ERC-404 semi-fungible tokens, true innovation or just a gimmick?

Author: HAMSTER, ChainFeeds

ERC-404 has emerged, PANDORA has skyrocketed, and several exchanges such as OKX and Binance have launched the ERC-404 section in their Web3 wallets.

Concept

ERC-404 is an experimental Ethereum token standard designed to combine the characteristics of fungible tokens (like ERC-20) and non-fungible tokens (like ERC-721) to create a "semi-fungible token" that is both fungible and non-fungible. This type of token can exhibit fungible or non-fungible properties depending on its use case or purpose, allowing NFTs to be traded in a split manner like ERC20 tokens, possessing the dual attributes of "image token," being both a picture and a currency.

To understand ERC-404 through examples, the prices of blue-chip NFTs like BAYC and Azuki can be prohibitive for ordinary retail investors, especially those with rare attributes, which are priced so high that they are difficult to trade. With ERC-404, these expensive NFTs can be directly split into tokens and traded on DEX without waiting for buyers to take the orders. The operation of ERC-404 is akin to dividing an image into multiple parts, allowing multiple individuals to jointly own a portion of that image.

Innovations

PANDORA is the first token based on the ERC404 standard. Since its launch, PANDORA's value has rapidly increased, with its token price soaring from under $5,000 to over $23,000 in a short time, and its market capitalization approaching $200 million. This significant growth demonstrates the market's interest and potential confidence in this new standard. Nevertheless, as an experimental standard, ERC404 is still in the early adoption phase and is undergoing rigorous testing to ensure its robustness and reliability.

The innovations of ERC-404 are reflected in the following aspects:

Conditional fungibility: A key innovation of ERC-404 tokens is their conditional fungibility. This means that these tokens can act as fungible assets under specific conditions, while in other cases, they behave as non-fungible assets. This flexibility broadens the application scenarios of the tokens, allowing ERC-404 tokens to be used more widely in various blockchain applications.

Enhanced utility: By introducing semi-fungible tokens, ERC-404 increases the utility of tokens and provides new token opportunities. This includes partial ownership of NFTs or dynamic assets that change over time. For example, an ERC-404 token can represent partial ownership of a piece of artwork, allowing multiple users to share ownership of this valuable digital asset.

Increased market liquidity and lowered entry barriers: By allowing the splitting of NFTs, ERC-404 tokens help improve liquidity in the NFT market and lower the barriers faced by potential investors. This splitting mechanism makes high-value digital assets more accessible, thereby attracting a broader audience to participate in the NFT market.

Token minting and burning process: ERC-404 involves a process of token minting and burning, allowing for partial transfers of NFT ownership. When an ERC-404 token is purchased, an associated NFT is minted in the buyer's wallet. Correspondingly, when the wallet does not hold enough tokens to form a complete token, the corresponding NFT will be burned, and when the wallet accumulates enough shares to form a complete token, a new NFT will be automatically generated. This mechanism provides an innovative way for exchanging and interacting with NFTs, increasing market activity and inclusivity.

Some may wonder how ERC-404 handles NFTs with rare attributes.

For NFTs with rare attributes, ERC-404 proposes an innovative handling method, exemplified by the PANDORA project. Within this framework, each ERC-404 token is linked to a unique Replicant box NFT with different rarity colors. When purchasing an ERC-404 token, the system randomly generates an associated box NFT, with the color reflecting its rarity. This not only increases the liquidity of NFTs but also provides buyers with a new way to enhance the rarity of their collections by selling tokens and re-minting NFTs.

Specifically, ERC-404 also allows users to assess the rarity of the obtained NFT after the initial purchase of the token and "re-draw" the characteristics of the NFT by transferring the token to a new wallet, aiming to enhance its rarity. This mechanism not only stimulates token trading activities on DEX but also creates additional revenue opportunities for liquidity providers.

However, this mechanism for handling rare attributes also presents some challenges, such as how to maintain the value of rare NFTs during the re-minting process and how to balance market demand and valuation for NFTs of different rarities. These considerations need to be addressed and balanced in the further development and practice of the ERC-404 standard.

Limitations

Despite the many innovative application possibilities offered by ERC-404, it also faces some limitations and challenges.

1. Code risks: The auditing agency Beosin conducted a detailed analysis of the design mechanism of ERC-404 and the contract code of ERC-404 v2. They indicated that while the v2 contract introduces EIP-2612 support and improved minting and burning logic, risks still exist: the whitelist feature may lead to centralization issues or potential abuse; developers or users may make errors when calling transfer functions; there is still much room for improvement in gas optimization; and there is a lack of an emergency pause function. Therefore, the development team needs formal verification and manual audits by security experts to ensure that the code has no logical vulnerabilities.

2. Lack of official recognition: ERC-404 is not an officially recognized token standard by Ethereum, which adds risk since this standard has not undergone the rigorous review of the EIP process. This process provides security, usability, and compatibility assurances for community discussion and review. Additionally, the experimental label of ERC-404 itself poses a risk. This status means that the standard is still in the development phase and may undergo significant changes. Projects adopting ERC-404 may face challenges in adapting to these changes, leading to instability or compatibility issues.

3. Potential exploitation risks: A developer named "quit" pointed out that if NFTs under the ERC-404 standard are placed in lending protocols that do not adequately accommodate their unique requirements, there may be a risk of NFT theft. This highlights the need for rigorous configuration and compatibility checks when integrating experimental standards into broader ecosystems to prevent such vulnerabilities. Additionally, since the ERC-404 standard is informal and eager to go live, there may be a wave of non-innovative projects, rug pulls, and other malicious activities falsely claiming to use the ERC-404 hype.

4. Integration challenges: Integrating the characteristics of fungible and non-fungible tokens in ERC-404 may pose difficulties for platforms and protocols built on existing standards. These barriers may limit the efficiency and effectiveness of projects using ERC-404.

Extensions Based on ERC-404

1. PORTAL404

PORTAL404 is a project based on the ERC-404 v2 standard that has launched a series of portals with rich interactive interfaces, enhancing user experience and simplifying the trading process. Although ERC-404 v2 introduces ultra-high liquidity, splitting, and resetting features, this rapidly evolving technology also brings new complexities and risks, such as managing multiple dApps and interfaces, and uncertainty about which NFT will be burned or transferred. To address these challenges, PORTAL404 introduces the ERC-5169 standard—by calling the corresponding token front end through the token contract, it provides a token interface that allows ERC-404 token holders to view complete data associated with each token, including balances, owners, market prices, contracts, etc., on the same interface, and allows interaction with external contracts, such as increasing leverage through the Wasabi Protocol, using Candlestick for trading analysis, or monitoring trading pairs through the Floor Protocol.

Overall, the PORTAL404 project combines the ERC-404 and ERC-5169 standards to provide NFT and token holders with enhanced control and security.

2. DN-404

DN-404 is a supplement and improvement to the ERC-404 standard, launched by developers cygaar and quit, aimed at addressing the rising Ethereum network fees caused by ERC-404. DN-404, known as "Divisible NFT-404," differs from ERC-404, which attempts to merge NFT and token functionalities into a single contract, by using two separate contracts: a standard ERC-20 token and a mirrored ERC-721 NFT. The developers believe that this separation approach can mitigate potential security risks, adhere to established standards, and ultimately simplify the process. However, the code for DN-404 has not yet been audited, so there are inherent risks in its use.

The introduction of the DN404 standard aims to address the efficiency issues of ERC-404. This newly proposed "divisible NFT" standard is designed to allow NFT holders to trade fractional parts of NFTs with others. Developer cygaar explained on social media that their ultimate goal is to create an NFT standard with native splitting functionality.

3. Smart Layer

Previously, we conducted a detailed analysis and introduction of Smart Layer's TokenScrip and ERC-5169: TokenScript is a programming interface designed for tokenization proposed by Smart Token Labs in 2019. This interface not only helps users access all functions of tokens but also allows for the creation of more advanced, complex, and flexible "user token" interactions. To enable tokens to interact with various services and applications in the Web3 ecosystem, Smart Token Labs proposed the Ethereum standard ERC-5169 in May 2022 (which has become Final state). This standard introduces the concept of executable scripts, allowing tokens to carry their own logic and behavior, enhancing their interactivity. TokenScripts can be embedded in tokens according to the ERC-5169 standard, allowing tokens to exhibit dynamic behavior when interacting with various services and platforms.

Smart Layer recently launched an upgraded ERC-404 application, based on ERC-404 V2, adding ERC5169 and TokenScript to ERC404 tokens as token front ends, helping users operate ERC404 tokens more securely and conveniently, making transactions safer and frictionless, and even further amplifying liquidity. Crypto researcher Haotian analyzed that "Smart Layer is actually unrelated to ERC-404; it just so happens that ERC-404 aims to give tokens the basic functionality corresponding to NFT images, while Smart Layer is a standard that integrates ERC-5169 and TokenScript, essentially aiming to achieve programmable execution properties for FT tokens."

Conclusion

The ERC-404 standard brings new possibilities for the application and liquidity of tokens by combining the characteristics of fungible and non-fungible tokens. With the launch and practice of tokens like PANDORA, the market's interest and potential confidence in this new standard have been significantly demonstrated, proving its potential in enhancing liquidity in the NFT market and lowering entry barriers. However, as an experimental standard, ERC-404 still faces many challenges and limitations, including code risks, lack of official recognition, and potential exploitation risks, all of which require close attention and prudent handling from developers, investors, and users.

As technology continues to evolve and the market matures, we can expect ERC-404 and its derivative projects like PORTAL404 and Smart Layer to continue exploring and expanding the boundaries of tokenization. These innovations not only provide NFT and token holders with richer interactive experiences and investment opportunities but also bring new vitality and development potential to the entire blockchain ecosystem. In the future, as more projects adopt and optimize this standard, we may witness a significant transformation in the blockchain tokenization field, creating more value and opportunities for users and developers.