Ethereum's new experimental token standard ERC-404: What risks exist in the combination of image tokens and new explorations?

Author: defioasis, Wu Says Blockchain

Editor: Colin Wu, Wu Says Blockchain

The token standards on Ethereum can be divided into ERC-20 fungible tokens (FT/Token) and non-fungible tokens (NFT) represented by ERC-721, both of which have been regarded as two distinct assets for quite some time. After the launch of Uniswap, the on-chain liquidity of ERC-20 was greatly improved; however, NFTs have long been mired in liquidity issues. Over the past two years, numerous solutions for NFT liquidity have emerged, including representative examples such as Bid Pool, lending protocols, perpetual contracts, and fragmentation protocols. The protagonist of this issue is also the Ethereum experimental standard ERC-404, which has been widely discussed in the community recently and shares certain commonalities with NFT fragmentation, further blurring the lines between Tokens and NFTs.

Continuous Exploration of the Combination of Images and Coins (Images refer to NFTs, Coins refer to Tokens)

The combination or interchange between images and coins began with the exploration of NFT liquidity solutions, particularly the fragmentation ideology; Bitcoin inscriptions laid the groundwork for the combination of images and coins; Solana Tiny SPL further expanded this concept.

The earliest instance can be traced back to the NFT fragmentation protocol Fractional (later renamed Tessera), which proposed to fragment high-value NFTs into a certain number of smaller units called Raes. Raes are essentially NFTs that represent collective ownership and governance of a high-value NFT and can be traded on NFT marketplaces. Fragmenting high-value NFTs into smaller units may also face the risk of liquidity depletion and could lead to confusion regarding the value of the whole NFT.

Fractional's fragmentation solution did not achieve widespread adoption and ultimately exited the crypto stage in May 2023 due to poor profitability. However, the fragmentation ideology inspired NFT OG player FreeLunchCapital, which launched a new NFT fragmentation solution called Flooring Protocol in mid-October 2023. Flooring's solution fragments high-value NFTs into a fixed 1 million μTokens, leveraging DEX liquidity to promote NFT trading. With the help of Flooring, the barriers between images and coins are gradually being dismantled. However, since it relies on a third-party protocol, there are new thresholds for liquidity guidance, and users must use Flooring and adhere to its specific rules to achieve the conversion between coins and images.

On another network, domo developed a new Bitcoin token issuance standard BRC-20 based on the Ordinals protocol launched by Casey. Although we commonly refer to BRC-20 as inscription tokens, BRC-20 essentially serves as JSON text files used for transactions. JSON files are Ordinals inscriptions, each with a unique identifier. Each JSON file corresponds to a specific BRC-20, resembling an NFT, and data websites like CryptoSlam classify BRC-20 as NFTs for calculation purposes. In terms of on-chain trading, BRC-20 is primarily conducted through order forms, similar to the previous NFT trading forms in Blur Bid Pool. However, BRC-20, which resembles an NFT, has gradually entered CEXs, with even leading assets entering major exchanges like OKX and Binance, further blurring the boundaries between images and coins.

If BRC-20 represents a gentle disruption of the boundaries between images and coins, then Bitmap/BRC-420 is more forceful. The builders at Bitmap Tech explain that for assets like Bitmap, images represent land in the metaverse, supported by GameFi to underpin the land's value; coins represent the fiat currency of the metaverse, where all GameFi projects will have better circulation, thus releasing greater financial attributes through the combination of images and coins.

On the eve of the explosion of ERC-404 and Pandora, Solana's new token standard Tiny SPL launched AMM trading, reviving the first Tiny SPL token Deez Nuts (DN). Here, two concepts need clarification: one is the rent of the Solana account model, which is the cost of storing data on the Solana network, becoming more expensive as the price of SOL rises; the other is state compression introduced in April 2023, which allows for more economical storage of any type of data on the Solana chain, with the first use case being the compression of NFTs: official data indicates that the on-chain storage cost for minting 100 million compressed NFTs is only $1,193. Tiny SPL introduces state compression at the token level, eliminating the need to pay rent, thus enabling bidirectional flow between compressed NFTs and tokens, allowing them to be traded as NFTs on Magic Eden or as tokens through project-built AMM. Additionally, the metadata of Tiny SPL tokens is entirely stored on-chain, similar to Bitcoin Ordinals inscription assets.

ERC-404 and Pandora

Acme (Twitter: @0xacme), who claims to be a former engineer at Coinbase, released ERC-404 on GitHub on February 2, describing it as a hybrid implementation between ERC-20 and ERC-721, where the implementation of ERC-721 is non-standardized, and NFTs are not permanently minted but are repeatedly burned and minted based on trading needs.

Pandora is the first project built around the ERC-404 hybrid token standard, launched by ctrl (Twitter: @maybectrlfreak), who claims to be an angel investor in Syndicate, and anonymous developer Searn (Twitter: @searnseele). In fact, ERC-404 and Pandora belong to the same team.

(Note: This "Syndicate" is not the Syndicate invested by a16z. According to historical tweets, this "Syndicate" announced its investment in the BRC-20 trading terminal project BeFi Lasb on January 22 this year.)

From the NFT perspective, Pandora is a collection of NFTs called Replicants, with a maximum total of 10,000, which can be traded on supported NFT marketplaces like Blur and OpenSea; from the token perspective, Pandora is a token with a maximum supply limit of 10,000 PANDORA tokens, which can be traded on Uniswap.

Example:

When a user purchases 1 PANDORA on Uniswap, in addition to receiving the token, the user will also receive a newly minted Relicant NFT, which is an ERC-721 standard and can be traded directly on NFT marketplaces; when a user sells 1 PANDORA on Uniswap, the Relicant NFT they own will be destroyed; if a user transfers their 1 PANDORA to a new address, the Relicant NFT in the original address will be destroyed, and a new Relicant will be minted in the new address.

It is important to note that "1" here refers to an integer, for example, if a user purchases 1.5 PANDORA on Uniswap, only 1 Relicant NFT will be newly minted; purchasing less than 1 PANDORA will not result in any newly minted NFTs; if a user holds 2 PANDORA and sells 1.5, both Relicant NFTs will be destroyed.

Conversely, when a user purchases 1 Relicant NFT from a seller on an NFT marketplace, in addition to receiving the NFT, they will also receive 1 PANDORA token, which is an ERC-20 standard and can be traded directly on Uniswap; when a user sells 1 Relicant NFT on the NFT marketplace, the 1 PANDORA they own will also be transferred to the buyer.

From the example, it is clear that when a user purchases n.d tokens on Uniswap (where n is an integer greater than or equal to 1, and d is a decimal), they will receive n newly minted Relicant NFTs. This involves the process of minting and regenerating NFTs, leading to two issues: one is the minting fee, which will be included in the fees paid by users when purchasing tokens or transferring; the second is the change in rarity after regeneration, which may impact existing gameplay that relies on obtaining rare NFTs through image generation, potentially transforming it into an unrestricted lottery-like format, where users can continue to swap and collide until they obtain a certain rare type.

The Greatest Advantage of ERC-404 is Native Liquidity

In terms of the interchange between images and coins, ERC-404/Pandora is very similar to the fragmentation protocol Flooring and Solana's Tiny SPL Deez Nuts. It is worth mentioning that Pandora's core user profile is NFT + DEX players, and behind the frenzy of token price increases, it may be closely related to the strong push from Flooring players.

Flooring fragments NFTs into 1 million μTokens (ERC-20 Tokens) and supports the redemption of NFTs for 1 million μTokens. However, for users, Flooring is a third-party protocol, and any exchange or redemption must go through this specific third-party protocol; additionally, Flooring has taken on the liquidity guidance of μTokens on behalf of NFT project parties, relying on its own platform tokens to incentivize liquidity.

Deez Nuts (DN) is essentially similar to Pandora, but the starting point of Solana's state compression function is to economically solve the rent issue, which differs from Ethereum. Furthermore, the liquidity pool for DN tokens will rely more on the project's self-built DEX AMM pool; if external DEXs or aggregators need to add DN tokens, they must index them correctly, similar to inscriptions.

ERC-404/Pandora is a hybrid implementation of the mainstream asset standards ERC-721 and ERC-20, natively adapting to NFT marketplaces and DEXs without other third-party barriers.

This point is also evidenced by the launch of the ERC-404 project, where the project deployment address initially holds all tokens, and then adds liquidity on Uniswap to place the tokens into the pool. When users purchase tokens on Uniswap and trigger transfer transactions, NFTs will be minted. Theoretically, it is also feasible to hold all NFTs in reverse, but the initial deployment incurs high transaction fees.

Risks

First, it must be clarified that although ERC-404 uses the "ERC" standard framework, it does not actually belong to an officially recognized standard, as there is no ERC-404 standard in Ethereum Improvement Proposals. As noted in the ERC-404 GitHub documentation, this is merely an experiment. Unlike Bitcoin, Ethereum places great emphasis on orthodoxy, and Vitalik Buterin and the Ethereum Foundation have significant influence; if it cannot gain recognition, it may only become niche. It is worth mentioning that ERC-20 was proposed by Vitalik Buterin himself, while the main NFT standards ERC-721 and ERC-1155 were not. Additionally, a new ERC standard must undergo a lengthy process from proposal to implementation, including but not limited to: drafting an EIP proposal and submitting it to the Ethereum Improvement Proposals repository, broad community discussion, EIP editor review, revisions and iterations based on community and editor feedback, and final proposal.

Second, ERC-404 also has its shortcomings. From a trading perspective, if a user holds 1 rare Relicant NFT and 1 ordinary Relicant NFT, when selling 1 PANDORA token on Uniswap, the user cannot choose which one to sell. The deeper reason is that the contract cannot determine which token is being sold, as from the perspective of fungible tokens, the fungible tokens corresponding to rare and ordinary NFTs are the same. Of course, users can store them in a way that each token has a separate address to avoid this issue.

Moreover, the issue of rarity for newly minted NFTs after transfer may be more severe. CyberVector, the founder of the 111 Shelter community, pointed out that there is actually no gameplay in Pandora that frequently transfers to mint rare NFTs, as rarity is essentially fixed from the beginning. In NFT projects, rarity algorithms are undoubtedly kept secret, or use some unpredictable sources of randomness to increase randomness. If the rarity determination algorithm used in the contract is public and predictable, potential attackers could exploit this information to manipulate the system. They could calculate off-chain which ID would be rare and only mint those rare NFTs; if the rarity of a certain ID does not meet their expectations, they could choose not to mint that NFT on-chain, or roll back the transaction after an on-chain operation fails. In the frequent destruction and minting of NFTs in Pandora, the rarity determination algorithm may still be predictable, which does not resolve the issue of manipulated rarity.

Finally, ERC-404 is still in a very early stage and is more experimental in nature. I believe that the combination of images and coins is not the key; rather, the practicality after the combination is more important. However, the current hype and FOMO are already very strong. As of February 8 at 16:00, on the seventh day since its launch, the price of PANDORA has exceeded $21,000, with a market cap of over $210 million, a hundredfold increase compared to the initial price of about $200. I hope all investors can approach this rationally and not follow blindly.

References:

https://www.theblockbeats.info/news/50383?search=1

https://x.com/cybervector_/status/1754756756155294103?s=20