f(x) Protocol (FXN): A comprehensive overview of a protocol that reinvents DeFi

Introduction

The cryptocurrency market as we know it today would probably not exist without stablecoins. Whether it's for securing profits, providing liquidity in decentralized finance, or even enabling cross-border transfers, stablecoins are absolutely essential to web3.

Over the years, multiple models have emerged, but centralized stablecoins backed by physical assets, such as Tether's USDT or Circle's USDC, have ultimately come to dominate the market. This raises a fundamental contradiction with the principles of DeFi.

More or less decentralized alternatives exist, but they are often unattractive due to their lack of stability (e.g., LUSD), their high capital requirements (e.g., DAI), or their absence of true decentralization (e.g., USDe).

The goal of f(x) Protocol is to offer a truly decentralized and reliable stable asset while providing yields derived from DeFi.

Key Information

• f(x) Protocol provides a solution for decentralized stable assets integrated with DeFi.
• f(x) Protocol uses a system fully collateralized by cryptocurrencies, such as stETH.
• f(x) Protocol also issues leveraged assets designed to absorb the volatility of stablecoins.

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The Thesis Behind f(x) Protocol

When discussing the stablecoin market, it’s difficult to avoid the associated trilemma. The stablecoin trilemma states that an asset can, at best, combine only two of the following three characteristics:

1. Decentralization: The asset is not controlled by a single entity.
2. Stability: The asset’s value closely tracks the fluctuations of its reference index.
3. Capital Efficiency: The asset is considered efficient if it does not require more capital than its own value.

According to the stablecoin trilemma, creating a decentralized stablecoin with stable value inevitably sacrifices capital efficiency. In practice, this means decentralized stablecoins require much more capital than their own market capitalization.

For instance, the Liquity protocol requires users to deposit ETH to borrow LUSD stablecoins. The deposited ETH serves as collateral to ensure the borrower will repay their debt. To protect against ETH's volatility, the protocol imposes margins to cover potential defaults. Currently, each LUSD issued is backed by about five dollars’ worth of ETH. This system is decentralized and stable but very capital-inefficient.

In reality, f(x) Protocol does not propose to solve the stablecoin trilemma but introduces an innovative solution that combines decentralization, stability, and efficiency. The idea is that each stable asset is paired with a second, highly volatile asset designed to absorb the collateral’s excess volatility.

At any time, each stable/volatile pair is 100% collateralized by assets deposited in the pool. The price movements of this collateral are distributed between the stable asset and the volatile asset.

This mechanism creates a market enabling:

• A decentralized stable asset offering yield.
• A leveraged volatile asset without liquidation risk or holding costs.

This system is adaptable to any type of asset. As a result, f(x) Protocol offers a truly decentralized solution that is more capital-efficient than traditional decentralized stablecoins while providing speculators with less restrictive leveraged products.

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Origin of f(x) Protocol

Founded in 2021, Aladdin DAO is the organization behind the development of f(x) Protocol. Aladdin DAO brings together various Web3 developers with the goal of creating useful tools for decentralized finance. During the golden age of DeFi in 2021, Aladdin DAO developed two protocols focused on the Curve ecosystem:

• Concentrator: Automatically reinvests funds deposited on Curve, Convex, and f(x) Protocol.
• Clever: Provides leverage without liquidation on Convex's $CVX and its yields.

Today, these two protocols are in decline, mainly due to the decreasing popularity of the Curve ecosystem. Thus, f(x) Protocol is Aladdin DAO’s third project, marking a significant turning point as it is the first time they have proposed an independent solution not relying on other protocols.

Launched in August 2023, f(x) Protocol introduced its first pseudo-stable asset called fETH and its volatile counterpart, xETH. In the following months, several other stable assets were launched, including fxUSD. To date, f(x) Protocol remains a niche DeFi project but has managed to attract a TVL of over $50 million within 15 months of its launch.

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Architecture and Technology

Currently in its v1 iteration, f(x) Protocol offers several stable assets with somewhat complex names: fETH, fxUSD, rUSD, cvxUSD, btcUSD. While each has unique characteristics, which will be detailed later, they all operate on a broadly identical model involving a pool and a safety mechanism.

The Pool

As mentioned in the introduction, the solution adopted by f(x) Protocol for capital efficiency involves pairing each stable asset with a volatile token that absorbs the collateral’s excess volatility. Each stable/volatile pair is always 100% collateralized by a liquidity pool containing a single asset. There are no restrictions on the nature of this asset, except that it should ideally generate yield. For illustration, let’s consider a fictional token called TOKEN.

Any user can deposit TOKEN into the pool and choose to receive an equivalent amount of either a stable asset, named here fTOKEN, or a volatile asset, named xTOKEN. At any time, the total value of the TOKEN deposited in the pool equals the sum of the value of the fTOKEN and xTOKEN.

Let’s assume there are currently 100 TOKEN deposited in the pool, each worth $10, resulting in a total TVL of $1,000. These funds are distributed as follows:

• 500 fTOKEN, valued at $1 each, totaling $500.
• 500 xTOKEN, valued at $1 each, also totaling $500.

As long as TOKEN’s price remains stable, the value of fTOKEN and xTOKEN does not change. However, if TOKEN’s price fluctuates, the protocol redistributes this volatility between the two tokens.

As long as TOKEN's price remains stable, the value of fTOKEN and xTOKEN does not change. However, if TOKEN's price fluctuates, the protocol redistributes this volatility between the two tokens.

Let’s suppose TOKEN’s price increases from $10 to $12, raising the total value of TOKEN deposited in the pool from $1,000 to $1,200:

• The 500 fTOKEN retain their fixed value of $1 each, totaling $500.
• The 500 xTOKEN absorb the entire $200 gain. Since their quantity remains fixed, their unit value increases to $1.40, representing a 40% rise, even though TOKEN’s price only rose by 20%.

It is crucial to note that the xTOKEN absorbs all the pool’s volatility, both upward and downward. This means that while it can generate significant gains, it also exposes holders to larger losses compared to a direct spot purchase of the underlying asset.

This unique system allows for the creation of a perfectly secured stable asset and a leveraged volatile asset while maintaining decentralization. Furthermore, positions are always 100% collateralized, ensuring they can be closed at any time to retrieve the underlying asset.

Stability Mechanism

For this model to function properly, it requires a balance between fTOKEN and xTOKEN. If the number of fTOKEN becomes too high, the xTOKEN would become extremely volatile, to the point where it could no longer absorb price fluctuations effectively. Conversely, if the number of xTOKEN is too high, their volatility would be too low, significantly reducing the incentive to use f(x) Protocol.

In practice, the ratio between xTOKEN and fTOKEN is dynamic. It varies depending on the additions or withdrawals of collateral made by users. This fluctuation implies that xTOKEN provides leverage that evolves over time. Currently, this leverage oscillates between x1.25 and x2, although some pools allow leverage up to x5.6.

To keep this leverage within acceptable bounds, f(x) Protocol has introduced several defensive mechanisms, the most crucial of which is the Stability Pool. Each fTOKEN/xTOKEN pair has its dedicated Stability Pool, where users can deposit their fTOKEN. In the event of an excess of fTOKEN in a pool, the Stability Pool reduces their quantity by burning the fTOKEN it holds to recover the underlying asset, TOKEN. The recovered assets are then redistributed to users who deposited their fTOKEN in the Stability Pool.

To encourage users to deposit their fTOKEN in the Stability Pool, it is rewarded with several incentives. These include emissions of FXN tokens and, more importantly, the entirety of the revenue generated by the pool’s collateral.

In the event of a major imbalance where the Stability Pool cannot rebalance the pool, an automatic mechanism is triggered. It relies on two main measures:

1. A significant increase in fees for burning xTOKEN and a temporary halt to minting fTOKEN.
2. Temporary bonuses, funded by f(x) Protocol’s treasury, are offered to incentivize the minting of xTOKEN and the burning of fTOKEN.

Since its launch, the Stability Pool’s redemption process has been activated only once, in November 2024, when a user holding a significant share of xeETH decided to close their position. This rare intervention highlights the robustness of the system in place and its ability to effectively handle critical situations.

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The Different Assets Offered by f(x) Protocol

Now that the general model of f(x) Protocol has been presented in detail, it is time to quickly examine the unique features of the different assets offered in the protocol’s v1.

fETH/xETH

This was the first pool to be launched and is collateralized by stETH on Lido, providing a revenue source for the Stability Pool. The unique feature of this pool lies in its volatility distribution: 10% for fETH and 90% for xETH. Thus, fETH is not entirely stable but only pseudo-stable. Holding fETH nevertheless allows users to benefit from a very low-volatility asset, ideal for securing long-term gains. It offers a DeFi alternative to the U.S. Dollar, independent of central bank decisions, and based on the Ethereum ecosystem.

fxUSD/(xstETH + xfrxETH)

fxUSD is a stablecoin pegged to the value of the U.S. Dollar and generates yield from liquid staking for fxUSD deposited in the Stability Pool. It is collateralized by two xTOKENs: stETH from Lido and frxETH from Frax. These two xTOKENs each have their own pool, with slightly different ratios and thus leverage levels, allowing speculators to choose the pool best suited to their needs. The fTOKENs generated from these pools are deposited into a common pool that serves as collateral for issuing fxUSD.

In this way, fxUSD is backed by two other stable tokens, reducing the number of tokens to manage, simplifying their use, and promoting their integration into other DeFi protocols. However, this model works only with assets that are relatively similar in terms of volatility.

Note on Risk : A fxUSD engaged in a Stability Pool is guaranteed only by the collateral of that specific Stability Pool, which reduces systemic risk exposure.

Note: Technically, it would be possible to add any asset to fxUSD. However, since fxUSD’s value is guaranteed by these underlying assets, their selection must be made carefully to maintain a credible and secure asset for DeFi.

With a total value locked (TVL) of $13.5 million, fxUSD is currently the flagship product of f(x) Protocol, and its adoption is expected to grow further with the launch of v2.

rUSD/(xeETH + xezETH)

rUSD operates on the same principle as fxUSD, but here, liquid staking tokens are replaced with liquid restaking tokens. This choice involves slightly higher risk but allows rUSD holders in the Stability Pool to benefit from the combined yields of staking and restaking, as well as rewards offered by various protocols, while still maintaining a stable asset.

Concentrator offers a pool called arUSD (auto-compounding rUSD), which reinvests the gains generated automatically.

cvxUSD/xCVX

cvxUSD is a stable asset collateralized by CVX tokens staked on Convex. It is the first stable asset proposed by f(x) Protocol based on a relatively volatile asset, thus demonstrating the flexibility and adaptability of f(x)’s model. CVX tokens generate an annual yield of about 20%, distributed to cvxUSD holders in the Stability Pool. Additionally, xCVX holders benefit from leverage on the CVX token without liquidation risk or holding costs.

btcUSD/xWBTC

btcUSD is a stable asset whose value is guaranteed by wrapped BTC. Unlike other stable assets, WBTC does not naturally generate yield, which presents a challenge for attracting deposits into the Stability Pool. To address this issue, f(x) Protocol has introduced a funding rate system similar to that of perpetual markets. This mechanism adjusts fees based on borrowing costs on Curve between crvUSD and WBTC, ensuring fair fees for xWBTC holders.

Conclusions on v1

After more than a year of existence and five stable assets introduced, f(x) Protocol has demonstrated the robustness of its model. It remains very flexible and easily adaptable to different types of collateral.

However, the v1 of f(x) Protocol presents certain limitations. The demand for xTOKEN and fTOKEN must be regulated to maintain balance. Additionally, the floating leverage of xTOKEN can create uncertainty and discourage some investors.

Thus, f(x) Protocol addresses these issues by proposing a solution that is both elegant and effective, paving the way for significant improvements in its next version.

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f(x) Protocol v2

Proposed in October 2024, the whitepaper for f(x) Protocol v2 addresses the limitations of v1, launched the previous year. The proposed solution retains the overall model with two assets backed by a single pool and a Stability Pool to ensure stability but redefines how assets move between these components. These improvements rely on three main modifications: xPOSITIONs, fixed leverage, and flashloans. These changes also impact the Stability Pool, whose role is redefined.

xPOSITION and fixed leverage

In v1, the ratio between the stable asset and the volatile asset fluctuates based on the issuance and destruction of the two assets, according to current market demand. These variations are the root cause of the fluctuating leverage of xTOKEN. When the pool contains a large number of xTOKEN, leverage is low; conversely, a small number of xTOKEN leads to high leverage.

v2 resolves this issue by introducing the possibility of fixing the ratio between the two assets, thereby maintaining stable leverage over time. For every leveraged position, there exists a fixed number of stablecoins in the market.

However, each level of leverage requires different ratios, which would theoretically necessitate the use of separate pools. To avoid this problem and preserve unified liquidity, f(x) Protocol v2 introduces xPOSITIONs, an evolution of xTOKEN. Unlike xTOKEN, which are fungible, xPOSITIONs have specific parameters, particularly in terms of leverage and deposited amount, while still being backed by the same pool and the same collateral.

Let’s consider the fxUSD/xstETH pool, collateralized by stETH, with two traders, Alice and Bob:

• Alice holds an xPOSITION worth $1,000 with x5 leverage, meaning the pool has also issued $4,000 fxUSD.
• Bob holds an xPOSITION worth $1,000 with x10 leverage, implying the pool has issued $9,000 fxUSD.

In total, this hypothetical pool has a TVL of $15,000, composed of $2,000 in xPOSITIONs and $13,000 in fxUSD. As in v1, xPOSITIONs absorb the pool’s volatility. However, unlike in v1, these variations are not distributed equally among the different xPOSITIONs.

In this example, if the value of stETH increases by 10%, this represents a $1,500 gain for the pool, distributed as follows: two-thirds go to Bob, and the remainder to Alice. This concretely means Bob’s xPOSITION will double in value, while Alice’s will increase by 50%, due to the differences in leverage. As always, leverage amplifies gains on the upside but also amplifies losses on the downside.

In this way, f(x) Protocol v2 allows traders to open speculative positions with leverage of their choice while guaranteeing that this leverage remains fixed over time and without liquidation or financing fees. This is achieved while maintaining unified liquidity, making the system more flexible and attractive to users.

Flashloan

This model is effective at solving the limitations of v1. However, it has a drawback: for the pool to remain balanced and leverage to remain fixed, the amount of fxUSD in the pool must be proportional to the total xPOSITIONs. This means that any opening of an xPOSITION requires the creation of an equivalent amount of fxUSD.

To revisit the previous example, if Alice wishes to open an xPOSITION worth $1,000 with x10 leverage, this implies that 9,000 additional fxUSD must be created to balance the xPOSITION. This poses a problem, as Alice probably neither needs fxUSD nor has the capital required to acquire it.

f(x) Protocol v2 resolves this issue by leveraging a flashloan mechanism. A flashloan is an instantaneous loan without a limit on amount or collateral, which must be repaid in the same transaction in which it is initiated. If the loan is not repaid immediately, the transaction fails, and the loan is simply not granted. Flashloans are frequently used to perform arbitrage on DEXs.

In this case, f(x) Protocol v2 uses flashloans in an innovative way. To revisit the example of Alice wishing to open an xPOSITION with x10 leverage, here’s how it works: Alice deposits $1,000 worth of stETH into the pool and simultaneously initiates a flashloan for $9,000 USDC, which is converted into stETH and deposited into the pool. This allows the opening of the xPOSITION while minting the 9,000 fxUSD required.

These fxUSD are then sold for USDC on the secondary market to repay the flashloan. Finally, with only $1,000 in initial capital, Alice is able to open an xPOSITION while generating $9,000 in additional fxUSD.

When closing an xPOSITION, the reverse occurs. A flashloan borrows USDC to repurchase the required amount of fxUSD. The xPOSITION and the fxUSD are destroyed in exchange for stETH collateral, part of which is sold to repurchase USDC and repay the flashloan. The remainder of the stETH is returned to the user and corresponds to the final result of their leveraged position.

A positive side effect of using flashloans is that each opened xPOSITION creates a larger volume of fxUSD, which greatly improves fxUSD’s liquidity, facilitates its adoption, and allows users to acquire fxUSD without having to open xPOSITIONs themselves.

Stability Pool v2

In v1, the Stability Pool’s role was to rebalance the ratio between fTOKEN and xTOKEN in cases of an overabundance of fTOKEN. While useful, this mechanism was only activated once. In v2, the Stability Pool retains this stabilizing role but now plays a more active role in position management. Although v2 introduces fixed leverage for xPOSITIONs, this leverage can vary slightly within a defined interval. The role of the Stability Pool v2 is to keep these leverage levels within acceptable limits and to protect fxUSD’s stability.

The Stability Pool v2 consists of fxUSD and USDC deposited by users. Since v2 involves significant swaps during xPOSITION openings, this can lead to abnormal price variations for fxUSD. In such cases, the Stability Pool uses its funds to buy or sell fxUSD to correct these discrepancies. This arbitrage activity generates additional income for Stability Pool users, in addition to the collateral-based income already present in v1.

The Stability Pool also balances xPOSITIONs and fxUSD. Maintaining a fixed leverage requires the fxUSD/xPOSITION ratio to remain stable. However, price changes in the collateral can disrupt this balance. When leverage approaches levels that could threaten a position, f(x) Protocol rebalances the quantity of circulating fxUSD.

This mechanism destroys a portion of the fxUSD held by the Stability Pool to recover stETH, which is sold for USDC and redeposited into the Stability Pool. This resets the leverage level to its intended value, avoids liquidation, and maintains the user’s market exposure.

This system also introduces the possibility of xPOSITION liquidations. Liquidation may occur if rebalancing fails. In such cases, the xPOSITION is automatically closed, the Stability Pool destroys the required amount of fxUSD to maintain balance, and the xPOSITION’s collateral is sold for USDC, which is returned to the Stability Pool.

In the case of major issues or bad debt, f(x) Protocol has additional security measures, such as using reserve funds supplied by a portion of protocol fees. If this is insufficient, governance can decide to recapitalize the pool using funds from f(x) Protocol’s treasury.

Conclusion on v2

The new model introduced by f(x) Protocol v2 effectively resolves the issue of fluctuating leverage while preserving the core advantages of v1 in terms of decentralization and stability. It also enables the use of fixed leverage without maintenance fees or liquidation, offering an attractive solution for traders.

Furthermore, the use of flashloans enhances the overall liquidity of fxUSD and marginally increases Stability Pool revenues. This strategy will provide sustainable yields over time as it correlates to f(x) Protocol’s real usage, TVL, and market volatility without requiring the protocol to act as the counterparty for traders, as is often the case in decentralized perpetual DEXs. f(x) Protocol v2 is thus a credible competitor to current stablecoin solutions as well as leveraged trading options.

These improvements could play a key role in the future expansion of f(x) Protocol, which aims to integrate further into the Ethereum ecosystem and its Layer 2 solutions in the coming years.

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FXN: The Native Cryptocurrency of f(x) Protocol

Launched in September 2023, one month after the launch of f(x) Protocol, FXN is the platform’s native token. It serves four main purposes:

• Governance: Allows holders to vote on decisions regarding the project’s future.
• Gauges: Enables voting on the allocation of FXN token emissions.
• Boost: Offers additional yields in the Stability Pools and Curve pools for stablecoins.
• Fees: Captures 75% of the revenue generated by the protocol.

All these features are accessible only to holders who choose to lock their FXN tokens into veFXN. The amount of veFXN received is proportional to the locking duration, which can range from one week to four years. In summary, the longer a user locks their FXN, the more veFXN they receive, increasing their influence over votes and revenue distribution.

Gauges

Each week, veFXN holders can vote for the Stability Pools or liquidity pools they wish to receive FXN emissions. The amount of FXN allocated to each pool is proportional to the number of veFXN votes it receives.

Boost

The FXN tokens distributed to Stability Pools are allocated to users based on the amount of liquidity they have deposited. However, veFXN holders can boost their FXN rewards up to a maximum factor of x2.5, significantly increasing their yields.

Fees

The protocol generates fees through the minting and burning of tokens. Seventy-five percent of these fees are distributed to veFXN holders, while the remaining 25% are placed in a reserve to fund incentives in cases of significant pool imbalances.

FXN Distribution

The maximum number of FXN in circulation is capped at two million tokens, with issuance spread over 48 years, until 2071.

f(x) Protocol has chosen not to involve venture capitalists, allocate tokens to the team, or distribute more than 50% of FXN to the community. This distribution occurs primarily through liquidity incentives, airdrops for users of Clever and Concentrator, as well as rewards for content creators within the community.

The team is compensated through FXN emissions from the treasury, as well as tokens from other Aladdin DAO projects (ALD, CLEV, and CTR).

Notably, 30% of FXN’s supply is held by Aladdin DAO ($ALD), which locks these tokens for four years. These tokens will therefore never be sold.

Integration into the Ecosystem

Aladdin DAO’s close ties with the Curve ecosystem have naturally facilitated f(x) Protocol’s integration into numerous liquidity pools on Curve. This integration extends to related protocols, such as Convex, StakeDAO, and Concentrator, all of which offer liquid staking solutions for FXN.

Beyond the Curve ecosystem, f(x) Protocol is also integrated into other DeFi protocols, such as Beefy, Morpho, and Spectra, further strengthening its compatibility and adoption within the Ethereum ecosystem.

Treasury

f(x) Protocol’s treasury is primarily composed of FXN tokens, representing a total value of approximately $25.5 million. Of these assets, $4.5 million is currently available for team compensation or project development.

The remaining assets in the treasury are primarily deposited on Curve, where they are used to provide liquidity, particularly to facilitate exchanges between FXN, ETH, and sdFXN (StakeDAO’s liquid FXN token).

Please note that this information is taken from the financial and on-chain data provider, Octav. For greater transparency, the f(x) Protocol treasury can also be accessed at the following address on Ethereum: 0x26B2ec4E02ebe2F54583af25b647b1D619e67BbF.

Conclusion

v2 of the f(x) Protocol introduces major improvements, notably in leverage management for traders, while optimizing stablecoin liquidity. The integration of flashloans and the evolving role of the stability pool are crucial innovations to reinforce stability and encourage adoption of the protocol.

Although still in its infancy, f(x) Protocol has what it takes to position itself as a key player in the future of DeFi. By offering advanced solutions in two key sectors, perpetual trading and stablecoins, it is well on the way to becoming a benchmark in its field.

This analysis was commissioned by f(x) Protocol and written independently by the OAK Research teams, based on available documentation and questions put to the team behind the project.