Exploring the Buyout Mechanism in NFT Fractionalization
NFT fractionalization is a fancy way of saying NFT ‘tokenization’, essentially what one means when they say NFT fractionalization is they are going to lock their original NFT in a contract and create fungible tokens (referred as fractional tokens) that represent ownership in the original NFT.
The benefit of fractionalization for an NFT owner is to make their NFT holding liquid, as well as potentially increasing the valuation of their NFT.
On the buyer side, it allows people to invest with small amounts by buying the fungible token in a single high value NFT or even an NFT collection. Fractionalization also allows NFTs to bridge over to the world of fungible tokens (via fractional tokens) where they get all the benefits of being composable with DeFi applications.
Note : Fractionalizing multiple NFTs and creating a single token backing them is also possible. It makes sense to buy such a fractional token if you want to gain exposure to a bundle of similar NFTs like rare cryptopunks or to a prominent collector’s NFT collection.
Fractionalization can’t be a one street though because if the NFT is locked forever after fractionalization, it loses its utility. For example, for a fractionalized art NFT no one would be able to display it in galleries in the metaverse. As a result, having some sort of mechanism for unlocking the NFT and making it whole again is needed. Having a good architecture for doing so would actually increase the value of the fractional tokens as well.
Now we have established the fact that fractional NFTs need a buyout mechanism, let’s look at some possible buyout clause architectures in detail.
- Acquiring all the supply of the fractional token
The most simple buyout clause is to unlock the NFT when someone gets 100% of the fractional token supply. This sounds good on paper but getting every token holder to sell all their tokens to you is almost impossible, the cost of acquiring more tokens after a certain point increases exponentially, therefore, this buyout model is not feasible.
- Token holder voting
Getting fractional token holders to vote whether buyout should happen is another architecture for designing a buyout clause. There is a minimum percentage of ‘yes’ votes needed to trigger an unlock of NFT(s). For voting to happen on chain, token holders are to stake their tokens as a way to signal ‘yes’ to a buyout (eg: unicly). This approach is good because it allows people to signal their decision without doing anything else like putting in more money to cancel buyout bids.
The issue with voting is that it requires token holders to actively monitor the buyout bids and vote accordingly — as we have seen with many DeFi projects, most people actually don’t vote. Also, since token whales suffer the highest slippage while selling their tokens, they would vote in favour of accepting the buyout even when the money you get per token on a successful buyout is significantly lower than the current token prize. In case such a buyout passes, the smaller holders can get rekt.
Overall, I’m excited by the potential of using voting for accepting buyout bids and will be monitoring the usage of this mechanism closely.
- Buyout rejection games
Another architecture for buyout clause is allowing token holders or outside speculators to participate in buyout rejection games. The process works as follows:
NFT collector buys some percentage of fractional token supply (needed as a condition for the buyout) and submits a bid to buy the NFT(s) at a fractional token price greater than or equal to the current price.
Speculators or token holders put money into the system to cancel the buyout by buying out the fractional tokens of the NFT collector at the price equal to the one they submitted while placing their bid (eg : Niftex) in hopes that the price of fractional token eventually rises in the secondary market.
The advantage of this architecture is that an individual fractional token holder will always be able to get an equal or higher price for their token in case of buyout success. On the other hand, the disadvantage of this model is that the speculators and token holders that participate in cancelling the buyout by paying a higher price don’t have a guarantee that the price would appreciate in the secondary market (i.e. DEXs), that’s why most of the buyout bids actually succeed in such an architecture. This is one of the problems we are trying to solve at Nonce Finance and I find buyout rejection games to be the most exciting of all the architectures.
I’ll keep on updating this article as more fractional NFT buyout mechanisms come into existence . The design space for fractional NFTs buyout clauses might be similar to the design space we have for AMMs/L1s because there are various trade-offs with each design, what’s for certain is that coming months would be party time for all people in the NFT space.