May 16, 2023: f(x) Protocol π§π
Aladdin DAO proposes splitting $ETH into low and high volatility derivative assets
Ancient storytellers recount the legend of Aladdin, a poor urchin who fell in love with the daughter of the sultan Badr-al-Budur. With the help of a wicked magician, Aladdin retrieved an oil lamp from a hidden cave. From this lamp, he released a powerful djinn who had the power to grant three wishes.
First Aladdin wished his wealth could grow faster than even the richest merchants in the land, and the djinn blessed him Concentrator.
Second Aladdin wished for the ability to bend time to his will and travel into the future, and the djinn created CLever.
For his third and final wish, he wished for the power reshape reality itself. The djinn thought long and hard, and provided the most powerful tool yet in f(x) protocol.
With these powers, Aladdin defeated his rivals and won the hand of the princess, whereupon two enjoyed all the pleasures and blessings that life had to offer. The tale of their adventures and the powers granted by the djinn were recounted for generations to come.
Aladdin DAO has indeed granted degens our third but hopefully not final wish. Last week they released their white paper for f(x) protocol.
Overall, f(x) protocol is an intriguing and well-considered concept which uses ETH to back two tokens, both of which may carry appeal to traders.
$fETH (Fractional ETH), a low-volatility token functioning like a stablecoin
$xETH (Leveraged ETH), a token functioning as a long perpetual future
The creation of such tokens may sound like magic, but in truth itβs an easy concept: redistribution of gains. Consider this example from the A-Teamβs highly recommended thread on the subject:
The protocol works to set the gains/losses of fETH at exactly 10% of ETH gains/losses whenever possible.
In the example above, $200 worth of ETH is divided into $100 of each token. When the price of $ETH goes up 10%, the entire bucket is now worth $220. This surplus $20 can be apportioned between $xETH and $fETH in any fashion.
Since $fETH targets 10% of raw $ETH price movements, the $fETH pile must gain a tenth of 10%, or 1%. This means the $fETH tranche pockets a $1, and the remaining $19 (19%) goes to $xETH.
Of course, if you do it in reverse, $xETH nukes harder than $ETH, in order to protect $fETH from dropping too hard.
With this simple concept in mind, the protocolβs success becomes a question of product-market fit. From the white paper, the team suggests a compelling use case for each asset.
$xETH
As they describe it in the white paper, βdemand for ETH long positions never disappears.β The illustrate this by considering the funding rate, which is almost entirely positive (green bars on the bottom).
Even in the times when it dips negative, they observe βopen interest is still so large that there is clearly still demand for longsβ
In other words⦠in bull or bear markets, degens gonna degen. We can grant that increasing leverage is always of interest to our friendly gambling community.
$fETH
The other side of f(x) protocol is the βlow volatility assetβ they describe in their white paper. As we saw above, itβs an asset that behaves like Ethereum, but with the volatility greatly reduced (10% of the gains/losses).
This 10% correlation with how asset prices move in tandem is whatβs called Ξ² (beta) in financial circles. An asset with Ξ² = 100% relative to ether would skate perfectly in sync. In contrast, USD has no correlation with ETH price movement, so it carries a value of Ξ² = 0% relative to ether. At Ξ² = 10%, the $fETH asset behaves mostly like a stablecoin, but carries a little exposure to ether volatility.
The rationale for architecting $fETH in this fashion appeals to core crypto values.
mildly deflationary (assuming continued printing)
moving crypto toward a βstablecoinβ less aligned with fiat
unaligned with centralized risk factors
In practice, imagine you promised your team youβd pay their bills in dollars and invested your teamβs $1MM seed round into $fETH instead of USD in 2020 (when ETH was $125). By 2021 ETH had done a 6x, now worth $650. The $1MM treasury is now worth $1.6MM β not the upside of raw ETH, but definitely not bad! At the start of 2022, ETH was at $3500, now your treasury is worth almost $2.5MM after two years. In this manner, youβre happy you didnβt hold it as a stablecoin.
However, what if you started two years late, and put your $1MM treasury into $ETH when its price was $3500? We now know $ETH would go on to plummet 67% into the mid thousands by yearβs end. This would become a major source of stress for the entire crypto community. Fortunately, because youβre parked in $fETH, your treasury doesnβt fare so poorly. Instead of dropping to about $300K, you still have a viable $900K instead. A bit of a haircut, but youβre better off than crypto exchanges that canβt make payroll and go out of business.
Stability
The open question is how this all functions in the wild. As you can easily imagine, periods of extreme volatility could quickly stress the mechanics β ie what happens if the price drops more than 50% and $xETH suffers complete losses.
As you might expect, therefore, the meat of the White Paper covers stability mechanics.
The basic premise of their stability system is to activate different modes based on how much leverage is in the system. As leverage grows, new constraints get imposed, like jumping to yellow and red alert under extreme conditions.
Will these stability mechanics work? Tough to say. The team are notoriously smart, but nobody has any way to know if itβs actually foolproof until it is unleashed into the wildβ¦ even the best programmers are at risk of hacks, errors in design, et al. These are the bonus risks you would accept by participating in any innovative system.
For the most part, users who have reviewed the risk mechanics are impressed by the level of detail and thought put into the problem.
The broad principle at play here is scalability. The functionality of the ecosystem depends on balancing demand for longing ETH against demand for a reduced volatility stablecoin-like asset. The protocol is resilient enough to tolerate some mismatch, but if these demands are balanced the system has the potential to scale up to billions of dollars.
Check yesterdayβs livestream with Leviathan News for more from the A Team!