FraxFinance & Stablecoins Linked to Inflation
Frax Finance is building one of the most interesting applications of DeFi yet
In this post, we will discuss:
Frax Finance and FPI
The Utility of FPI and Why It Matters
Last week, Frax Finance announced the launch of its second stablecoin project - FPI. The stablecoin will track the U.S Consumer Price Index, and balance of FPI holders will increase proportionally with inflation. A lot of the mechanics here are quite similar to UST and Luna, and if you’re interested or just getting started, I would go check out my post on that here.
Now, let’s dive into it. According to Frax Finance Founder Sam Kazemian, there are three trillion-dollar opportunities in crypto. First, Bitcoin. Second, Ethereum. And third, stablecoins. This is where Frax Finance is making a dent. Their first stablecoin FRAX was the first ever fractional algorithmically backed coin, a model that other stablecoins such as Terra are quickly adopting.
Side Note: If you don’t know who Sam Kazemian is, I would highly recommend you go check him out. He is one of the brightest thinkers and innovators in DeFi as of this moment, at least in my opinion. He recently appeared on the Bankless Podcast here.
FPI, or the Frax Price Index, represents the second culmination of capturing a portion of this trillion dollar opportunity. Given that U.S inflation is red hot and at the highest it has been in almost 40 years, the launch could not have come at a better time. To mint the FPI token, users can now use FRAX on their Metamask, and redeem FPI through FraxSwap. It’s a bit clunky and complicated, but thats just where crypto is for now.
The Utility of FPI Stablecoin
FPI has some obvious composability in the DeFi ecosystem. Being a liquidity provider for token pairs such as USDC/ETH provides decent yield, but FPI/ETH can now yield staking rewards while also protecting your stablecoin asset from inflation.
FPI creates a bridge between TradFi and DeFi. In traditional finance, Treasury Inflation-Protected Securities, or TIPS, are not a new concept. These instruments have existed for a long time and investors commonly flock into them during periods of high inflation. FPI is creating this parallel instrument in crypto and providing incentive to switch over to DeFi.
There are also lots of challenges along the way.
For example, we know that the CPI index is composed of a weighted basket of goods and services. It tracks the change in price of this basket, and Central Banks commonly use it as a measure to gauge whether the economy needs more or less liquidity.
The controversial part here is that the government gets to determine what goes into this basket. For example, if these government institutions decide that maybe having a car is not so much of a necessity, they can leave it out of the basket in the future. In summary, the CPI number can be easily manipulated.
So, simply keeping up with CPI numbers may not be enough. FPI is attempting to solve this issue in a decentralized manner. In the future, Frax Finance wants to let users vote on what the basket should be comprised of when tracking price inflation with FPI. This gives the entire community a say into what the APY should ideally be.
Another concern is with borrowing. If you lend out your FPI, you need to earn a return of at least 8.5% today to make it worthwhile as a creditor. From a debt and lending point of view, other stablecoins and pairs seem to offer some better engines of growth.
The biggest concern of all is the strain that a product such as this puts on the margins of Frax Finance. The treasury has to pay out 8.5% APY to holders at current inflation levels, and its not quite clear how sustainable this is. As inflation comes down towards the end half of 2022, this problem fixes itself. It does still raise the question of whether FPI can be useful during prolonged periods of inflation or in other geographies where inflation is consistently high.
In conclusion…
Frax Finance is building an ecosystem with unique features and products that deserves attention from crypto natives and investors. FPI is a DeFi token with clear utility and advantages, and it will be interesting to watch it evolve in the upcoming years.