ERC404 is an exciting new asset, but it’s not what you think
I had the opportunity to delve into the ERC404 contract, version 1 and 2, over the recent weekend. It’s a fascinating experiment, diverging from previous attempts at blending ERC20 and ERC721. However, it might not function as you’d anticipate.
According to its README, “ERC404 is an experimental, mixed ERC20 / ERC721 implementation with native liquidity and fractionalization.”
Usually, native liquidity implies that a token can be bought or sold with ease. This is often achieved by establishing a market maker ready to buy or sell to individuals. Therefore, one might assume that the native liquidity implementation would include some purchasing and selling logic or perhaps a pool to manage demands from both sides. Well, the ERC404 contract, as released by the Pandora team, doesn’t have such features.
Regarding the implementation with native fractionalization, typically, it means one can take an NFT and divide it into pieces to share ownership of the unique NFT with others. However, this isn’t how ERC404 operates.
Upon closer inspection, ERC404 introduces a token type that functions as both an NFT and a fungible token. You can transfer it as either, leading to its listing on both coin markets and NFT markets like OpenSea. This seems to be what the author refers to as “implementation with native liquidity.”
As for native fractionalization, as an owner, you can’t actually fractionate your favourite NFT in this new scheme. Instead, it uses a “pegging” mechanism: if your ERC20 balance is less than one, you don’t own any NFT token; once you reach 1 ERC token in your balance, an NFT token is automatically minted for you. You don’t get to choose. As exemplified by Avatar tokens — made by the same team that created the ERC — the NFT you receive is randomly coloured, similar in appearance, and almost random in rarity. There are several colours, some rarer than others.
While you can manipulate the system to obtain rarer NFTs by purchasing new ERC20 tokens at the right time or sequence, the developers haven’t attempted to prevent this kind of gaming behaviour. Be cautious, though, as when you transfer out your ERC20 balance, your hard-earned rare NFT is at risk of being lost.
The possibility of losing your hard-earned rare NFT by transferring some ERC20 balance out warrants further explanation. As the owner loses the NFT through transfer, the recipient doesn’t receive the same NFT. Instead, new ones are minted. This reflects the idea that these tokens, which are burned and created on-demand, are probably interchangeable, like Avatar NFT tokens — not a single one of them is truly unique. Is this a bug or a feature? The developers apparently viewed it as a bug, as they somewhat addressed it in the v2 contract. The updated contract transfers NFT tokens instead of burning them during an ERC20 token-transfer, thus preserving rarity, if any. In reality, this means ERC721 tokens are never burned, just stored away, adding a reason to seek out rare ones. Moreover, the new contract implements a FIFO queue (via DoubleEndedQueue in one direction) to ensure a predictable set of NFTs is minted.
Having scrutinized the contract, what problem does the new contract aim to solve? It doesn’t address liquidity provision, at least not within the contract, nor does it offer a way to fractionalise a specific NFT in its collection. So, what is the problem it’s targeting?
The answer is multifaceted.
Firstly, individual investors face considerable risks when purchasing NFTs. These often come with a high price tag and require time to find a worthy investment. Fractionally owned Apes only alleviate the former issue, not the latter — one still needs to window-shop their ideal NFT. ERC404 tokens differ in that users investing in a fraction of the token receive a fraction of a “generic” NFT token, although they don’t know which one or what colour, as this doesn’t become minted until the user owns a full NFT token. This reduces a barrier to trading NFTs.
Secondly, individuals investing in the new type of ERC404 tokens can leverage UniSwap or any other DeFi protocol, as it is fully ERC20 compatible. However, it’s noteworthy that users don’t receive the same set of NFTs if they deposit and withdraw the same amount from the pool using the same address. This raises questions about the intended rarity of the NFTs if they can be so easily lost. Neither version explicitly supports the shuffling of the tokens, so there’s no straightforward and inexpensive way to control which NFT tokens are taken from the user upon depositing them into a DeFi pool.
Thirdly, the fact that every NFT can be traded as an ERC20 token implies a floor price for the NFTs. If a unique NFT loses its value, it can simply be traded as a project stake token. To do so, a user must create two Ethereum accounts: one to hold rare NFT tokens and another to hold NFT tokens with perceived lower scarcity or market value to be used as ERC20 tokens, as there is no other way to specify which NFT to be used in a ERC20 transaction. Interestingly, as unique pieces are created, they are naturally removed from ERC20 token circulation, creating a form of scarcity for the ERC20 aspect. If a project is designed to first issue ERC20 with generic NFT like Avatar, then, allow more and more interesting NFTs progressively enter the market to replace the generic ones, some of them will be removed from the ERC20 market as collectables, following Gresham’s law, which could potentially reduce the effective supply of ERC20s and improve their valuation. To exemplify this effect, if red pieces (an unusual colour) are priced higher, a user will transfer red NFTs to a special NFT holding wallet (to prevent it from being transferred out as ERC20). As humans tend to exhibit anchoring bias, people may consider NFTs that haven’t been traded recently to retain the value they were last traded at. Consequently, they may refuse to return mediocre NFTs into the ERC20 pools by using them as ERC20, creating a net inflow to the collectable market and lift up the remaining ERC20’s price.
Finally, the v1 contract provided uncertainty about what NFT token would be minted for a user once they accumulated a whole one. This is exciting! The thrill of opening a box without knowing what’s inside has been exploited to the maximum by mobile game developers to drive interactions. However, the algorithmic predictability of the contract diminishes the fun, as hackers will exploit it to the max, and the developers don’t consider this a core selling point worth protecting.
So, what tokens are suitable for ERC404?
Firstly, tokens that are abundant. Most NFT projects limit their NFT tokens to about 10k, but some projects, such as the current top trending project on OpenSea: “Smart Cats,” have a whopping 900k of them. This means a huge clowder of ordinary cats, with only a few having collectable value. The majority can be considered fungible. As discovery occurs, more cats are perceived as collectables, enhancing the value of not-so-collectable cats as they are used as a currency in their ERC20 form. Fortunately, we are the developers behind these cats, so we could upgrade it to ERC404 as the tech matures.
Secondly, utility tokens with collectable aspects. Consider a subway token, each redeemable for a ride to the city centre. I can’t predict which city will adopt such a concept first, but I believe it’s only a matter of time. To increase revenue, each subway token could be imbued with unique graphics or personality. This can be done at the point of minting, which occurs when a passenger pays for a ride. If a passenger is bored enough to read subway advertisements about home insurance, they might be motivated to check what their subway token looks like. Some might decide to keep it instead of using it at the city centre exit, allowing the public infrastructure company to sell tickets twice on occasion.
Thirdly, gaming items and virtual assets. Games could make every asset — a shield, a sword, a ring — effectively unique, allowing price discovery to occur naturally. Most such assets will be sold to NPC traders in bulk in exchange for more powerful ones as a player levels up. However, some will find their way to the collectables market, while most are handled cheaply with ERC20.
Is there any drawback? One thing is that it uses a lot of gas and has much room for optimisation. However, something akin to Cost Signaling might be at work here to support the recent dramatic valuation increase: if it costs so much gas to mint, it must be worth a lot!
All in all, ERC404 presents an intriguing concept for creating more trading options, fun, and possibly a pathway to riches for a lucky few! I bet we’ll see more token types and richer functionalities in 2024, making the landscape vastly different from the previous year.
