You are reading an excerpt from our free but shortened abridged report! While still packed with incredible research and data, for just $20/month you can upgrade to our FULL library of 50+ reports (including this one) and complete industry-leading analysis on the top crypto assets. 

Becoming a Premium member means enjoying all the perks of a Basic membership PLUS:

• Full-length CORE Reports: More technical, in-depth research, actionable insights, and potential market alpha for serious crypto users
• Early access to future CORE ratings: Being early is sometimes just as important as being right!
• Premium Member CORE+ Reports: Coverage on the top issues pertaining to crypto users like bridge security, layer two solutions, DeFi plays, and more
• CORE report Audio playback: Don’t want to read? No problem! Listen on the go.

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

1. 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.
2. 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:

1. 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.
2. 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:

1. 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.
2. 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.
3. 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.

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.