The f(x) Protocol: A Paradigm Shift in Decentralized Stablecoins and Leverage

Intro

Spurred by the USDC depegging event, Aladdin DAO’s core contributors embarked on creating a dynamic, decentralized stablecoin. Their efforts not only realized this goal but also led to the inception of a novel leverage product, marking the genesis of the f(x) protocol.

Key Insights

• Innovative Stability with fETH: fETH represents a novel approach to stability in DeFi, tracking the value of ETH but with significantly reduced volatility, providing a more dynamic stablecoin experience compared to traditional fiat-pegged stablecoins.
• Enhanced Leverage through xETH: xETH offers a unique method for gaining leveraged exposure to ETH’s price movements, amplifying potential returns without the typical overheads of traditional leveraged products.
• Dynamic Ecosystem Synergy: The interdependent relationship between fETH and xETH demonstrates a balanced ecosystem where the stability of one complements the volatility of the other.

fETH & xETH

The f(x) protocol introduces a dual-token system: Fractional Eth (fETH) and Leveraged Eth (xETH). This innovative structure bifurcates ETH, catering to users desiring a decentralized stablecoin and those seeking cost-effective, high-volatility exposure to leveraged ETH.

The USDC depegging event served as a wake-up call in the crypto industry, casting doubts on the reliability of even widely trusted fiat-backed stablecoins. In response, Aladdin DAO created fETH. Unlike traditional stablecoins, fETH is not tethered to a $1 peg. Instead, it mirrors ETH’s price movements at a reduced scale, offering a lower volatility profile. Most investors don’t necessarily need a stablecoin that clings rigidly to the $1 mark around the clock. fETH’s value moves 10% of Ethereum’s price changes. For instance, if ETH jumps by 50%, fETH would only rise by 5%. This design enables fETH to benefit from Ethereum’s growth without the constraints of U.S. inflation, policy, and banking risks tied to traditional USD-pegged stablecoins. You might wonder how fETH achieves this stability in a decentralized and scalable way. The answer lies in its counterpart, xETH.

xETH serves as the complement to fETH in the f(x) Protocol. xETH stabilizes fETH’s volatility, enabling a leveraged ETH token with 2-3x the price movement of regular ETH. For example, if Ethereum increases by 10%, xETH surges by 30%. Unlike traditional leveraged products, which incur financing charges or margin interest, xETH requires no holding costs, offering a unique, cost-free leverage experience.

The only downside: the leverage of xETH is constantly in flux. The leverage of xETH is tailored to counterbalance the volatility of fETH. As the supply of fETH increases, xETH’s leverage also increases to absorb these fluctuations. Conversely, when fETH’s supply diminishes, xETH’s leverage decreases accordingly. This mechanism ensures that xETH remains a responsive and dynamic leveraged product, adapting to the changing market conditions of fETH.

Essentially, F(x) splits ETH into two products, targeting two types of crypto users:

1. Low-risk users, such as DAOs planning for future liabilities and institutional investors seeking stable crypto investments.
2. High-risk users, including bullish investors and DAOs employing aggressive strategies.

At its core, the concept is straightforward. Investors from both groups pool their ETH together. Within this pool, high-risk investors create xETH, which absorbs the volatility, shielding the more conservative fETH holders. This results in the combined market cap of xETH and fETH equalling the total market cap of the original ETH reserve. Effectively, the protocol redistributes ETH’s volatility based on user demand, functioning like an asymmetrical seesaw.

Let’s consider an analogy. Imagine two real estate investors: Johnny, who is risk-averse and seeks stability, and Billy, who is bullish and embraces risk. Johnny wants a secure investment with minimal fluctuations, acknowledging that real estate usually appreciates over time. Billy, on the other hand, is eager to capitalize on a significant potential increase in property values.

At a real estate convention, they share their perspectives and devise a collaborative investment strategy. Billy proposes, “Let’s pool our resources to buy a house. We’ll sign a contract stipulating that you’ll absorb only 10% of any price changes, while I’ll handle the remaining 90%.” This arrangement lets Johnny enjoy the benefits of a stable, appreciating asset, while Billy, shouldering more risk, stands to gain higher returns compared to if he invested alone.

This scenario mirrors the f(x) protocol’s approach with Ethereum: Johnny’s cautious investment is akin to fETH, while Billy’s aggressive strategy resembles xETH. If they each invest $250,000, Johnny’s exposure is effectively $25,000, and Billy’s is $475,000, reflecting their respective risk appetites.

The f(x) protocol, starting with Ethereum, xETH, and fETH, has broader potential applications for various tokens. It also introduces a stablecoin, fUSD, pegged to $1. Unlike centralized stablecoins like USDC or USDT, which are vulnerable to banking issues, fETH is minted via ETH and balanced by xETH, offering a decentralized and scalable solution.

System Stability

In the design of f(x), a primary focus was on robust safety mechanisms, essential for protecting users’ investments. A critical element of this safety is the protocol’s stability modules, which safeguards fETH in volatile markets. A notable example is the ‘System Rebalance pool.’

Here’s how it works: when users deposit ETH to create fETH or xETH, the protocol converts the ETH into stETH, enabling the protocol to earn yield on these reserves. If the system’s collateral ratio exceeds 130%, users have the option to stake their fETH in the Rebalance pool, where they earn stETH yield. This feature is a significant draw for f(x), as it allows investors to gain stETH yield through a stable token, fETH, bypassing the direct volatility associated with holding stETH.

The Rebalance Pool effectively earns substantial stETH yield as long as the collateral ratio between stETH and fETH remains at or above 130%. But what happens in times of market turbulence when this ratio falls below 130%? Let’s explore this through a hypothetical situation.

Consider a scenario where the collateral ratio starts at 150%. In this case, the total stETH reserve is valued at $100, and the fETH market cap stands at $66. This leaves $54 in xETH to mitigate fETH’s volatility. Additionally, 80% of the fETH is staked in the Stability Pool of the f(x) system.

The system functions well until the market faces a challenge: stETH’s price drops sharply by 25%. This decrease in stETH’s value directly affects the protocol’s collateral ratio, which falls to 116%. As xETH is designed to absorb the volatility of fETH, this market shift results in a reduction of xETH’s value to $10.75. Consequently, while the collateral ratio’s decline is due to the drop in stETH, xETH’s decrease serves its purpose in cushioning fETH against this volatility.

When the stETH price drop threatens to destabilize the fETH/stETH balance, the protocol’s stability mode is activated. In this mode, the fETH staked in the Stability Pool is gradually converted into stETH. This process allows fETH stakers to effectively dollar-cost average into stETH. As this conversion progresses and the majority of the funds in the Stability Pool are redeemed, the protocol’s financial landscape shifts. We observe a new distribution: the stETH collateral value stands at $24.52, the fETH market cap adjusts to $13.87, and xETH, continuing to buffer the volatility, is valued at $10.75. These adjustments successfully elevate the collateral ratio to a safer level of 176%.

NOTE: Please note that this scenario is intentionally exaggerated to clarify the underlying mechanics of the f(x) protocol. It is not meant to be a mathematically precise depiction of the exact reactions within the protocol. The purpose is to provide a conceptual understanding of how the system responds to market changes, rather than to offer exact numerical predictions

If the Rebalance Pool fails to restore the collateral ratio, the protocol employs two alternative strategies:

1. xETH Minting Incentives: To bolster the stETH reserve and enhance its capacity to absorb volatility, the protocol may offer incentives for xETH minting. This could involve waiving minting fees or even providing rewards for minting xETH. As a result, the growth in stETH reserves strengthens the overall system.
2. fETH Redeeming Incentives: This approach encourages holders of fETH, especially those not participating in the Stability Pool, to reduce their holdings. By offering incentives for redeeming fETH, the protocol aims to manage and balance its liabilities more effectively.

What distinguishes these methods is their reliance on the protocol’s inherent fee structures and the yield from the stETH reserve. This is a significant departure from the more common governance-based or ‘sacrificial tokenomics’ approaches seen in other systems. These strategies underscore a more sustainable and integrated approach to maintaining protocol health and stability.

FXN

FXN, the governance token of the f(x) protocol, plays a pivotal role in generating real yield and has already shown success in fee generation. The protocol’s revenue sources are twofold:

1. stETH Yield from the Reserve: Of the yield generated by the stETH reserve, 37.5% is distributed to holders of veFXN (voting-escrowed FXN), and the remaining 12.5% is allocated to the protocol’s treasury.
2. Minting and Redemption Fees: Fees are levied for the minting and redemption of tokens within the protocol.

A significant benefit for FXN holders is that by locking and staking their FXN to obtain veFXN, they receive a substantial portion of the stETH reserve yield. This mechanism is advantageous for the protocol, as it negates the need to use its own FXN tokens for bootstrapping. Instead, FXN can be utilized for other strategic opportunities.

Additionally, the protocol earns revenue from fees associated with minting and redeeming tokens. The current structure includes a 0.25% fee for minting fETH and a 1% fee for minting xETH. While minting and redemption activities contribute to revenue, the majority is designed to come from the yield of the stETH reserve.

Regarding tokenomics, the allocation is as follows: 49% is dedicated to liquidity incentives, 30% to AlladdinDAO, and 10% resides in the treasury reserve:

(Source: https://docs.aladdin.club/f-x-protocol/tokenomics)

F(x) Protocol Metrics

Let’s take a look at protocol usage and metrics (metrics by @diligentdeer).

1. f(x) NAV constantly increasing, meaning people are depositing stETH/ETH to mint fETH/xETH.

2. The collateral ratio sits at a healthy 238%

3. With $2.8 million in fETH staked in the Rebalance Pool, accounting for 74% of its total market cap of $3.8 million, the protocol is well-prepared with substantial reserves to handle potential turbulent market conditions.”

Written by: Qorban Ferrell

Sources:

1. F(x) protocol docs
2. F(x) protocol metrics – Dune dash by diligentdeer
3. F(x) White Paper
4. Scalable Decentralized Stablecoins – Blocmates Podcast
5. FIP 01 – Introduction of fUSD – a hard pegged USD stablecoin
6. Flywheel #73