Authors: ultimatepro, benjamine, atreides
Frax is a fractional-algorithmic stablecoin, the first of its kind: parts of its supply is backed by collateral, while the other parts of its supply are algorithmic. This means that FRAX is a stablecoin where part of the supply is floating/unbacked.
The Frax protocol is based on a two-token system including a stablecoin, Frax (FRAX), and a governance token, Frax Shares (FXS)
How is Price stability achieved?
Normally FRAX trades at $1.
When FRAX is more than $1 (e.g. $1.01) the system can relax its Collateral Ratio (CR), leading the CR to decrease from 100% to 98%, meaning you would need $0.98 of collateral (e.g. USDC) and $0.02 in its own governance token (FXS) to mint 1 FRAX. The FXS gets burned during this process. FRAX is now partially collateralized -> The newly minted FRAX can be sold on the market to normalize the peg (so it goes back to $1).
Redemptions are the inverse: 1 FRAX can be redeemed for $0.98 of newly minted collateral and $0.02 newly minted FXS.
When FRAX is <$1 (e.g. $.99), there is too little collateral in the system and the peg goes down.
To bring the collateral up again, the CR increases until peg is normalized again. At 100% CR the peg is restored because it is always possible to redeem 1 Frax for 1 collateral (e.g. USDC).
Many stablecoin protocols have entirely embraced one spectrum of design (entirely collateralized) or the other extreme (entirely algorithmic with no backing)Collateralized stablecoins either have custodial risk or require on-chain over-collateralization.
Purely algorithmic designs provide a highly trustless and scalable model that captures the early Bitcoin vision of decentralized money but the issue with algorithmic designs is that they are difficult to bootstrap, slow to grow and exhibit extreme periods of volatility which erodes confidence in their usefulness as actual stablecoins.
On top of that FRAX has some very interesting mechanics in place, allowing the protocol to generate additional revenue through different Algorithmic Market Operations Controller (AMOs) strategies.