An Overview of the NFT Fractionalization Landscape
NFTs as Alternative Assets
A central theme in cryptocurrency is community: returning power to content creators sans middlemen, promoting accessibility via removing barriers to entry, and creatively leveraging developers, artists, and creators to build amazing protocols. Non-fungible tokens (NFTs) and their use cases play beautifully into this theme. An NFT is a unique digital asset that lives on the blockchain — such as art, music, or collectibles — that allows an artist to monetize their creations. Fractionalization has allowed users to decompose NFTs into smaller fungible shards with a variety of use cases.
NFTs are emerging as a highly versatile asset class when compared with traditional art, and their creative use cases are exploding. For example, in Uniswap V3, LP positions are represented by NFTs. NFTX, Unicly, and Fractional all decompose ERC-721 tokens into ERC-20 tokens which allows them to be used in DeFi for functionality such as 1) pooling tokens on Uniswap or Balancer to earn trading fees, 2) using tokens as collateral for yield farming on networks such as Curve or Aave, or 3) borrowing stablecoins against the tokens. This increased liquidity for NFTs makes these protocols’ methods of fractionalization highly attractive for investors because they essentially transform each individual NFT into a liquid, yield-bearing, productive asset. As NFTs rise in value, fractionalization enables individual investors to acquire a smaller stake in a high-value NFT or a basket of NFTs. Entry and exit are easier and heavier trade volume allows the market as a whole to better discover the price of assets. Without fractionalization, many investors might be unable to obtain exposure to these NFTs at all. Additionally, investors and artists are able to sell proportional shares of NFTs, which enables a community ownership approach. Regardless of their physical location, notoriety, or crypto-knowledge, any artist can monetize their work with increased flexibility on a UI-friendly platform.
NFTX — Index Fund Approach
NFTX is a decentralized protocol that pools NFTs of equal value into index funds. A user acquires an ERC-20 token by contributing art to an index or purchasing a slice of the index. This ERC-20 token from NFTX is called a vToken, which is a 1:1 proportional claim on a random NFT in the index your NFT was minted into. There are pros and cons of NFTX and how it fractionalizes baskets of NFTs. First, it assumes that all NFTs in an index are of equal value. In practice, this is seldom the case and could become an issue when the owner of a vToken redeems their token. Rather than receiving a monetary payment, the owner of the vToken randomly receives one of the actual NFTs in the index basket.
Knowing that you’ll receive an actual NFT in the index when you cash out of the fund, rather than just ETH, may create a more personal dynamic between the index and the buyer. NFTX users may be more likely to believe in the NFT’s long-term value since some investors will acquire it (vs ETH etc) when they redeem from the vault. Index tokens are a more capital efficient way to represent floor assets since individual Fractional or Unicly vaults require capital formation for each vault/asset. The greater capital efficiency allows lower collateralization ratios on protocols due to the increased depth of the asset. However, the equal-value model can be problematic because each NFT’s value is constantly changing depending on the market’s view, similar to the way a stock behaves. For example, if certain information is uncovered about an NFT, such as notoriety of the prior owner, its face value may rise. In a rapidly developing ecosystem where clout is important and information spreads quickly, equal-value NFT indexes can be complex.
A brief example: On NFTX, a user cashes out of a basic CryptoPunk index. He receives from the vault a punk of relatively low value since the index is composed of floor punks. However, personal preferences come into play here — the user may want a particular punk in the index and be unhappy with the one he received.
NFTX addressed this issue in V2: a user can pay a 5% bonus of the token to specifically choose an NFT in the index versus randomly receiving one. Technically, if a user chose the random route, they could return the NFT to the index vault and try again, but gas costs would add up, so they would only iterate over the art pieces if the fees and gas prices were lower than 5% of the value of the piece of art they wanted. Similarly, a user could begin the process of cashing out of the index, discover which actual NFT they would receive as part of the transaction, then revert or cancel the transaction before it is completed. They could then repeat that process until they obtained the NFT they wanted. This creates an interesting dynamic because it may result in an incentive to cash out as rapidly as possible, since the earliest user obtains the most optionality if they use the method described above. Even in V2, with buyers paying an extra 5% fee, multiple users may vie for a specific NFT in the vault.
As of now, NFTX primarily has lower-value artwork such as floor CryptoPunks on its platform rather than higher-end NFTs, making it comparatively the most interesting platform for floor assets. Users can collateralize NFTX floor index tokens in a protocol like Compound to borrow against. From the liquidator’s perspective though, these floor assets may lose value due to slippage when the time comes to redeem. If there isn’t much depth behind the index token, the liquidator would probably immediately sell it for USDC once the price dropped since they don’t want a tanking asset on their balance sheet. Similarly, if multiple people had one floor index token each that they were borrowing against, a shortage of liquidity in the market may occur if the price of the token dips.
The question of NFT used as collateral comes into play here as well: when the time comes to liquidate, the piece may be able to be partially liquidated. In partial liquidations, the defaulted NFT is deposited into an index fund. In theory, some of the tokens representing the index fund would go to the lenders and some would go to borrowers. The half-collateralized NFT could then continue to be used as collateral but only with the pro-rata amount of shards. It’s extremely difficult to make an NFT whole again once it’s fractionalized, so this use case could discourage investors from using their NFTs as collateral. Whether partial liquidations will be mainstream (or even plausible) is up to the community to decide, but we will undoubtedly continue to see creative efforts to transform NFTs into productive assets.
NFTX tokens are the most effective way out of the three protocols to track the value of a floor asset. This is because compared to other protocols, the investors have so much fluidity in depositing or redeeming from the index fund. The less liquid method in other protocols means that the price shown of the floor assets lag behind the true valuation since there’s less incentive to keep up with the market because 1. investors aren’t redeeming for the actual asset, and 2. users can’t actively move in and out of protocols like Unicly & Fractional with NFTs.
Unicly & Fractional — Direct Fractionalization Approach
While NFTX operates as a series of index funds composed of NFTs, Unicly and Fractional directly fractionalize single NFTs or collections of NFTs. Fractional & Unicly’s vaults are of fixed size, whereas NFTX is mutable in that it allows anyone to permissionlessly deposit and remove assets from the fund subject to the vault’s criteria. Another difference between NFTX vs Unicly & Fractional is the redemption mechanism: in NFTX a user redeems for artwork in the index. If a user created an index of 10 CryptoPunks on both NFTX and Fractional, the user would not be able to perform a buyout on Fractional/Unicly for a single punk. Unlike NFTX, Fractional and Unicly are not suited for index funds since entry and exit of NFTs into the fund isn’t possible after its creation.
On Unicly, NFT owners looking to fractionalize create a uToken (an ERC-20 token) that represents a collection of NFTs, or a single NFT, on the platform. Once this collection is created, users can interact with it by purchasing its uToken, bidding on NFTs in the collection (including bidding on a singular NFT), and governing the collection. While NFTX allows you to redeem an underlying asset in the fund, in Fractional and Unicly users receive ETH when the collection is unlocked. A percentage of the total uToken supply must be in favor of unlocking the collection in order to distribute the NFTs to bidders and pay the tokenholders their pro rata share of the payment. In Unicly, this percentage is set by the creator of the uToken at the start of the fractionalization process. Since users must depend on others to want to unlock the collection as well, Unicly has a more community-reliant governance approach paired with decreased flexibility.
The high quality baskets of NFTs will be rewarded by Unicly through whitelisting, which means the pool can liquidity mine UNIC (Unicly’s governance token) by staking LP tokens. In addition, Unicly plans to enable farming, so users will be able to stake their UNIC to earn even more UNIC. This would likely have the effect of decreased selling pressure on UNIC. Currently, users can add liquidity to the network and earn a 0.25% fee on trades that are proportional to their share of the pool — meaning that whenever a trade is made in or out of that pool, they earn a fee. Anyone can list their uToken on Unicly, so it’s the buyer’s job to make sure it’s priced correctly.
Fractional aims to be the most unopinionated protocol in the space. They take a very minimalistic approach, with the fundamental bare bones of the protocol available for developers to build features and mechanisms on top of, depending on how they want to fractionalize their NFT. This flexibility allows for creative ways to fractionalize and enables varying levels of complexity for each piece of artwork. Just as each NFT is unique, the fractionalization method cannot be standard across all art; Fractional strives to solve this issue by acting as a user-friendly foundation with the essential elements for fractionalization and letting the developer design the rest. While NFTX contains more floor assets, Fractional is likely to be used for singular expensive NFTs.
Fractional incentivizes artists to add NFTs to the platform by instating a curator fee for the NFT originator, which operates like an AUM fee. In the buyout mechanism, token holders vote on the reserve price for an NFT and the protocol takes the weighted average of the token holders’ votes. A token holder cannot place a reserve price more than 5x divergent from someone else’s vote, ensuring that the weighted average remains fair. Fifty percent of token holders need to agree to trigger a buyout.
The Future of NFTs and NFT Fractionalization
The NFT fractionalization landscape is still relatively new, and if a winner is to emerge in the space, factors such as curator fees/incentive structures for NFT owners, artists, and investors alike will decide the champion. However, these protocols could also coexist in harmony, each with a rich, diverse, and distinct collection of NFTs on their platform, with new investors entering and exiting the space frequently. Regardless of whether a clean winner will emerge, NFT fractionalization truly allows a more feasible and accessible approach to the industry and deeply broadens the financial utility of owning — a whole or a piece of — an NFT. NFTs themselves are also being leveraged for new and exciting use cases such as:
DAOs as an NFT investment vehicle: DAOs are gaining traction by enhancing accessibility to rare, expensive NFTs through forming a community around a piece of artwork that few singular individuals could afford. For example, PleasrDAO, the owner of the iconic $5.4M Snowden NFT, is creating a Shiba Inu competitor backed by the $4M Doge NFT. Similarly, JennyDAO — a new DAO with a Unicly token — provides benefits to members such as access to exclusive research, group chats, and NFT leaders. The funds raised will be allocated to purchasing NFTs chosen by the DAO-governing token holders.
Social media NFTs: We may begin to see social media posts converted to NFTs and distributed among original supporters of an individual, leading to a community-based reward to fans. For example, the likers of a celebrity’s first-ever Instagram post could be rewarded for their initial support with fractions of that post. Or, posts could be transformed into NFTs, automatically fractionalized, and sold on a bonding curve. The platform Minti allows users to mint their social media posts as NFTs and create a digital identity around content that’s able to be monetized. This puts the power back into the hands of content creators and allows the underlying community to better support their favorite artists without the middleman taking the biggest cut. Social media NFTs also empower fans to get more involved in the content the artist posts and lets the artist himself generate extra income.
Mini communities: Exciting communities are being spun up around NFTs that allow more individuals to get involved in unique ways. Permissionless platforms such as PartyBid make it easy for supporters to collectively bid on NFTs as a group and create community around the piece. Users can create a PartyBid, target a specific auction on Foundation or Zora, and pool funds to bid on the NFT. With these cohesive communities forming around pieces, more attention is drawn to the artist and more fans are able to get directly involved in supporting them.
NFT personalization: As the metaverse community broadens in terms of breadth and depth, digital representations of individuals will require more individuality and uniqueness. This could be achieved through accessorizing your NFT with certain defining characteristics that set your image in the metaverse apart from others. Filta has entered this marketplace with distinct NFT filters that users can buy from their favorite artists and then share to social media.
We’re still at extremely early stages of NFT adoption, but there’s no doubt that experimentation with these concepts will yield new and exciting solutions that will further develop the rapidly emerging landscape and allow the NFT ecosystem to flourish.
Disclaimer: Divergence Ventures LLC is an investor in Fractional, PleasrDAO, Minti, and Filta.
