecoin's competitiveness in a high-interest-rate environment. We will touch on FRAX V3 in a bit.

frxETH (Frax Ether)’s growth in a bear market 📈

In contrast to FRAX, frxETH, the liquid staking protocol, has thrived despite the prevailing bear market conditions. Currently, with a Total Value Locked (TVL) of $414 million, it stands as the 5th largest provider.

Competitive yield

The first factor driving growth for FrxETH is that it offers the most competitive yield in the market.frxETH boasts an Annual Percentage Rate (APR) of 4.45%.  This surpasses its closest competitor, Lido, which offers 3.84%. This edge is primarily attributed to Frax's innovative dual-token system, comprising frxETH and sfrxETH.

Growing trust over time

The second factor driving growth for FrxETHAs as it nears its one-year mark is that it has earned increasing user trust. Trust, a critical factor that drives adoption for new staking providers, naturally takes time to cultivate. With frxETH nearing its first anniversary, users increasingly rely on its stability and performance, elevating it to a favoured choice in liquid staking.

What do Frax Finance's financials look like? 🏦

The review of Frax Finance’s products (previous section) shows a dichotomy between shrinking FRAX market cap and growing frxETH TVL. Yet, another empirical factor could help us make sense of the current state of Frax Finance – and that’s the financials.  

Frax Finance holds a significant amount of assets on its balance sheet. However, it's crucial to recognise that many of these assets serve as collateral for the FRAX stablecoin, meaning not all of them are part of the treasury.

When we examine what the DAO currently possesses after deducting its liabilities, we are left with $63 million, which is a significant amount, especially in a bear market.

This positions Frax Finance as the 15th largest DAO in terms of asset holdings, signifying a robust financial position to support its operations and grow its business.

We know that Frax has a strong financial position that can provide a runway for doing both the operational work that runs the business and the strategic work that grows the business. 

Frax Finance: The future 🚀

Frax Finance is undergoing a major transition, revamping nearly every aspect of its products to improve them.

In this section of the report, we dive into how the strategic work in the Frax ecosystem could translate into game-changing developments for the future of Frax Finance. This development falls into three broad areas, namely;

1. FRAX V3, the new version of Frax’s stablecoin
2. frxETH V2, the updated liquid staking protocol
3. FraxChain, Frax’s own layer 2 network. 

Part 1: A two-pronged improvement with FRAX V3💸

The main goal of FRAX V3 is to eliminate USDC and other stablecoins as the sole collateral for FRAX and revamp the stablecoin to generate yield. 

What is the best way to achieve this? 

Direct access to U.S. Treasuries without intermediaries like Circle. And that's exactly what FRAX V3 aims to do.

FRAX V3 will rely on Financial Reserves and Asset Exploration Inc Public Benefit Corporation (FinresPBC) to directly bridge traditional finance (TradFi) yields to FRAX. This way, it will tap into the treasury yield itself through Finres instead of losing out on it, utilising multiple strategies Finres can provide.

This will enable FRAX to transition from being primarily backed by non-bearing USDC tokens to a diverse range of yield-bearing stablecoins and direct access to U.S. Treasuries.

Now that Frax Finance will have access to the juicy treasury yield through Finres, they can completely redesign their stablecoin by creating two separate products: Fraxbonds and sFRAX. 

Introducing Fraxbonds

Fraxbonds are on-chain bonds that will be issued by FRAX for four years, with a 1-year maturity each, allowing anyone to purchase them. Fraxbonds provide discounted future Frax, giving investors fixed income and bond-like exposure without traditional finance. 

Frax will issue 4 separate bonds over four consecutive years, each with a 1-year maturity. Anyone can buy the Fraxbonds. When a bond matures, it converts to FRAX tokens. Fraxbonds do not pay coupon interest. However, they represent the purchase of discounted future Frax - similar to how bonds work.  For investors, Fraxbonds offer bond-like exposure and safe, fixed yields completely on-chain.

Introducing sFRAX

sFRAX allows users to deposit FRAX stablecoins into a smart contract and earn interest paid in FRAX, similar to a savings account or money market fund in traditional finance.  The yield comes from Frax protocol revenue generated from strategies like AMOs and RWAs. sFRAX aims to target a yield of 5-10%, allowing it to be competitive against other stablecoins like DAI.

Users receive sFRAX tokens representing their share of the pool, making it easier to trade the yield-bearing position. Frax handles automatic compounding by depositing additional yield into the vault weekly. Overall, sFRAX offers users simple, low-risk interest on FRAX stablecoin holdings comparable to traditional savings products.

Key Differences between Fraxbonds and sFRAX

• Fraxbonds raise capital reserves for Frax while sFRAX provides yield on existing FRAX deposits
• Fraxbonds offer discounted future FRAX at maturity instead of periodic coupons like sFRAX
• sFRAX targets low-risk yield like a savings account, Fraxbonds provide bond-like duration exposure
• Fraxbonds raise capital from broader markets, and sFRAX utilises user deposits

Part 2: Scaling for success frxETH V2 🔓

FrxETH V2 is the next version of Frax Finance's liquid staking protocol for Ethereum, aimed at making several key improvements focused on addressing the main issue that frxETH currently faces – a lack of decentralisation.

Currently, not everyone can easily set up a validator node for frxETH. However, through a mechanism developed by Frax Finance, they will significantly reduce the barrier to entry for individuals looking to set up a validator while simultaneously decentralising frxETH. This approach allows participants to earn extremely competitive yields.

Here are the key points on how this is achieved.

• Introduces validator borrowing - users can now borrow ETH to set up validators by putting up as little as 4 ETH as collateral. This makes running a validator accessible to more users than protocols like Lido, which require the full 32 ETH.
• Creates an on-chain lending market for ETH - lenders can supply ETH and earn interest, and borrowers can collateralise ETH to borrow ETH to set up validators. Interest rates are set algorithmically based on supply/demand dynamics.
• Incentivises high-quality node operation through a validator selection mechanism that considers metrics like MEV profits, hardware, uptime, etc. This ensures capable operators help secure the network.
• Greatly reduces capital lockup requirements through lower collateral needs. This frees up user capital for other productive uses.
• Promotes greater decentralisation of validator nodes by making it easy for small users to participate.

This positions frxETH V2 as a leading platform for accessible, efficient, decentralised ETH staking and lending. The upgrade is expected to go live in October.

At this point, it will instil more confidence in institutions and large entities to use frxETH. The main challenge it currently faces is decentralisation, which sets it back compared to competitors like Rocket Pool. 

Part 3: Unifying the Frax ecosystem with the FraxChain 🤝

The last major upgrade, expected in December or at the start of 2024, will be the launch of FraxChain, Frax Finance's own layer 2 solution. This layer 2 solution will be the foundational layer for all Frax products, secured by Ethereum.

This setup enables Frax to earn fees from the products people use and on the chain that records those transactions.

FraxChain is pivotal as the unifying force within the Frax Finance ecosystem. Its vision is to serve as the ultimate hub for all your DeFi needs by consolidating all the products that Frax Finance has been building into one layer 2 solution.

And here's the exciting part – when you stake your FXS tokens, you have a say in decisions and earn a share of the network's generated fees. FraxChain empowers you with governance and financial rewards, transforming FXS into a highly influential token.

It not only earns fees from the transaction revenue of FraxChain through staking but also has the potential to generate revenue from all the products that Frax offers if the Frax DAO decides to allocate revenue to FXS stakers from those products.

When are we buying FXS? 🤑

FXS's price has mostly traded between $7.50 and $3.90 for the greater part of the last 455 days. The only exception (highlighted in yellow) was a break of the upper side of the range that lasted for about 120 days before falling back inside it.

This tells us that the current range FXS is trading is compelling. This accumulation zone provides a significant opportunity for the next bull run.

Our ideal entry? Anywhere between $4.30 - $3.90 (green zone).

FXS's price has been recently rejected from the upper side of the range and is now heading for a test of support. We estimate that FXS will reach the region sometime between late September and mid-October.

To us, this is a long-term investment - but we still have a plan B 

If FXS drops under $3.90, we will wait for $1.90 - $1.50 to accumulate even more, reducing our average entry price and recovering losses in time.

Our targets are $15 (middle of a resistance region highlighted on the chart) and 

FXS's all-time high of ~$42. We will leave some for when the token enters upside price discovery during the next bull run.

Cryptonary’s take 🧠

Our confidence in FXS has strengthened since our previous report, with Frax Finance addressing key product issues. These include reliance on USDC, the inability to earn FRAX yield, and frxETH centralisation. 

While specific fee details and revenue sharing remain undisclosed, we anticipate revenue to triple after the frxETH V2 and FRAX V3 launch.

FXS offers diversified exposure, combining low-risk FRAX yield with market-agnostic frxETH. The game-changer is FraxChain, enabling Frax Finance to become a DeFi super app, consolidating all products into one user-friendly hub. It also boosts revenue through transaction fees, significantly increasing the value of FXS.

As such, we maintain our long-term price target of $70 for FXS, as previously stated. Given current market conditions, there may be opportunities to accumulate FXS at ideal entry points between $4.30 and $3.90 before substantial price appreciation.

As always, thanks for reading! 🙏

Cryptonary, out!