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FrxETH
Frax's entry into the ETH staking landscape in late 2022 introduced a unique two-token design that sets it apart from conventional staking derivative models. When users stake ETH through Frax, they receive frxETH, which acts as a stablecoin loosely pegged to ETH. In contrast to other liquid staking derivatives, frxETH does not accumulate value from staking rewards. Its behavior is very similar to wrapped ETH (WETH).
Frax has also introduced sfrxETH, a token that represents a deposit receipt in an ERC-4626 vault receiving all profits from Frax’s Ethereum validators. A notable aspect of this design is that depositors do not automatically receive staking rewards. Instead, they must actively choose between sharing in the protocol's staking rewards through the sfrxETH vault, or trying to earn a higher return on their frxETH elsewhere, such as on Curve.
Frax's Unique Two-Step Staking Process
- Minting frxETH: Users deposit ETH into the Frax protocol to mint frxETH (Frax ETH). All the ETH exchanged for frxETH is staked by Frax. frxETH, however, does not accrue staking rewards like other liquid staking tokens (LSTs) such as Lido’s stETH or Rocket Pool’s rETH. Instead, it is pegged by Frax at a 1:1 redemption rate with ETH.
- Choice Between sfrxETH or Curve: From this point, frxETH holders have two options:
- They can deposit their frxETH into an ERC-4626 vault and mint sfrxETH, an LST that does accrue staking rewards.
- Or, they can deposit their frxETH into the frxETH/ETH liquidity pool on Curve to earn rewards paid out in CRV, CVX, and FXS tokens.
Because frxETH holders have these two competitive options to earn significant rewards, the staking rewards earned by Frax are divided among fewer users, resulting in a higher rate of rewards for sfrxETH holders compared to other LSTs.
Earning Higher APR With Frax
sfrxETH yields ~6.5% a year, higher than wstETH (Lido) at 5% and Rocket Pool at 4.4%. This higher yield is because frxETH does not need to be staked in the validator nodes, and all the yield from all the frxETH that are not staked is given to sfrxETH. Therefore, the less frxETH is staked, the higher the APR for sfrxETH.
Frax is a significant holder of Convex Finance’s CVX token, giving it considerable influence over Curve's gauge system and the ability to earn a higher yield on Convex Finance by voting for more incentives to be directed to their frxETH LP tokens. Frax can direct CRV and CVX rewards to its frxETH / ETH Curve pool, providing an alternative for frxETH holders who decide to forgo staking in the sfrxETH vault. This option benefits sfrxETH holders as it increases their share of the protocol's total ETH staking rewards.
Holders of frxETH have two options:
- Mint sfrxETH to earn ETH staking rewards: By depositing frxETH into an ERC-4626 vault, users can mint sfrxETH and start accruing staking rewards. This process is comparable to traditional ETH staking in terms of yield generation.
- Provide liquidity on Curve for CVX, CRV, and FXS rewards: The alternative is to pair frxETH with ETH on Curve to earn token rewards in CVX, CRV, and FXS. However, this strategy does not provide validator rewards in ETH, thus differentiating itself from traditional ETH staking. By providing this alternative option, Frax encourages a more dynamic environment where users can choose, or even rebalance between, whichever strategy is currently most lucrative.
The advantage of this model is that all frxETH deposits are staked by the protocol, but only those who opt for sfrxETH receive the ETH staking rewards. This system allows Frax to maintain a competitively higher yield for sfrxETH compared to other LSDs. Holding frxETH without providing liquidity does not yield any rewards and can best be compared to holding WETH.
Frax's revenue from staking is divided into three categories:
- 90% accrues to sfrxETH stakers: The majority of the staking revenue goes directly to the users who chose to stake their frxETH in the sfrxETH vault.
- 8% goes to its treasury: This portion of the revenue is set aside for the protocol's treasury. FXS holders will eventually vote on how to distribute the treasury revenue to accrue value to token holders. In the past, the distribution has occurred via FXS buybacks and FXS distribution to veFXS holders.
- 2% flows to a slashing insurance fund: This small portion of the staking revenue is set aside as insurance to cover unforeseen issues and mainly exists to keep frxETH overcollateralized.
As of your note, Frax operates 1,848 ETH validators. However, in the future, governance will introduce a more decentralized architecture where independent validators can be added, further promoting the protocol's growth and decentralization.
Frax also has its own lending product, allowing it to retain the lending revenue generated by users borrowing against their sfrxETH collateral, thus growing the Frax treasury.
Entire Step-by-Step Process
This analysis delves into the intricacies of a prominent workflow, elucidating the process of depositing Ethereum (ETH) into the frxETHMinter contract, the generation of frxETH tokens, and how these synthetic tokens are utilized for income generation and rewards distribution.
Starting from the deposit process's initiation, a user sends their ETH to the frxETHMinter contract via the submit() function. In response, the contract issues the user an equivalent quantity of frxETH tokens, which are synthetic equivalents of ETH akin to Wrapped Ethereum (WETH). A salient point of note here is the price constancy of frxETH in relation to ETH, which remains static at a 1:1 ratio, barring conditions of insufficient liquidity on Decentralized Exchanges (DEXs).
As the accumulated ETH in the contract reaches a threshold of 32, automated bots dedicated to the FRAX protocol run the depositEther() method. This function interacts with the getNextValidator() function of the OperatorRegistry contract, where information about available validators is fetched. Following this interaction, the contract deposits the ETH into the DepositContract address, providing crucial arguments such as the public key, withdrawal credential, signature, and deposit data root of the selected validator.
To provide some historical context, the DepositContract contract, serving as the primary contract for ETH staking, was established by the Ethereum Foundation on October 14, 2020. The addresses of validators find their place in the OperatorRegistry contract via the protocol's governance mechanism. Once the DepositEvent is identified on the DepositContract contract, the consensus layer activates the respective validator, enabling the node operator to initiate the validation process.
Subsequently, users can start generating income from staking by trading their frxETH tokens for sfrxETH tokens via the sfrxETH contract. This contract implements the functionalities as laid out in the ERC4626 standard. Validators who contribute to the block validation process reap their rewards in ETH. This reward ETH is then sent to the FRX Eth Multisig address, a Gnosis Safe contract designed for secure storage and management of funds.
The FRX Eth Multisig contract then carries out the conversion of the received ETH into frxETH, employing the frxETHMinter contract. The frxETH generated is transferred to the sfrxETH vault. This results in the exchange rate between frxETH and sfrxETH rising, considering the increase in frxETH tokens' circulation while the supply of sfrxETH remains stable.
The syncRewards() method can be invoked by bots or users to facilitate the distribution of frxETH rewards among users, adhering to the ERC4626 standard. The final stage in this workflow offers users the choice to convert their sfrxETH tokens back to frxETH, thus enabling them to realize their profits.
A flowchart of ETH to frxETH. Source
Frax's Fees and Risks
Frax takes a 10% cut of the staking rewards, distributing 80% to veFXS holders, and 20% to the insurance pool, with the remaining 90% going to sfrxETH holders.
However, risks exist in the model. While the frxETH/ETH total value locked (TVL) on Curve increases, the incentives get distributed to a larger pool, lowering the APR and potentially deterring new investors from staking their ETH with Frax. But with frxETH market share still in single digits, there is still ample growth potential, and frxETH synergizes well with the rest of the Frax ecosystem, creating additional value for frxETH and FXS holders.
Frax's stablecoin (FRAX) model, which is 90% collateralized by USDC, has proven to be stable, with peg deviations of less than 0.66% in the past three months. Despite potential risks in algorithmic stablecoin models, Frax's deep liquidity on Curve and its partnership to create the Frax basepool help maintain its stability and organic demand. Notably, even during the UST depeg crisis, Frax maintained its peg, which should give confidence to investors.
Below we break down a few identified vulnerabilities, how they can affect users, and why it's crucial to recognize and address them.
An issue was found by an auditor that could allow a dishonest person controlling a node (the computer processing the transactions) to access other users' funds. This issue arises from a specific part of the process called the DepositEvent. During the first deposit of Ethereum (ETH) into the DepositContract, certain details, like the WithdrawCredentials and public key, are set and can't be changed later.
Here's where the problem can occur. If the dishonest person jumps in and executes the deposit function before the LSD protocol does, they can input their own WithdrawCredentials. Even if they only send a tiny amount of ETH (like 1 ETH), their credentials will remain in effect for the main transaction, which involves 33 ETH. This means that these funds will be sent to the dishonest person's address, affecting 32 other users. Interestingly, this vulnerability was first noticed back in 2019.
There are also penalties, called "slashing penalties," for any validator (the person validating the transactions) who breaks the consensus rules. The least penalty is 1/32 of the balance of the offending validator. If more than one validator breaks the rules, the penalty depends on the number of offenses within 4096 blocks of transactions (also known as "epochs") since the first violation. These penalties are important because they encourage people to follow the rules.
But these slashing penalties can lead to another problem. An auditor found that if the number of ETH falls due to these penalties, frxETH, a kind of synthetic ETH, could become worth less than real ETH. This is a big issue because synthetic and real ETH are supposed to be worth the same.
Finally, another vulnerability related to the potential centralization of power was identified. With the FRAX contract, the owner could add or remove validators, assign the Minter role for creating frxETH, and more. Because there's so much value in LSD protocols, it's important to make sure that one address doesn't have the power to control everything.
In conclusion, understanding these vulnerabilities and working towards solving them is vital for anyone involved in cryptocurrency. They provide a key example of why vigilance, transparency, and knowledge-sharing are the cornerstones of a strong, resilient, and trusted cryptocurrency ecosystem.
