FRAX Finance Votes to increase FRAX Collateralization Ratio to 100%
No more algorithmic stablecoins after Terra and USDT
The FRAX stablecoin derived its unique proposition by being an algorithmic stablecoins which was undercollateralized.. Well, apparently not anymore!
This article provides a quick overview of:
The voted proposal to improve the Collateralization Ratio (CR);
The reasoning behind;
The ultimate FRAX vision.
Why the Change?
The original FRAX protocol included a variable “collateral ratio which adjusted based on the market demand of FRAX, effectively letting the market dictate how much collateral was necessary for each FRAX to equal $1.00”.
According to Sam, FRAX has now “outgrown” this approach.
Of course, the defining event that changed forever the history of algorithmic stablecoins and the way they are perceived is the collapse of Terra.
After that, it became clear that legislators would have never allowed algorithmic stablecoins to be regulated.
For instance, on February 22, 2023, the Canadian Securities Administrators published a list of requirements for crypto companies and stablecoin issuers wanting to remain legally compliant in the country, including strict rules for stablecoin trading and a prohibition on algorithmic or non-fiat-backed stablecoins.
Even initially Frax had approached the algorithmic backing of Frax carefully: only a small % of the tokens were floating.
The costs of being slightly undercollateralized now far outweigh the benefits – especially because it can undermine the perceived safety of FRAX.
As a result, moving Frax to 100% CR has been deemed to be the best path for the long-term “health and growth” of the protocol.
The Voted Proposal
The FIP-188 governance proposal — which would change the collateralization model of FRAX — initially posted on Feb. 15 has now reached a quorum with 98% voting in favor, according to a snapshot on Feb. 23 .
The voted proposal set the target collateral ratio (CR) of the Frax protocol to 100%, to be achieved over time through protocol growth and earnings.
This proposal does not include minting any FXS to increase the CR, instead, it approves the following changes:
I. Increase the target CR to 100%. This is the long-term target of the protocol and will require time to reach. No FXS will be minted to achieve this target. As part of this change, the protocol is retiring the algorithmic backing of FRAX and the decollateralize function.
II. Retain protocol revenue to fund the increased CR, including pausing FXS buybacks. veFXS yield will emain the same.
III. Exchange $3m of protocol assest for frxETH every month: increasing the CR while also increasing the supply of frxETH and validators; also offers a strong return potential for the protocol.
The Frax vision:
Increasing the “money” attributed of Frax as a long-term store of value: by removing the algorithmic backing, the token will be perveiced as more secure;
A CR of 100% means that additional collateral can be deployed “via AMOs to create liquidity and revenue for the protocol”: FRAX will continue to be the most capital efficient safe stablecoin while removing the need to constantly fund locked liquidity with rewards and emissions;
Retain protocol earnings as the protocol grows: FXS buyback will be delayed;
Long term sustainability, increasing protocol assets and removing the need for FXS emissions towards locked liquidity.
Food for Thought
Many of the critics of FRAX argued that given its CR below 100% it could have never been widely used, due to safety and scalability risks.
While this features was deemed to be very important initially to establish a product-market fit, it now outweights the benefits. As such, in order to stimulate protocol growth, widespread adoption and being regulated, FRAX is increasing its CR to 100%.
It will be interesting how FRAX will leverage the new CR in order to position as the most capital efficient stablecoin in the cryptocurrency market. Furthermore, the fxsETH LSD is the most rewarding compared to competitors. FRAX APY is expected to further increase, attracting more capital and liquidity, leading to a virtuous cycle.