Fractionalized NFTs
At Zap Protocol, we are paving the way for the next generation of decentralized finance on the Ethereum blockchain. We are launching a new NFT marketplace that will allow artists to offer their artwork in a variety of ways. The Zap team is currently looking at potential use cases for the NFT marketplace. These methods include using NFT collateralized loans, fractionalized NFTs (F-NFTS), and re-fungible tokens (RFTs).
Non-Fungible Tokens (NFTs)
Non-fungible tokens are growing in popularity, spawning a new market, and revolutionizing the way we think about assets. The term “fungible” indicates that the value of each item is uniform, mutually interchangeable with one another, and divisible. Examples of fungible items include the U.S. dollar, gold, Ethereum, and ERC-20 tokens. Fungible items usually make trading easier and provide more liquidity in markets. Non-Fungible Tokens (NFTs), on the other hand, are one-of-a-kind and non-interchangeable.
NFTs are associated with ERC-721 tokens. They are tracked on the blockchain to provide proof-of-ownership. Smart contracts store the exclusive data that differentiate the NFT from other tokens. When an NFT is exchanged between owners, it can be traced back to the smart contract address where it was first issued. Therefore, buyers and sellers are able to confirm that an NFT came from the original artist and is not a forgery. NFTs have become popular with artists who want to receive proper recognition for their artwork, as well as collectors who want to ensure their digital art is original.
There are, however, some drawbacks to the widespread adoption of NFTs. They are not interchangeable with other ERC-721 tokens, making the trading process more difficult and markets less liquid. Furthermore, because of high prices, most investors don’t have the funds to participate in the market for rare NFTs. These constraints have stunted the growth of secondary markets for rare NFTs. Additionally, it is difficult to derive a price estimate of an NFT since there is not usually historical data on these unique items with limited supply. Fractional NFTs could provide solutions to these limitations.
What is a Fractional NFT?
When an NFT is fractionalized, it is first locked in a smart contract. That smart contract then splits the ERC-721 token into multiple fractions in the form of ERC-20 tokens. Each fraction represents partial ownership of the NFT. Shareholders will possess a fraction of the NFT, equal to the value of their ERC-20 tokens divided by the total number of those tokens produced when the NFT was locked in the smart contract. Fractions are typically put up for sale at a fixed price for a period of time or until they are all sold out. Fractional NFTs offer a variety of benefits compared to traditional NFTs.
Imagine if we could fractionalize Vincent Van Gogh’s masterpiece Starry Night. Suppose the painting was valued at $1 billion; an NFT or ERC-721 token would represent it because it is unique. Since the artwork is expensive, only a small number of major investors could bid for it. If a smart contract fractionalizes the Starry Night NFT, each fraction would then represent fungible ERC-20 tokens. Every fraction owner could then use their ERC-20 tokens to buy, sell, or auction off their share of the NFT.
There are three major benefits to NFT fractionalization:
- Price Discovery
- Liquidity
- Democratization
Price Discovery
Price discovery mechanisms determine how much an NFT should cost.
There are three:
- Past Sales — The past sales mechanism uses historical data to generate a price estimate for an item. It is commonly used on the open market where there are a large number of similar or interchangeable products for sale. Applying this mechanism to come up with a price estimate for an NFT would not be efficient. Most of the time, we do not have historical data of similar assets to properly discover the price of an NFT because they are rare.
- Auction — Auctions reveal people’s willingness to pay and are used to derive a price estimate for an item. This mechanism takes value from the bidder who is willing to pay the highest price for an asset. Usually, this is an excellent way to come up with an estimate for NFTs since collectors hold different private valuations.
- Fractionalization — Fractionalization consists of taking an NFT, dividing it into fungible ERC-20 tokens, and selling those tokens on the open market. This process produces a price estimate for each ERC-20 token. We can then use those price estimates to come to an evaluation of the tokenized asset’s price. Additionally, we can use the buyout option to also derive a price estimate. The buyout option allows fraction-holders to specify the price they are willing to pay to un-fractionalize the NFT.
More liquidity
NFTs are distinguished by the fact that they are one-of-a-kind. However, liquidity remains a concern since the marketplace limits access to an extensive number of potential buyers. The market becomes illiquid with just a few investors willing to buy the NFT. F-NFTs were established to address the lack of liquidity that exists in secondary markets. When an NFT is fractionalized, the ERC-20 tokens representing the fractions could be traded on a decentralized or centralized exchange. Instead of an artist waiting weeks for their NFT to sell, numerous investors may buy fractions immediately, at a reduced price, addressing market liquidity issues. They can also be traded among family and friends, sold at auction, used to secure collateralized loans, or staked.
Democratizes Ownership
Most of the time, the prices in NFT marketplaces prevent smaller investors from participating, leaving only a few investors capable of purchasing the most expensive NFTs. Breaking an expensive NFT into fractions lowers ownership costs, making expensive ones accessible to a broader range of investors. It should be noted that if the price of the entire NFT increases, the cost of all fractions increases as well. However, if someone were to resell or purchase a fraction, it would not affect other fraction owners. As a result, the fraction mechanism boosts total market activity by democratizing ownership to investors.
Buyout Option
The buyout option potentially allows someone to purchase 100% of the fractions’ supply. This method elicits accurate prices of the asset. A buyer can initiate the buy option by transferring ERC-20 tokens to the smart contract, and it will un-fractionalize the NFT. There is then a fixed period of time for the auction to take place. If the buyout offer goes through during this time, the buyer will collect full ownership of the NFT, and the fraction owners will collect the ERC-20 tokens that the buyer paid out. On the other hand, if the buyer is outbid by the fraction owners, the other shareholders would collect fractions of the NFT at a higher price.
Suppose all fractions of an NFT are worth $10,000,000, and a potential buyer owns ten out of a hundred fractional shares representing 10%. Since the buyer owns 10%, they would have $1,000,000 representing their portion of the supply. The buyer could send $9,000,000 worth the remaining ninety fractions owned by other shareholders to the protocol; this would trigger an auction. If the other shareholder wants to keep their fractions, they would have to raise capital to pay more than the $10,000,000 at auction. Therefore, each bid price of a fraction needs to be greater than the 10% or $1,000,000. If the buyer is outbid, it demonstrates that the NFT is worth more than $10,000,000 since the other shareholders raised the market price to keep the fractions. If the fraction owners are outbid, the buyer will receive the NFT, and the $9,000,000 will be split among each fraction owner. The buyout method provides a price discovery point and raises the overall value of the NFT.
Future of Fractions
Fractions have a variety of applications in both the physical and virtual world. Bringing liquidity, price discovery, and democratization to the NFT market opens up lots of new opportunities. An NFT could represent the mortgage on a house, and multiple people could take ownership of the property through fractions. Alternatively, this approach can be used for digital art, online games, fantasy sports, and more. One could crowdfund and co-own an asset by turning a virtual gaming product into an F-NFT. The possibilities of investment strategies with fractional NFTs are endless.
Review
- Fractionalization adds liquidity, helps with price discovery, and democratizes ownership of NFTs.
- Zap Protocol is launching a new NFT marketplace that will allow artists to offer their artwork in a variety of different ways.
- Zap aims to create more demand for artwork while also incentivizing artists with rewards.
References
Brukhman, J. (2021, January 26). Appraisal games and the NFT liquidity problem. Medium. https://blog.coinfund.io/appraisal-games-and-the-nft-liquidity-problem-904afe6bc7af.
How Algorand Democratizes the Access to the NFT Market with Fractional NFTs. Algorand. (n.d.). https://www.algorand.com/resources/blog/algorand-nft-market-fractional-nfts/
Howard, M. (2018, November 4). The Future of Virtual Assets: Introducing the Fractional NFT. Hacker Noon. https://hackernoon.com/the-future-of-virtual-assets-introducing-the-fractional-nft-84c218da73c9.
Vohra, A. (2021, June 20). Exploring the Buyout Mechanism in NFT Fractionalization. Medium. https://medium.com/nonce-finance/exploring-the-buyout-mechanism-in-nft-fractionalization-ab6722b50d19.
