Original Title: FXS——Coiled Spring

Author: Ouroboros Capital; Translation: Golden Finance cryptonaitive

Overview

This report details our investment thesis in Frax Finance (FXS), one of our most confident investments in the cryptocurrency space over the next 6-12 months. We believe that FXS will outperform most other coins during the same period and convey our opinion through this report.

The report structure is as follows:

**1. Investment Thesis: We highlight why we believe buying FXS at current levels has an asymmetric risk-reward profile. **

**2. Value Accumulation: How we view FXS accumulating value over time. **

**3. Valuation: We use a non-academic but pragmatic approach to value FXS. **

**4. Myth busting: Common misconceptions about Frax. **

**5. Appendix: Mainly links to other useful information related to Frax. **

In this report, the first in our research series, we will cover our most confident investments - from small to large caps, presented in various formats (written, video, audio, etc.).

While this is an in-depth report highlighting elements of Frax’s investing thesis, it is not a complete how-to guide. We won’t introduce Frax and its history, nor will we go into detail about every single element of Frax.

However, we understand that there may be readers who need to know about Frax. As such, we have included links to external resources in the appendix section at the end of the report (a nod to Flywheel DeFi), which we believe will be a great resource for anyone wanting to learn more about Frax.

1. Investment theme

Summary: Our investment thesis for FXS is simple. We believe that buying FXS at the current level has an asymmetric risk-reward for the following reasons: 1) FXS valuation at the current level is supported; 2) The market is likely to give the token significant appreciation in the next 6-12 months.

Specifically, we see less downside risk for FXS compared to other tokens because 1) after passing FIP-256, its valuation is now supported (FXS has more aggressive FXS repurchases if below $5 ); 2) Our valuation exercise (later part of the report) shows that key parts of FXS have not yet been priced in, especially in light of upcoming catalysts for FraxChain and frxETH v2.

Most importantly, we observe the team’s track record in building and rolling out, giving us confidence in the execution of the aforementioned catalysts. We think FXS will at least outperform most other coins, and with the launch of FraxChain and frxETH v2, may even be a multi-folder in the bull market.

Investing Theme 1: Asymmetric Risk/Return - $4 to $5 Buybacks at FXS

On June 16, 2023, shortly after Frax restarted the FXS buyback program and conducted a $2 million 6-month TWAMM (time-weighted average market maker), we made a proposal proposing protocol optimization Its buybacks are designed to better achieve the goals of the program. We highlighted in our proposal that doing buybacks more aggressively at lower levels but halting buybacks above $5 could help the agreement to: i) signal to the market the bottom line of valuations; ii) acquire at lower prices FXS for future use; iii) accumulating value for the agreement to own liquidity (POL).

While at first glance, such a proposal might appear to be just for FXS prices, it is far from it. Signaling the bottom line of valuations to the market and thus obtaining a strong FXS price is of enormous strategic value to the protocol, as it becomes apparent upon reflection.

About 12,000 FXS are issued every day (4.38 million FXS per year or $21.9 million at $5) for weight pools and bribes, and it can be said that ensuring the most efficient use of issuance is critical to the protocol. These are the complex mechanisms that drive the protocol - AMOs, bribes, etc. Strong FXS prices and cheap storage of FXS ensure efficient functioning of these mechanisms, so we came up with this proposal. Also, we illustrate with the chart below that FXS is definitely undervalued at the $4 to $5 level.

Given the progress the protocol has made in development and upcoming developments, we don’t think pricing at the low end of the range (on its own and relative to other alternatives) is unreasonable.

FXS has come a long way, with more to come. The low price is not justified.

FXS - price at low points and relative to competing coins - considering i) progress, ii) roadmap, iii) low inflation/unlocking and iv) A+ team.

The repurchase proposal was passed on June 30, 2023, which we believe sends a strong signal to the market that there is a valuation floor when FXS is below $5. This provides an asymmetric risk reward for accumulating FXS, not only for the range below $5, but also for the range between $5 and $6, as the risk below the “buy zone” is limited.

Investment Theme 2: Blockbuster - Catalyst storm in the next 6 months

Now that we’ve highlighted the limited downside risk, let’s talk about upside growth - FXS’ roadmap for the next 6 months. We think the next 6 months for FXS will be very exciting due to i) growth in value accrual metrics (like frxETH supply), ii) protocol expansion to the part of the market that will impart significant value (FraxChain), iii) removal of existing drag (like Frax v3 and frxGov). We’ve ranked them based on importance and proximity as follows:

Catalyst 1: Adoption of frxETH

For us, sfrxETH is the most exciting growth engine for FXS in the near term. Although frxETH has achieved impressive growth since its launch, reaching $450 million in total value locked (TVL) in staked ETH in less than 6 months. But we think there is still a lot of room for growth when it catches up to rETH’s $1.5 billion total value locked in ETH pledged (the next highest total value locked in ETH pledged). We believe that in the next few months, there are two important factors that will drive the growth of frxETH:

sfrxETH on AAVE: For those who remember, when stETH formed a loop on AAVE (aka stETH’s leveraged income), it triggered a lot of stETH supply creation, and we think there will be similar after sfrxETH listing Phenomenon. The proposal to incorporate sfrxETH into Aave has passed in Snapshot, so we see this as an upcoming catalyst.

frxETH v2: One of the goals of building frxETH v1 is to optimize users’ earnings. Currently, frxETH v1 has the highest yield among ETH LST. As of July 3, 2023, the yield of 1000 ETH locked on sfrxETH in the past 6 months is higher than that of rETH (RocketPool) and stETH (Lido) (56% / 35%). The earnings of sfrxETH and competitors can be tracked in real time on Frax’s dashboard.

As of now, 1 ETH on sfrxETH is consistently more profitable than 1 ETH on rETH (Rocket Pool), stETH (Lido), or cbETH (Coinbase). This is intentionally achieved through the mechanism of frxETH, where ETH staking rewards are not distributed to all frxETH, but only to sfrxETH (frxETH stakers). Therefore, the same numerator (ETH staking yield) is assigned to a lower denominator (sfrxETH), since not all frxETH is staked, resulting in a higher yield.

This is simply a unique advantage achieved through the 3.65 million CVX owned by Frax. Additionally, sfrxETH charges the same or lower fees than most major ETH staking tokens. Read “What is FrxETH? Interpretation of Frax’s ETH Liquid Staking Derivatives” to learn more about the mechanism of how frxETH and sfrxETH achieve higher returns.

Source: DefiLlama

FrxETH v2 will introduce a mechanism to attract the best verifiers, that is, high-quality verifiers, which will further increase users’ benefits. Sam Kazemian wants to create a market mechanism that prioritizes “the best, most proficient and knowledgeable entities who know how to run a good node.” This market mechanism can be based on a variety of factors including “MEV revenue, minimum hardware cost, maximum internet speed, block propagation, proof of response” etc.

FrxETH v2 will introduce a mechanism to attract the best verifiers, mainly including 1) fees (how much revenue the verifier gives up to those who pledge ETH - currently 90% for FrxETH and Lido, it may be lower in frxETH v2) and 2) The amount of ETH validators need to contribute (i.e. the leverage they get). While most ETH staking protocols currently charge validators a fixed fee, frxETH v2 will introduce dynamic rates - allowing validators to pay lower fees when there are more ETH stakers who need validators, and more validators when more validators are available. Pay higher fees when not an ETH staker.

Therefore, frxETH v2 will have the most competitive rate - dynamically adjusted between validators and ETH stakers. Additionally, validators on frxETH v2 will also allow validators to offer less ETH than competing ETH staking products, making it a natural choice for the best validators. According to Sam Kazemian, validators only need to provide 4 ETH as collateral to lend 28 ETH. Compared to competitor Rocketpool which requires 8 ETH plus an additional RPL bond. If you want to learn more about frxETH v2, please read “Everything about FrxETH v2 with Sam Kazemian”.

Catalyst 2: Collateral Ratio (CR) reaches 100%

When CR>1, FXS will resume distributing fees to veFXS. Additionally, given the misconception (albeit incorrect) of the Frax stablecoin that a CR below 1 could pose a risk to its fixed value, this event will also dispel that misconception. We expect this event to occur over the next 12 months and will be a significant catalyst. Collateral Ratio (CR) is the ratio of non-POL (protocol owned liquidity) FRAX assets to non-FRAX/FXS/FPI assets held by the protocol. The current ratio is 94.5%.

First, the ratio doesn’t quite tell if Frax is likely to be unanchored (see Myth Busted #1). The collateralization ratio is currently about $16.5 million (4.5%) less than non-POL FRAX ($300 million). There are two main variables: i) volatile assets owned by the protocol - mainly $13m CVX, $7.5m sfrxETH, $5m cvxCRV, $1.7m wBTC, $1.7m SYN, etc. - and ii) Agreement revenue (approximately US$20 million), most of which are based on CRV and CVX.

In other words, the velocity of CR > 1 is adjusted according to the price of these assets. We’d also add that Reserve Protocols’ recent announcement of its proposed purchase of an additional $20 million in CRV/CVX or equivalent does support the value of most of the aforementioned assets. Figures in this section are as of June 27, 2023.

Catalyst 3: Fraxchain

There is not much information about Fraxchain at the moment, but what we do know is:

• Fraxchain will be a hybrid layer-2 solution, compatible with EVM.
• All assets of Frax will be natively supported on Fraxchain, and Fraxferry will be integrated on day one to ensure that liquidity can be transferred seamlessly.
• frxETH will be used to pay Gas fees on Fraxchain - this means that every frxETH transferred to Fraxchain will reduce the supply of sfrxETH used for pledge, so the yield of sfrxETH will increase.

See “Fraxchain: The Ultimate Boost to the FrxETH Currency Premium and Yield Potential” for details.

This is certainly an unpriced re-rating catalyst that we are watching closely. Low-activity Layer 2 solutions are able to capture at least ~$100 million (25% of FXS’s market capitalization) in market capitalization, and Appchains like INJ have achieved a staggering 7x returns so far this year after successfully transitioning to Appchains ( market cap growth of about $400 million). When it comes down to it, there’s no doubt a huge boost to valuations.

When will Fraxchain launch? Sam Kazemian mentioned in a recent podcast that Fraxchain is most likely to launch before the end of this year.

Revaluation case study: INJ successfully transitioned to Lisk, which showed 4x growth in the market.

Catalyst 4: Frax v3

Frax v3 is an updated version of the Frax stablecoin. Little is known about Frax v3, except for the following:

• It is designed to reduce the risk of FRAX, especially considering the recent USDC de-peg event.
• Not limited to USDC or the basic stable currency supporting FRAX, but also involves complete trustless governance on the chain.
• It will make FRAX more decentralized and resistant to de-anchoring of fiat currency stablecoins.
• This will have a positive effect on FXS.

Here are some snippets about the details of Frax v3:

the most important is:

Catalyst 5: frxGov

Currently, although veFXS holders are the ones who vote on proposals and thus decentralize the governance protocol, the execution of these proposals is still done through the protocol’s multi-signature smart contracts. Multisig is composed of Frax core team members such as Sam Kazemian, Travis Moore, etc.

Therefore, the protocol still faces important risks if a majority of multisig signers fail to sign. An example of this risk is the increasingly hostile attitude towards cryptocurrencies in certain jurisdictions. Assuming some government arrests enough core team members today, it could lead to a situation similar to OKX, where the exchange was unable to process withdrawals for months until CEO Star Xu was released.

While frxGov is unlikely to result in value accumulation, we list it as a key catalyst as it could ease investor concerns about the recent regulatory environment and make more investors comfortable owning FXS. For more details on frxGov, see “Frax 101: Governance 2.0 - What is frxGov?”.

Investment Theme 3: Sam Kazemian and the A-Level Team

The first part of our investment thesis highlights valuation support (limited downside risk). The second part highlights growth from upcoming developments (catalysts). However, it was the last part that gave us the most confidence, namely the quality of the core team.

The Frax team has assured us that its highly anticipated roadmap will be successfully executed. Promise and hope abound in the cryptocurrency space, but credible teams with a firm grip on control are few and far between. We feel reassured about this by looking at the track record and history of the Frax core team.

We spoke to some people who worked closely with the core team who can attest to this (even before Frax Finance was founded). For more details on Sam Kazemian’s background, see “Sam Kazemian” in the appendix.

2. Value accumulation

Sam Kazemian said in Frax’s public Telegram chat that Frax generates around $20 million in annual revenue, proving the protocol’s vibrancy in terms of revenue. To provide context, this puts Frax in the top 30 out of 176 listing protocols, according to Token Terminal data. Unfortunately, Frax is not available on Token Terminal. This section of the report aims to break down the key existing and future elements driving Frax’s revenue accumulation.

Frax currently generates approximately $20 million in annual revenue.

Value accumulation 1: frxETH

The protocol’s fee structure distributes 90% of all deposit earnings in frxETH to sfrxETH stakers. The remaining 10% is allocated to the Frax Protocol Treasury (8%) and Penalty Insurance Fund (2%). 8% allocated to protocol finances in the form of frxETH will eventually be distributed to FXS holders. The 2% allocated to the insurance fund will be used to cover any potential penalty events to effectively keep frxETH over-collateralized. $500 million *5%*8% = $2 million. While this may not seem exciting, we have noted in the investment thesis section that we expect frxETH to overtake rETH quickly. On rETH TVL (approximately $1.5 billion in staked ETH), frxETH’s cumulative revenue to FXS is estimated to be close to $8 million.

Value Accumulation 2: AMO

AMO (Automated Market Operations) is one of Frax’s main revenue drivers, but certainly one of the most conceptually complex elements within Frax. Therefore, we provide a detailed introduction in the appendix specifically for those readers who want to know more about how it works. In short, AMO has two goals: 1) To ensure the anchor stability of Frax’s native assets (FRAX and frxETH); 2) To generate income by utilizing the liquidity owned by the protocol.

In the process, it mints FRAX/frxETH, and moves POL. For example, if FRAX breaks off the peg on Curve (i.e. the FRAX/USDC base pool is unbalanced and there is more FRAX), the protocol will withdraw the FRAX owned by the protocol and destroy it, thereby maintaining the peg by rebalancing the distribution of FRAX and USDC. Similarly, if FRAX exceeds the anchor on Curve, the protocol will mint new FRAX, deposit it into the FRAX/USDC base pool, and bring FRAX back from above the anchor to below the anchor.

This webpage provides a good look at how AMO deploys the liquidity that the protocol has.

We estimate that the major AMOs (i.e. Curve/Convex AMO, frxETH AMO, and FraxLend) alone generated approximately $14 million in revenue (most of which is in CRV and CVX tokens). Considering the $2 million contributed by frxETH and Sam Kazemian’s estimate that the protocol as a whole generates $20 million in revenue, the total revenue of all AMOs is expected to be closer to $16 million.

Value Accumulation 3: Fraxchain

Since Fraxchain is likely to launch before 2024, it is a driver of future value accumulation that we must consider.

We currently know that Fraxchain will allow the use of native Frax assets (FRAX, frxETH, etc.) as Gas. Therefore, through the frxETH and Frax stablecoins, there will definitely be value accumulation indirectly.

We conservatively estimate that FraxChain’s gas fee may be $5,000 per day ($1.8 million per year), similar to Fantom, zkEVM, and Osmosis. This would allow FraxChain’s revenue to easily reach 10% of current protocol fees (approximately $20 million). But more importantly (which we will elaborate on in the valuation section of the report), we believe the market will assign significant incremental market capitalization to FXS on FraxChain. We have seen this phenomenon in other successful Lisk transitions.

3. Valuation

Before we start this part, we would like to state up front that we do not like to use traditional valuation models in the cryptocurrency space. Traditional valuation models such as target multiples and discounted cash flow analysis, which often have arbitrary variables that are highly sensitive to valuation outputs (discount rates, multiples, TAM analysis, etc.), are academic exercises for us.

However, we still think this section has value as it provides insight into: 1) how cheap FXS is currently valued and how much value remains to be assigned; 2) how much upside FXS has in a bull market (“ “basic” valuation models and imagination prevail).

Our valuation exercise divides the market capitalization of FXS into three key components: i) stablecoin Frax; ii) frxETH; iii) Fraxchain.

We start from a conservative perspective (base case valuation) and divide these partial values as follows:

1. The stable currency Frax**: 300 million US dollars. **This is the lowest point of the FXS market cap range, after the introduction of AMO. Given the importance of AMO as a revenue driver (nearly $20M in revenue and most of FXS’s revenue), we think it’s fair to employ such a time frame when assessing the conservative value of stablecoin components.

**2. frxETH: 200 million US dollars. **We use a conservative 25x multiple on projected frxETH revenue (~$8M per year) after it grows to rETH and cbETH scale. Considering the superiority of frxETH in terms of revenue, we think it is an inevitability for it to grow to the scale of rETH and cbETH, as well as the advantages of frxETH v2 in terms of decentralization and verifiers.

**3. Fraxchain: USD 100 million. **This is a conservative estimate given that we used the average of low-activity L2s such as BOBA, METIS, and LRC.

The above exercise also seems to assign more value to each part based on time, which we think is also sensible and consistent with the Lindy effect.

As Frax launches, develops, and the market’s bullish sentiment increases, we expect this sliding scale to move closer to our bull case valuation, as follows:

**1. Stable currency Frax: 500 million US dollars. **This is the highest point of the FXS market cap range, after the introduction of AMO, the collapse of LUNA, but not yet the introduction of FrxETH, because then the price has already taken into account some factors of FrxETH. We chose to take a cautious approach, including the market capitalization range after the LUNA crash.

**2. frxETH: $700 million. **Equal to RPL as frxETH supply exceeds rETH.

**3. Fraxchain: USD 500 million. **This is the incremental market capitalization obtained by INJ after successfully transitioning to the application chain. For reference, this is only slightly above the LRC ($300m) and is equivalent to 5-10% of the FDV of the ARB and OP.

As can be seen from the above, in the more bullish scenario, each part gained equal value. This also makes sense in a bull market, as participants are more willing to pay for the future and look forward, thus assigning more value to growth.

A simple valuation exercise and charts from earlier in the report reinforce our view that FXS is currently significantly undervalued by the market and that value growth will occur as more evidence emerges regarding the development of frxETH and Fraxchain.

4. Myth Analysis

This section addresses what we believe to be common misconceptions about Frax.

Myth 1: Like LUNA and other algorithmic stablecoins, FRAX is at risk of a death spiral. Frax’s collateralization ratio below 1 means that it is not safe and may break the anchor.

Absolutely not. The total amount of non-POL (Protocol Owned Liquidity, protocol has liquidity) FRAX is 300 million US dollars, which is supported by the equivalent stable currency assets held by the protocol and 37 million US dollars of volatile assets (such as CVX, CRV, etc.). The calculation formula of the mortgage ratio is (non-POL FRAX)/(non-FRAX/FXS/FPI assets held by the agreement).

That said, there are currently over $100 million non-POL FRAX/stablecoin liquidity providers (LPs) locked up for over 1 year. This means that only $200 million of FRAX can be sold for $237 million worth of equivalent assets in protocol-owned stablecoins. But what happens a year from now? According to our estimates, the protocol is likely to achieve a collateralization ratio exceeding 1 within a year.

Myth 2: The Frax team is based in the US, which means that if the US stance on cryptocurrencies gets tougher, the protocol will face an existential crisis.

frxGov addresses this issue, as described in the Investing Themes and frxGov sections above. Once deployed, frxGov will hand over full control of the protocol to veFXS holders, so there is no centralized operational element to the protocol and the risk of any form of regulatory action is eliminated.

Existing core teams can still work on the protocol and drive upgrades through, for example, governance proposals, while removing the risk of any regulatory action threatening to jeopardize the protocol’s existence.

Myth 3: Frax is a patchwork project with little innovation.

Totally incorrect. While some parts of Frax are not new ideas such as FrxETH (Liquid Mortgage ETH), FraxFerry (Bridge), FraxSwap (AMM) and FraxLend (Lending), they are built to complement existing Frax products. FrxETH was built to provide the highest yield among ETH liquid collaterals and leverage Frax’s position as CVX’s largest protocol holder.

The construction of FraxFerry is to avoid the risk of attacks on native Frax assets (FrxETH or stable currency Frax), because users hope that these assets can be used across multiple chains.

FraxSwap was built to allow the protocol to efficiently utilize its balance sheet for buybacks.

FraxLend empowers lending AMOs, enabling the protocol to mint Frax as collateral for lending, similar to a CDP.

in conclusion

We reiterate our investment thesis, which we also presented at the beginning of this report. We think the risk/reward ratio of owning FXS is asymmetrical over the next 6 months and beyond, and we think it’s currently one of our most confident investments in the space.

We have detailed a number of short- to medium-term catalysts and developments that tilt us toward owning FXS, while we also feel comfortable owning FXS long-term as we see the quality of the core team and their history of driving protocol growth.

Frax has come a long way: Frax v1 (survived the LUNA crash and witnessed the death of other algorithmic stablecoins) → AMO (an innovative solution for stablecoin anchoring and value accumulation) → frxETH → FraxFerry (for Bridging vulnerability and CCTP response) → Frax v3 + Fraxchain + more (frxBTC, frxBonds, etc.).

We don’t see this trend of constantly launching, developing and further developing the protocol stopping anytime soon because of the dedication and perseverance of the team. Forward, up.

5. Appendix

About Sam Kazemian

Sam Kazemian is an Iranian-American software engineer who has achieved notable success in the blockchain and cryptocurrency industry. He double majored in philosophy and neuroscience at UCLA, demonstrating his multidisciplinary knowledge and problem-solving approach. Kazemian’s outstanding achievements and contributions have earned him recognition, including being named to the 2023 Forbes 30 Under 30 List.

**IQ.wiki:**In December 2014, Kazemian co-founded IQ.wiki, which has grown into the world’s largest blockchain encyclopedia. He initiated the project in his dorm room while he was a student at UCLA. Notably, Everipedia, the company behind IQ.wiki, attracted famed Wikipedia co-founder Larry Singer as chief information officer in December 2017. The project received $30 million in funding from Galaxy Digital in February 2018, a milestone that was widely covered by authoritative media such as Fortune, Reuters, and Business Insider. Everipedia’s reach continues to expand in 2020 with the launch of OraQles, a groundbreaking one-party oracle service used by The Associated Press to log events on Ethereum. As President, Kazemian led the growth of Everipedia from an online encyclopedia to a blockchain knowledge platform.

Frax Finance: In June 2019, Kazemian started a new venture, Frax Finance. The team’s relentless pursuit of innovation has led to the launch of Frax v1, an important milestone in the development of a decentralized algorithmic stablecoin. Frax becomes the first stablecoin to combine collateralized collateral with an algorithmic stabilization mechanism. On December 21, 2020, shortly after its launch, Frax Finance surpassed $43 million in total value locked (TVL), demonstrating its immediate success. Kazemian has played a key role in driving the growth of the Frax Finance ecosystem, launching groundbreaking innovations such as Frax V2, veFXS, Frax Price Index (FPI) and Fraxswap. As of July 2, 2023, Frax Finance’s TVL exceeds $1.08 billion, firmly ranking as the 14th largest DeFi protocol in the crypto industry. The team will continue to drive development, including upcoming projects such as Fraxv3 and Fraxchain.

Flywheel DeFi link

Hats off to the Flywheel DeFi team in the Frax community. They are definitely key Frax community members at the time of writing this report and their content has saved us a lot of time while we were writing this report.

Here are links to their explanations of some of Frax’s key concepts:

Frax 101 - The Complete Guide to Using Frax Finance - Video tutorials and demos covering the entire range of Frax products.

Fraxchain: The Ultimate Driver of FrxETH Currency Premium and Yield Potential - What is known about Fraxchain as of June 16, 2023

Dive into everything FrxETH v2 with Sam Kazemian.

What is liquid collateral, and how does frxETH v2 revolutionize it?

Frax 101: frxETH and sfrxETH - explains why frxETH has a higher yield than other competitors and has better liquidity relative to market cap.

Frax 101: Governance 2.0 - What is frxGov?

Frax 101: What is Frax? The complete history of the protocol’s flagship stablecoin.

Analysis of FrxETH AMO and its economic mechanism.

Frax 2022 Review: The DeFi Trinity Is Born (And More!) - A great look back at Frax in 2022.

Twitter link

Twitter links we found helpful to us along the way.

Zero_13x1 good overview on Frax (March 7, 2023)

Riley_GMI infographic on Frax (May 22, 2023)