Uncovering Frax's RWA strategy
There is a common critique that often arises in Defi - that it operates within a "closed-loop" system, detached from the "real world." It's a sentiment echoed by many, claiming that DeFi predominantly relies on speculative activity with little to no connection to tangible assets. However, there are emerging elements that seek to bridge this gap by integrating "real world assets" (RWA) into the DeFi ecosystem.
Before diving into the significance of RWAs, it's essential to define what constitutes a "real-world asset." RWAs encompass tangible off-chain assets, ones whose ownership is not purely digital. These include traditional assets like homes, cars, physical commodities, and even websites, despite their digital nature. The distinguishing factor here is that ownership is governed by real-world contractual agreements.
A crucial distinction arises within RWAs - the differentiation between tangible and intangible assets. While tangible assets, as mentioned earlier, pertain to physical goods, intangible assets often refer to digital properties. The regulatory implications associated with these two categories differ significantly.
In this round of the RWA narrative, the focus is on intangible assets, particularly the US Treasury bonds.
One might wonder about the rationale behind such initiatives. Why introduce RWAs into the DeFi space?
One of the clearest arguments is that as a result of the Federal Reserve's ongoing interest rate increases, the surge in US Treasury bond yields has led many DeFi protocols or cryptocurrency investors to resort to US Treasury bonds in order to receive risk-free high-yield returns.
Frax has not been left out.
Bringing US Treasury bonds to the blockchain is not easy. As Multicoin Capital co-founder Kyle Samani said, “This is a standard issue. You need to get all relevant parties, such as issuers, underwriters, fund managers, auditors, buyers, sellers, brokers, banks, etc., to agree on the new standard.”
Enters FinresPBC…
The integration of RWAs into DeFi brings forth a critical requirement - compliance with local legal and regulatory systems. Crypto-native assets can exist beyond government control, but RWAs must operate within established legal frameworks. Scaling RWAs in the crypto sphere calls for standardized contractual protections and legal assurances that facilitate seamless transactions in the real world.
FinresPBC answers that.
FinresPBC is the RWA custodian for Frax, just like how MakerDAO has entities holding tbills and MMFs for it.
FinresPBC holds US dollar deposits in FDIC Insured IntraFi savings accounts and earns interest on them. Without seeking profits or collecting fees, FinresPBC enables the public's access to secure traditional financial assets on the blockchain through the Frax Protocol. Its job is not just to ensure investor protection but also builds trust among traditional financial institutions and corporations.
Diversification and risk mitigation play a pivotal role in Frax’s RWA strategy. In the current DeFi landscape, where the emphasis often centres on high-risk, high-reward opportunities, Frax finance moves towards low-risk, stable-income products to access off-chain yield and government bond exposure.
The result?
Users can potentially earn risk-free yields approaching 5% annually, a significant enhancement compared to the stablecoin yield offerings we are all used to.
But to be able to access these yields, Frax has introduced sFRAX and FXBs.
sFRAX & FXBs
sFRAX offers a single-sided yield for depositors. sFRAX is similar to the DSR (Dai Savings Rate). It's a zero-duration yield vault where anyone can deposit $FRAX into an ERC-4626 smart contract and earn 5-10% interest in the form of $FRAX stablecoins.
The Interest on Reserve Balances (IORB), which is currently 5.4%, is what the APR will "softly target" at all times. If it is not possible, Frax will always prioritize maintaining a 100% collateral ratio for $FRAX before sending any extra money to sFrax.
According to a statement by Sam Kazemian, he suggests that the base rate of approximately 5%, may potentially scale with FRAX supply. Additionally, he mentions that there might also be a 10% rate for a specific range, similar to how DSR had an 8% rate. According to him, 10% is an ideal rate for the macro markets.
On the other hand, Fraxbonds are “decentralized utility tokens that denominate a debt in FRAX stablecoins at a certain timestamp” according to Sam K. FRAX holders will be able to buy discounted FRAX at a later date in the form of Fraxbonds or FXBs.
It’s all part of Frax’s RWA strategy, and it's very easy to understand.
Users deposit their FRAX tokens into a vault to get sFRAX.
The DAO chooses the best option to earn yield based on current market conditions.
If no good yield sources exist on-chain, Frax’s RWA partner (Finres) takes the FRAX tokens deposited in sFRAX and converts them into USDC.
The USDC obtained from the conversion is taken off-chain and invested in US Treasuries.
The receipt of this conversion is then converted to FXBs and transferred to the Frax treasury.
Users can then buy the FXBs at a discounted rate to capture the yields at redemption.
So for example, you could buy $1 worth of FRAX 2 years from now for $.90. When you swap the FRAX into the bond, the protocol now owns that collateral can do what it needs to ensure sufficient income is earned to pay the debt in two years.
As samSam Kazemian said “FXBs don’t entitle the holder to any asset offchain and don’t give a legal right to redeem for fiat or anything like that therefore they’re just a utility token within the Frax Protocol. They only guarantee that each FXB converts to 1 FRAX stablecoin on maturity. That’s all.”
FXBs automatically convert into FRAX at designated maturity dates annually on January 1st. Frax will offer 1, 2, 3, or 4-year terms for FXBs. This will allow Frax to bring the yield curve on-chain (at least for 4 years heh).
Frax will earn this debt by taking the collateral backing the FRAX, USDC or USDP, and then use FinresPBC to swap the collateral into cash and then invest it into treasuries with the nearest date to expiration or even other yield markets like Fraxlend, Aave, or Compound if the yields are high enough.
In terms of revenue, FXS holders will not lose any revenues to FXB holders when bonds are issued. The protocol's ultimate value goes to FXS holders. Bonds represent a form of debt, while FXS represents shares in the protocol. The bond design is distinct because FXB can be created when FRAX is below $1, and it will consistently convert to 1 FRAX upon maturity. FXS holders consistently receive fees and excess collateral, and FXS is used to create new FRAX. This design remains unchanged and is fundamental to the fractional algorithmic concept.
Yield Fiesta
All FXB tokens will be ERC20s with deep liquidity in Curve, as well as the usual bribes + FXS gauge incentives.
Given Frax's strategic utilization of the Curve flywheel, @cryptovestor mentions that he anticipates FXB could generate an overall APY ranging from 6% to 8% (U.S. treasuries yield of 5.25% + CRV, CVX, and FXS emissions).
If Frax can get a steady 8% yield on FXBs, what's the next step?
It’s LEVERAGE!
Imagine capitalizing on this impressive yield and amplifying it up to 9x on platforms like Fraxlend, BAMM, or Curve's LLAMA Lending market, incorporating soft liquidations.
Could APYs get as high as 15% - 25% when FXBs are employed in this fashion?
Like Sam, Kazemian said, “If we stay in a high-rate environment, we have to adapt and build new venues to capture rates. So, yes…sFrax and FraxBonds will be an integral part of Frax v3 and if the MakerDAO eDSR is any clue, degens are hungry for on-chain yield!
Parallel Positivity
sFRAX and eDSR share some similarities in that they both aim to provide yield to stablecoin holders within their respective ecosystems.
In the case of sFRAX, users deposit FRAX stablecoins and earn interest in additional FRAX stablecoins. eDSR allows Dai holders to lock their Dai into a DSR contract and earn additional Dai over time.
Both sFRAX and DSR address the issue of a near-zero duration yield curve for their respective stablecoins. They provide users with a way to earn passive income without committing to longer-term strategies. This is particularly beneficial for users who want to earn a yield on their stablecoins without taking on the risks associated with longer-duration staking.
Both sFRAX and DSR contribute to the growth of their respective stablecoin supplies. In the case of sFRAX, users buy and deposit FRAX, which helps increase the supply of FRAX stablecoins. DSR encourages Dai holders to lock their Dai, which can reduce the circulating supply of Dai, and keep TVL locked.
Both sFRAX and DSR offer liquidity and flexibility to users. Users receive tokens (sFRAX or DSR-locked Dai) that represent their share of the pool, and these tokens can be freely traded or transferred. This flexibility allows users to manage their yield-bearing assets effectively.
Both protocols involve governance mechanisms that can adjust the interest rates (Frax Staking Rate for sFRAX and Dai Savings Rate for DSR) based on market conditions and protocol needs. This governance control ensures that the interest rates remain adaptable and responsive to changes in supply and demand.
sFRAX and DSR exemplify innovative approaches to addressing the challenge of providing yield for stablecoin holders in a decentralized ecosystem.
In the past, Frax Finance and MakerDAO have struggled with an overwhelming reliance on USDC as collateral. Early in 2021, as a result of the de-pegging of USDC, both DAI and Frax fell below $0.9, which further motivated Frax Finance to increase its cash reserves and lessen its dependency on USDC. Thus the Frax v3.
On the other hand, MakerDAO, which has seen significant revenue growth, has boosted the DAI deposit rate many times this year, first from 1% to 3.49% and most recently directly from 8% to 8%, exceeding the risk-free rate of 5% for its underlying asset, the US dollar.
In the broader context, sFRAX and DSR represent parallel paths rather than direct competition. Maybe Frax’s RWA strategy of investing in US Treasury bonds will lower operational risks, and encourage a large number of users to hold their stablecoins with their profits.
All in all, Frax’s strategy is to contribute positively to the diversity of financial instruments available to users, enabling them to choose the stablecoin and yield-generation mechanism that best aligns with their risk tolerance and financial goals.