Fractional Stablecoin

A fractional stablecoin is a stablecoin that holds collateral worth less than the full value of the coins in circulation, relying on an algorithm and market incentives to support the rest. Most designs pair the stablecoin with a second, volatile token: users mint the stablecoin partly with collateral, such as a dollar stablecoin, and partly by burning the second token. The share of value covered by real assets is called the collateral ratio.

Fractional designs sit between fully collateralized stablecoins, such as fiat-backed stablecoins that hold a dollar of reserves for each coin, and purely algorithmic stablecoins that hold little or no collateral. The best-known example is Frax, launched in December 2020 as a "fractional-algorithmic" stablecoin. The term is also used loosely for any stablecoin whose reserves fall short of its liabilities, which is a quite different situation from a deliberate design choice.

Imagine a token that promises to be worth one dollar, but only 80 cents of real money sits in the safe for every token. The other 20 cents is supported by confidence: a second token that the system can sell or create to cover the gap, and traders who profit from nudging the price back to a dollar.

When people trust the system, that arrangement can hold steady and lets the issuer grow without locking up a full dollar for every coin. When trust breaks, the missing 20 cents can become a hole. Everyone tries to get their real money out first, the second token loses value, and the gap can widen quickly.

The collateral ratio sets how much collateral is needed to mint one coin:

• Value of collateral is the market value of the reserve assets held by the protocol.
• Value of stablecoins in circulation is the number of coins outstanding multiplied by their target price, usually one dollar.

At a ratio of 85%, minting one coin worth one dollar requires 0.85 dollars of collateral plus 0.15 dollars' worth of the protocol's second token, which is burned. Redeeming works in reverse: a holder gets back 0.85 dollars of collateral and newly minted second tokens worth 0.15 dollars. In Frax's original design, the protocol raised the ratio when the coin traded below a dollar, to rebuild confidence, and lowered it when the coin traded above a dollar, to allow growth.

Frax was the leading example of the design and used its governance token, FXS, as the second token. Following the collapse of other algorithmic stablecoins in 2022, Frax's governance voted in 2023 to move towards full collateralization, a sign of how the market's view of fractional backing had changed. Iron Finance, a project on the Polygon network, was a cautionary case. Its IRON stablecoin was backed partly by USDC and partly by its TITAN token. In June 2021, heavy selling of TITAN triggered a run in which holders redeemed IRON and sold the TITAN they received, sending TITAN's price close to zero and leaving IRON below its peg.

• Reflexivity. The second token's price supports the stablecoin, and a falling stablecoin pushes down the second token, a feedback loop that can lead to a depeg or collapse.
• Run risk. Like a bank run, holders have a reason to redeem first, since the collateral is limited.
• Collateral quality. If the collateral is itself a crypto asset or another stablecoin, its value can fall at the worst moment.
• Governance and oracle risk. Changes to the ratio, and the price feeds that drive them, depend on code and on holders of a governance token.

The design is sometimes compared with fractional reserve banking, where banks keep only part of their deposits as cash or central bank reserves, a share once set by a reserve requirement in many countries. The comparison is limited: banks are supervised, hold capital and have access to central bank lending and deposit insurance, whereas fractional stablecoins usually have none of these protections. Regulations that have emerged for stablecoins, including the European Union's MiCA rules, generally require full reserves for coins referenced to a single currency, which leaves little room for fractional designs in regulated markets. The stablecoin reserves entry describes what fully backed issuers hold.