ERC-404: Experts weigh in on the risks and rewards of hybrid NFTs

Ethereum (ETH) has been on a roll the past couple of months as multiple factors have driven interest in the second-ranked crypto by market cap, helping to propel its price to a near two-year high of $3,037 on Thursday, which translates to an increase of 40% since Jan. 23. 

Kitco Crypto previously covered two of the main drivers of interest: Speculation around the approval of the first spot Ether exchange-traded fund (ETF) in the U.S. and the approaching Dencun upgrade that will enable greater scalability on layer-two (L2) platforms. 

A third development that has piqued the interest of many crypto fans has been the release of ERC-404 token contracts, a potential game changer in the realm of non-fungible tokens (NFT) that allows tokens to be fractionalized for the first time. 

To get a better understanding of what sets ERC-404 contracts apart from other token standards, Kitco Crypto reached out to experts in the field, who provided insights into the basics of this new NFT-focused token standard. 

ERC-404: Making NFTs fungible

According to Zachary Friedman, Chief Strategy Officer at Secure Digital Market, “There have been two Ethereum token standards that have paved the wave for new venture creation in the Ethereum ecosystem.”

“ERC20 is the fungible token standard and has been the dominant vehicle for issuing stablecoins, altcoins, and other utility tokens on the Ethereum network,” he said. “ERC721 is the most widely used non-fungible token standard and has been used for use cases like digital collectibles, art, and tracking goods and services on-chain.”

“The most recent token standard, ERC404, is a hybrid of ERC20 and ERC721, giving previously non-fungible tokens, fungible properties,” Friedman explained. “This allows holders to own a fraction of an NFT. With high economic barriers to entry from blue-chip NFT collections like Pudgy Penguins and CryptoPunks, this new token standard would enable anyone to own a piece of an asset, democratizing access to this new use case and asset class.”

Nathan Leung, a Crypto Educator at Cryptonauts, also highlighted that ERC-404 “is essentially a hybrid non-fungible token (NFT).” 

“Think of this as a semi-fungible token, where one token is one NFT,” he added. “Since the birth of ERC404, there has been ERC404+ (which fixes the max supply cap using a function _burnedtokenIDs to keep track). After that came DN404, which is a divisible NFT, where 10000 tokens are now worth 1 NFT.” This helps create greater liquidity for these NFTs, he noted. 

“Basically, there is a new type of token that will allow NFTs to be represented by tokens, and vice versa,” he said. “If the tokens are sold, then the NFT is minted. If the tokens are bought, then the NFT is burned.” Leung said this is a very basic analogy intended to provide greater clarity.

According to Jeff Owens, Co-Founder of the Haven1 Foundation, “The exciting thing about the experimental ERC-404 token is that these are essentially non-fungible tokens (NFTs) made up of fungible ERC-20 tokens. This means that users have the option to purchase a full ERC-404 token, which includes minting rights, or fractions of it in the form of an ERC-20 token, with no minting rights.”

“We’ve also seen the emergence of the DN-404 proposal – the so-called ‘divisible NFT’ standard with native fractionalization built in, which is a more efficient construction than the original ERC-404 proposal,” Owens added. “The difference is that DN-404 operates two contracts – the ‘base’ ERC-20 token and a ‘mirror’ ERC-721 token, with most of the trading happening in the ‘base’ tokens.”

“Regardless of the specifics, however, the exciting thing about this innovation is that it removes the middleman from NFT trading, facilitating fractionalization and allowing for greater liquidity in the NFT market,” he said. “Already, we have seen a huge boost to trading on the Ethereum blockchain, with gas fees skyrocketing to an eight-month high last week.”

NFT industry shakeup 

Alejo Pinto, Co-founder of Pontem, called ERC-404’s “A novel way to have duality for coins to function as both NFTs and coins. This natively enables the fractionalization of non-fungible tokens.” 

“A good example of this could be an options contract which is relatively non-fungible in that it carries an expiration date and a strike price so it can be quite expensive to purchase on its own,” Pinto said. “If this contract can be split into many pieces, then fractions of it can trade and be more accessible to users. For now, most of the usage for this new standard has been for meme coin speculation, but real-world use cases are interesting as outlined in my example.”

“ERC-404 is the name of a token that is surprisingly non-standard due to not following the ERC (Ethereum Request for Comments) defined procedures,” said Miguel Prada, co-founder and Tech Lead at Diva Staking. “This token uses mint and burn functions to convert NFTs into tokens, and vice versa.”

Prada said the primary use case for ERC-404 “is mainly for generative NFTs, in which destroying them to make them liquid is equivalent to separating an asset from the atoms that form it.” 

“In this case, the atoms (the tokens) are fungible regardless of the asset (the NFT) where they came from,” he said. “The non-standard ERC-404 will probably have some use cases, but it is yet to be determined whether or not the market will embrace it.”

Ramy Bekhiet, Senior Advisor at PDX Global, added that the hybrid nature of ERC404 “allows for fungible trading on DEXes while still being supported on NFT applications. This means multiple wallets can collectively own an NFT, opening up investment opportunities to more participants and enhancing liquidity.”

Still an experimental token standard

While ERC404 holds promise for improving interactions within the NFT market, Kerel Verwaerde, Chief Marketing Officer for Cryptology.com, noted that it is “still not an accepted standard and is still in its infancy phase.” 

“Keep an eye out for it, but don’t buy into the hype too easily, as there are bound to be some hiccups,” he warned. 

Gracy Chen, Managing Director of Bitget, also warned about adopting the ERC-404 standard without conducting proper due diligence as it still needs to be audited. 

“It is important to note that the ERC-404 standard has not been audited or gone through the standard Ethereum Request for Comments (ERC) and Ethereum Improvement Proposal (EIP) procedures,” Chen said. “This rightfully raises concerns about incorporating unaudited and perhaps defective systems into the Ethereum ecosystem – which is why it might be too early to say just how ERC-404 will influence the ETH price.”

“Within the ERC standard, there are already many similar protocols that merge FT [Fungible Tokens] and NFT, such as ERC3475, ERC3525, etc.,” she said. “The current speculation around ERC-404 can be seen as the market’s desire for innovative things and new types of assets on the Ethereum network, but its longevity still needs time to be tested.”

Jesse Leclere, a Blockchain Analyst at CertiK, warned “The introduction of new and experimental token standards comes with inherent risk.”

“Scammers may attempt to capitalize on the hype around these new standards to launch fraudulent projects aimed at siphoning user funds,” he said. “Furthermore, because these standards are experimental, they may contain bugs or vulnerabilities that could lead to significant losses, as demonstrated by the $800k lost in projects experimenting with ERC-404 and other new standards.”

And Ilya Stadnik, CEO of Zent, warned about the scrutiny that ERC-404 assets could face from regulators. 

“Ethereum is obliged to continually innovate,” Stadnik said. “Hybrid assets like these will eventually face the need for regulation. That is, for sure, a more complicated process compared to cryptocurrencies.”