How to break down ETH volatility? Dismantling of F_X_ New Stable Assets and Leverage Scheme

Question

> As the latest work of AladdinDAO, the f(x) protocol splits ETH into two new derivative tokens: fETH and xETH.

Written by: Go2Mars Research

As the latest work of AladdinDAO, the f(x) protocol splits ETH into two new derivative tokens: fETH and xETH. fETH is a low-beta near-stable coin with little price volatility and no risk of centralization, which can effectively meet the needs of decentralized finance (DeFi).

xETH is a high-β leveraged long-term ETH perpetual contract, which can provide a powerful decentralized on-chain trading tool. Both tokens are issued and redeemed entirely based on ETH as collateral, thus maintaining the decentralization and native features of Ethereum.

Simply put, the f(x) protocol allows users to use ETH to generate fETH and xETH, and then use these two tokens to enjoy different degrees of ETH price changes. The price of fETH will only follow 10% of the change in the price of ETH, which means it has a beta coefficient of 0.1. The price of xETH will reflect the price change of ETH that fETH does not reflect, which means it has a beta coefficient greater than 1. In this way, fETH is equivalent to a floating stablecoin, and xETH is equivalent to a leveraged long-term investment tool.

AladdinDAO

AladdinDAO is a DAO composed of DeFi experts, aiming to screen high-quality DeFi projects and provide community members with high-yield investment opportunities. In the Curve War, a war for CRV voting rights, AladdinDAO launched two new tools: Concentrator and Clever, to help users win more profits and influence.

Through these two tools, AladdinDAO not only provides users with an opportunity to easily obtain high returns, but also provides a solution for DAO to manage treasury funds without the multi-signature process. At the same time, these two tools have also enhanced Convex's voice in Curve War, thereby influencing the development direction of Curve's ecology.

Since the USDC crisis, the core members of AladdinDAO have re-examined the shortcomings of stablecoins in the current market, and proposed a new solution, which is the f(x) protocol.

Stablecoins

Before discussing the f(x) protocol, let's first review the definition of a stablecoin:

A stablecoin is a digital currency whose value is pegged to another currency, commodity or financial instrument in order to reduce price volatility compared to other volatile cryptocurrencies such as Bitcoin.

The primary role of stablecoins is to provide liquidity and stability in the cryptocurrency market as a store of value and medium of exchange. Most stablecoins are anchored to the U.S. dollar or other fiat currencies, which makes them easy to interact and exchange with the traditional financial system. However, from a crypto-native perspective, if the crypto world continues to grow and grow, stablecoins are relatively inflated because they fail to capture the appreciation of cryptocurrencies relative to fiat currencies. Therefore, stablecoins may lose their attractiveness and competitiveness, and more people will seek an asset that can follow the development of the crypto market.

There are currently three main types of stablecoins: legal currency support, some algorithmic stablecoins, and CDP algorithmic stablecoins.

Purely algorithmic (uncollateralized or undercollateralized) stablecoins, such as Terra's UST, are the most obvious type of risk, as they are difficult to guarantee safe and reliable, and are not suitable as long-term options. It then divides existing stablecoins into three broad categories:

Fiat-backed stablecoins (such as USDC, USDT), which rely on third-party institutions to maintain fiat currency reserves, but also face the risk of centralization.
Algorithmic, but partially or fully fiat-backed stablecoins (such as DAI, FRAX), which are also subject to the centralization risk of fiat-backed stablecoins.
Fully decentralized CDP algorithm stablecoins (such as LUSD), which only accept decentralized collateral, but still need to be improved in terms of scalability and capital efficiency.

Therefore, the goal of the protocol is to create stable assets that can improve capital efficiency and scalability while maintaining low volatility, thus introducing two assets, fETH and xETH. In traditional finance, beta is a measure of the volatility of a given security or portfolio. compared to the market. Since fiat is the denominator of these measures, cash has beta = 0, and a portfolio with beta = 1 will perfectly reflect market returns (eg S&P 500 ETF). Portfolios that move in the same direction as the market but by a relatively small amount have β < 1, while portfolios that move in the same direction more than the market have β > 1.

In the f(x) protocol, the price of ETH is defined as the market, and β is a measure of the volatility of a given cryptocurrency relative to ETH. The β of ETH itself is 1, while the β of the perfect stablecoin is 0. Asset X has a target beta of 0.5, meaning it only reflects 50% of the change in the price of ETH.

How the protocol works

Keep f(x) invariant by adjusting the NAV (Net Asset Value) of fETH and xETH, namely:

The protocol then calculates a new NAV for xETH according to the f(x) invariant:

In this way, xETH captures all the ETH price movement that fETH masks out, thereby providing leveraged returns.

Fractional ETH - Low Volatility Asset / "Floating" Stablecoin

At the beginning of the protocol, the price of fETH is set at $1. The protocol controls volatility by adjusting fETH's NAV so that it only reflects 10% of ETH price changes (ie β_f = 0.1). When the price of ETH changes, the NAV of fETH will be updated according to the following formula:

where rETH is the rate of return of ETH between time t and t-1.

The advantages of stablecoins are mainly reflected in low price volatility, low inherent risk, and deep liquidity. fETH is a low-volatility asset, and its β=0.1 means that its price change is only one-tenth of the ETH price change. In this way, fETH can avoid the risk of centralization while capturing the growth or decline of a part of the ETH market.

Compared with traditional stablecoins, the issuance of fETH is based on market demand rather than CDP demand, and is only limited by the supply of xETH (xETH is a token that can absorb fETH fluctuations and provide leveraged returns), so it has more High scalability and capital efficiency. fETH can be regarded as a way of anchoring to ETH, but it does not maintain a fixed or close to fixed ratio like the traditional anchoring method, but is adjusted according to β = 0.1.

Overall, fETH as a store of value and medium of exchange provides liquidity and stability in the cryptocurrency market while retaining some of the market's growth potential.

Leveraged ETH

Leveraged ETH, also known as xETH, is a decentralized, composable leveraged long ETH futures contract with low liquidation risk and zero funding costs (in extreme cases, xETH minters can even earn fees), Designed as a companion asset to fETH. xETH holders collectively bear most of the fluctuations in fETH supply, and by using the f(x) minting and redemption modules or off-the-shelf on-chain AMM liquidity pools, traders can change positions as they please.

fETH can be minted and redeemed on immediate demand as long as there is sufficient xETH supply to absorb the volatility of fETH. The leverage ratio of xETH is variable, so a relatively small amount of xETH can support a large amount of fETH.

The leverage ratio calculation of xETH

Determined according to the following formula:

If the amount of fETH minted is 0, then $$\lambda_f=0, L_x=1$$, xETH becomes a perpetual contract with double long ETH.

The actual effective leverage of xETH tokens varies over time as the relative supply of xETH and fETH are minted and redeemed. The higher the supply of xETH relative to fETH, the lower the effective leverage of xETH, as the excess volatility of fETH is spread across more tokens. Conversely, a larger supply of fETH concentrates volatility on fewer xETH tokens, resulting in higher effective leverage.

System Stability

Since xETH is used as an asset for hedging fETH, the more xETH there is, the more stable the system will be. If we regard the total ETH reserve as the collateral of the CDP, and the total fETH supply represents the loan amount, then we can use the Colletral Ratio similar to the CDP system to monitor the health of the system. For the f(x) protocol, we can define CR is as follows

Whether it is minting fETH or xETH, or adjusting the net asset value of the two tokens, it will affect the value of CR. If the system CR falls to 100%, it means that the value of xETH is zero. At this time, the β value of fETH is 1, which means It will be fully exposed to the price fluctuations of ETH, and will no longer exist as a low-volatility asset. Therefore, f(x) has designed a four-level risk management module for risk control.

Wind control

The risk control system of f(x) is a four-level module, which is used to take corresponding measures to maintain the low volatility of fETH and the positive net asset value of xETH when the mortgage rate (CR) of the system drops to a certain threshold. Thereby improving CR. These measures include:

**Stable mode: ** When CR is lower than 130%, the minting of fETH is prohibited, the redemption fee of fETH is canceled, the redemption fee of xETH is increased, and additional rewards are given to minters of xETH.
**User balance mode: **When CR is lower than 120%, users are encouraged to redeem fETH to increase the mortgage rate of the system, and additional rewards are given to redeemers.
**Protocol balance mode: **When CR is lower than 114%, the protocol will automatically use the ETH in the reserve to buy and destroy fETH in the market to increase the mortgage rate of the system.
Re-capitalization: In the most extreme cases, the protocol has the ability to re-capitalize by issuing governance tokens to raise ETH, either by minting xETH or buying and redeeming fETH.

Earnings

The revenue of the f(x) protocol is achieved by charging fees to the minting and redemption of fETH and xETH. These fees are an operational parameter and will be determined at launch. Additionally, when the risk management module kicks in, holders of fETH are also required to pay stability fees, which are distributed to other users who help balance the system, or to the protocol itself.

β - the key parameter to adjust volatility

In order to better understand the impact of β on assets, we will analyze and evaluate the change of β from 0 to 1 from three different perspectives: value store, transaction medium and encryption native. These three perspectives cover the main functions and characteristics of the assets, as well as their place and role in the cryptocurrency market.

Store of Value

From the perspective of a store of value, as β goes from 0 to 1, the value stability of assets gradually decreases, because they are more and more affected by market fluctuations. Stablecoins (β = 0) can maintain the same purchasing power as fiat currencies, while ETH (β = 1) will increase and decrease as the market rises and falls. fETH (β = 0.1) is in between, and it preserves some of the market's growth potential while limiting volatility.

Transaction Medium

From the perspective of the medium of exchange, as β goes from 0 to 1, the liquidity and scalability of assets gradually increase, because they are more and more in line with the needs and characteristics of the cryptocurrency market. Stablecoins (β = 0) can be easily exchanged with fiat currencies, but there are also centralization risks and trust issues. ETH (β = 1) is a fully decentralized and Ethereum-native asset, but also suffers from high volatility and price uncertainty. fETH (β = 0.1) is in between, it avoids centralization risk while maintaining low volatility and high liquidity.

encrypted native

From a crypto-native perspective, as β goes from 0 to 1, the degree of decentralization and innovation of assets gradually increases, as they increasingly embody the spirit and value of cryptocurrencies. Stablecoins (β = 0) are assets anchored to fiat currency, and they rely on the support and supervision of traditional financial systems and institutions. ETH (β = 1) is the native asset of the Ethereum network, a leader and innovator in the cryptocurrency space. fETH (β = 0.1) is a new type of asset created based on the f(x) protocol. It is a low-volatility, decentralized, scalable, native Ethereum asset. It is paired with xETH, which is a High volatility, leveraged, perpetual contract tokens.

Assumptions in extreme market situations

Let's explore the performance of fETH in extreme market conditions and compare it to the centralized stablecoin USDT. If you are looking for a short-term hedging tool and hope to maintain low volatility, then USDT may be more suitable because it can maintain a fixed conversion ratio with fiat currency. However, if a long-term store of value is sought, fETH may be a better fit. The relationship between fETH and ETH is relatively stable, and it can follow the growth of the cryptocurrency market without being affected by the depreciation of legal currency. Importantly, fETH has a certain degree of resilience, and even in the case of violent fluctuations in ETH price, it can maintain low volatility through the risk management module to achieve its goal of β=0.1.

To illustrate with a practical example: Suppose the current price of ETH is 2000 US dollars, and the price of fETH is 1 US dollar (that is, the NAV of fETH is equal to 1 US dollar). If the price of ETH falls to $900, the price of fETH will drop by about 10% to $0.9. Despite the depreciation relative to fiat currencies, fETH still maintains low volatility. If ETH is expected to rebound in the long term, or fiat currencies continue to depreciate, then fETH can serve as a mildly deflationary currency to store value. In contrast, although USDT can maintain a fixed exchange rate with fiat currency, it cannot resist the risk of devaluation of fiat currency, and there are centralization risks, such as banking crisis or regulatory intervention. Therefore, fETH and USDT have their own advantages and disadvantages, and you need to choose according to your own needs and expectations

Summarize

In general, the positions of fETH and xETH in the Ethereum ecosystem and their future development trends are not isolated, but will be closely affected by market demand and trader behavior. Market demand is determined by a combination of factors, such as the price trend of Ethereum and the overall cryptocurrency market conditions. The behavior of traders is determined by multiple factors such as their expectations of market trends, risk tolerance, and their understanding and emphasis on the value of decentralization and composability. These factors are intertwined and jointly shape the roles and development prospects of fETH and xETH in the Ethereum ecosystem. Therefore, to predict and understand the development trend of fETH and xETH, it is necessary to deeply explore the changes in market demand and trader behavior, understand how they interact, and jointly affect the status and development direction of these two assets in the Ethereum ecosystem.

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