Decentralized finance (DeFi) has revolutionized the way we think about traditional financial systems. In a recent thread on Twitter, Frax Finance founder Sam Kazemian announced the launch of FraxETH v2, a new protocol that allows users to lend and borrow ETH. FraxETH v2 is designed to be more efficient and decentralized than other protocols like Rocket Pool and Lido.

In the thread, Kazemian explained that FraxETH v2 works by creating a peer-to-pool lending market for:

• Users who want to lend ETH can do so by depositing it into the FraxETH v2 pool.
• Users who want to borrow ETH can do so by taking out a loan against their ETH collateral.

The interest rate for borrowing ETH is set by market forces and utilization rates. There are no hardcoded fees or commissions. This means that the interest rate will be competitive and will reflect the demand for ETH.

Kazemian also highlighted several benefits of FraxETH v2, including:

• Efficiency: FraxETH v2 is a more efficient way to stake ETH than other protocols. This is because it eliminates the need for middlemen like Rocket Pool and Lido.
• Decentralization: FraxETH v2 is a more decentralized way to stake ETH than other protocols. This is because it does not require users to trust a central authority.
• Flexibility: FraxETH v2 offers users more flexibility than other protocols. This is because users can choose to either lend or borrow ETH, depending on their needs.

Now, let’s break all these down.

Understanding the Motivation and First Principles:

At its core, all LSD (Lending-Staking-Decentralized) protocols share a fundamental structure of lending markets. Regardless of marketing strategies or incentives, lenders provide their ETH and receive receipt tokens, referred to as LSD. Borrowers, on the other hand, rent the right to operate a validator and pay interest to the lenders.

To gain a deeper understanding, let’s examine two prominent LSD protocols: Rocket Pool and Lido, through the lens of first principles.

Rocket Pool’s approach is encapsulated in the phrase “stake ETH for rETH.”

This translation is simple: lenders lend ETH and receive receipt tokens in the form of rETH. Borrowers, in turn, borrow 32ETH to operate a validator, paying interest to lenders. The mechanism is straightforward and devoid of excessive marketing jargon.

On the other hand, Lido offers a different perspective with its phrase “stake Ether.”

Here, lenders provide Lido with ETH and receive receipt tokens known as stETH, similar to lending ETH on platforms like Aave and receiving aETH. However, Lido’s borrowing side currently operates under permissioned restrictions. Nonetheless, borrowers still pay interest to lenders, maintaining a similar structure.

Designing the Most Decentralized and Agnostic LSD Protocol:

To achieve the ultimate decentralized and agnostic LSD protocol, a peer-to-pool lending market is proposed. Lenders receive LSD/stablecoin receipt tokens, while borrowers can access validators based on Loan-to-Value (LTV) ratios, reminiscent of established platforms like Aave and Compound.

The process is simple: users collateralize a minimal amount of ETH (or approved collateral in the future, subject to veFXS holders’ approval) to borrow a validator. All aspects, including withdrawal addresses and custody, remain decentralized, on-chain, and immutable — reflecting the essence of DeFi lending markets. Interest is paid directly from users’ ETH and PoS cash flows.

Dynamic Interest Rates and Profitability:

Interest rates within the frxETH v2 protocol are determined by market forces and utilization rates. Unlike protocols with hardcoded fees, frxETH v2 leverages the interplay of supply and demand. When borrowing a validator becomes inexpensive, node operators can validate, pay interest to lenders, and benefit from spreads, MEV (Miner Extractable Value), and tips. This approach presents a lucrative opportunity for sophisticated node operators.

Flexibility and Ejecting Debt:

In situations where interest rates spike, making operations unprofitable, users have the freedom to eject or repay their debt. It’s crucial to note that the debt lies within validators, rather than ETH. Consequently, users can wind down their operations temporarily until favourable rates return.

The LTV ratio, calculated as validator_value.div(collat_value+validator_value), ensures that frxETH nodes remain performant without relying on whitelists, KYC, or reputation systems.

Liquidation and Risk Management:

To maintain the health of the system, it is crucial for users to ensure their Loan-to-Value (LTV) ratio remains within a healthy range. Failure to do so may result in liquidation, also known as validator ejection. Liquidation occurs when users get slashed or exhibit misbehaviour, leading to an increase in their LTV ratio and the potential seizure of collateral. It serves as a mechanism to protect the interests of lenders and maintain the stability of the protocol. Users must monitor their collateral levels and take appropriate actions, such as adding more collateral or adjusting their operations, to avoid the risk of liquidation.

Unlocking the Potential for sfrxETH Holders:

Efficiency. That’s it!

That’s what sfrxETH holders stand to benefit from the frxETH v2 protocol. In addition to staking rewards, they now have the opportunity to earn interest on their holdings. This added incentive makes staking ETH on Frax more attractive compared to other protocols that may not offer similar interest-earning capabilities.

The combination of staking rewards and interest payments creates a compelling value proposition for sfrxETH holders. One might question whether the interest rate imposed on borrowers could discourage individuals from becoming node operators.

However, it is important to note that frxETH v2 is designed to attract sophisticated node operators who can navigate the dynamics of interest rates and generate profitable returns. By leveraging the decentralized lending market and ETH stablecoin model, frxETH v2 offers node operators the opportunity to earn significant profits while contributing to the network’s overall performance.

frxETH v2 positions itself as the most efficient and decentralized lending market, backed by validator debt and serving as an ETH stablecoin. It also provides a highly programmable base layer for building innovative projects within the DeFi ecosystem. The protocol introduces various innovations, including utilizing idle ETH for liquidity and earnings through the Curve AMO. Moreover, the beacon oracle, powered by zk proofs, ensures complete decentralization and eliminates the need for administrative keys or trusted entities.

Conclusion:

frxETH v2 represents a significant evolution in decentralized lending markets and ETH stablecoins. By adhering to first principles and leveraging a peer-to-pool lending market structure, the protocol offers a unique and versatile ecosystem for both lenders and borrowers. With its decentralized nature, agnostic approach, and programmable capabilities, frxETH v2 sets the stage for a new era of decentralized finance. As the industry continues to evolve, frxETH v2 is poised to make a lasting impact and redefine the way we perceive and participate in the world of DeFi.

Question: Would there be an increase in APR for lenders?

Answer: Yes, it is expected that there would be an increase in APR for lenders. This is because FraxETH v2 is a more efficient and decentralized way to stake ETH. As a result, there will be more demand for ETH, which will drive up the interest rate.

Question: Is it permissionless to borrow a validator and could one run in parallel with a rocket pool rig?

Answer: Yes, it is permissionless to borrow a validator and you can run it in parallel with a Rocket Pool rig. FraxETH v2 is more agnostic than any other LSD protocol, meaning that you can run whatever kind of validator/client/software you want with your borrowed validator as long as your LTV is healthy and are paying interest.

Question: So I can run a validator without having 32 ETH?

Answer: Indeed. FraxETH v2 allows you to run a validator without having 32 ETH. This is because you can borrow 32 ETH from the FraxETH v2 pool. This is a powerful feature that makes FraxETH v2 a more accessible and inclusive way to participate in the Ethereum network.

Question: Does that mean, for sfrxETH holders, they now get the interest rate on top of the staking reward? This way, staking ETH on Frax is more attractive than staking in other protocols.

Answer: Yes, sfrxETH holders will now get the interest rate on top of the staking reward. This makes staking ETH on Frax more attractive than staking in other protocols.

Question: Does the interest rate serve as a disincentive for node operators?

Answer: Contrary to being a disincentive, the interest rate within frxETH v2 acts as a mechanism to attract sophisticated node operators. By offering the opportunity to generate significant profits through validation, frxETH v2 entices skilled operators to participate. The protocol’s agnostic nature allows node operators to utilize their preferred validators, clients, or software as long as their Loan-to-Value (LTV) ratio remains healthy, and they fulfil their interest obligations. The potential profitability and flexibility make frxETH v2 an appealing choice for node operators, driving the decentralization of validation processes and redistributing the means of validation.