What is ERC-404? Exclusive interpretation of the future of NFT protocols

Written by: NFTScan

At the beginning of last month, ERC-404 became the hottest topic. ERC-404 is an experimental token standard open-sourced by the Pandora team in early February for creators and developers, featuring a hybrid of ERC-20 / ERC-721 with characteristics such as native liquidity and fragmentation. With the early development, more and more participants began to pay attention to this brand new protocol standard, ERC-404.

1. What is ERC-404?

ERC-404 is a protocol standard that combines ERC-20 (fungible tokens) and ERC-721 (non-fungible tokens NFTs), allowing for mutual conversion between NFTs and tokens, with native liquidity and fragmentation.

In simpler terms, this protocol allows NFTs to be traded in a split manner like tokens, similar to dividing an image into multiple parts, enabling multiple individuals to jointly own a portion of that image. Some blue-chip NFT projects, such as BAYC and PudgyPenguins, have prices that are prohibitively high for ordinary retail investors, especially those with rare attributes, making them difficult to trade. The introduction of ERC-404 represents a significant improvement for these originally illiquid NFT projects, allowing these high-priced NFTs to be traded in a split manner on mainstream trading markets, as conveniently and quickly as purchasing BTC, ETH, and other token assets.

2. What is PANDORA?

Pandora is the first project built on the ERC-404 token standard, offering a unique trading method. In this project, every time a PANDORA token is purchased, an NFT is minted and automatically appears in your wallet. Conversely, when you sell a PANDORA token, the corresponding NFT will be destroyed. The same NFT destruction and re-minting process occurs when tokens are transferred. However, transferring the NFT does not result in any changes to the NFT itself.

This means you can choose to sell your NFT to liquidity pools without having to place orders and wait like on traditional NFT trading platforms. This new trading method provides holders with more flexibility and convenience while also bringing more liquidity and vitality to the NFT market. Through this approach, the Pandora project introduces new possibilities for NFT trading, promoting the development and maturity of the NFT market.

Leading project based on the ERC-404 protocol standard:

https://eth.nftscan.com/0x9e9fbde7c7a83c43913bddc8779158f1368f0413

3. Innovations Brought by ERC-404

• One innovation of ERC-404 is that it can act as fungible tokens under certain specific conditions, while in other cases, it behaves as non-fungible tokens (NFTs). This flexibility allows ERC-404 to have broader possibilities in the Web3 space, catering to both high liquidity trading scenarios and asset management scenarios that require personalization and uniqueness, providing users with more options.
• ERC-404 expands the application scenarios of tokens, bringing more possibilities to users. For example, it allows tokens to represent partial ownership of assets, enabling the concept of shared ownership in NFTs, where multiple users can jointly own the same NFT and share corresponding ownership rights based on the number of tokens held. Additionally, ERC-404 can be applied to a wider variety of assets, offering users more diversified management.
• It allows NFTs to be split into smaller fractional tokens, enabling more investors to participate in high-priced NFT investments without needing to purchase the entire NFT, thus lowering the market entry barrier. It also increases the liquidity of NFTs, as more tokens can be traded, enhancing market activity.
• ERC-404 involves the automatic minting and destruction of corresponding NFTs in wallets, achieving a seamless connection between token shares and NFT ownership.

4. Limitations of ERC-404

Initially, with various ERC-404 projects being launched, the Gas fees on the Ethereum network saw a significant increase. However, as issues arose and interest waned, the attention on ERC-404 projects began to decline rapidly. The leading project PANDORA has seen a severe drop compared to its peak, while other ERC-404 projects experienced earlier and larger declines. What limitations does ERC-404 have?

1. Firstly, due to the increased complexity of the underlying smart contracts, the Gas fees required for executing transactions are correspondingly higher than those for conventional ERC-20 transfers. Given the current limited performance of the Ethereum network, the high Gas fee issue becomes more pronounced, directly affecting the user experience.

2. Secondly, the lack of official recognition and integration challenges. The ERC-404 protocol is not officially recognized by Ethereum, which adds uncertainty risks before it can be widely adopted. Moreover, integrating this new standard into the existing ecosystem of wallets, exchanges, Dapps, etc., will face numerous obstacles regarding standardization, compatibility, and stability.

3. When trading fungible tokens, there is a possibility that the corresponding NFT (non-fungible token) could be indiscriminately transferred to the buyer without considering the rarity of the NFT. This situation could lead to the original holder losing their high-value NFT along with the transfer.

4. Potential technical risks. Although ERC-404 borrows mature elements from ERC-20 and ERC-721, the way it integrates both is entirely new, inevitably increasing the complexity of the smart contracts and potentially introducing new attack vectors and security vulnerabilities. The ERC-404 standard requires rigorous third-party security audits and penetration testing, and current efforts in this area may still be insufficient, necessitating strict configuration and compatibility checks to prevent such vulnerabilities.

The liquidity of NFTs has always been a challenging issue, with many projects striving to address this problem. Various market platforms are attempting to tackle this challenge by enhancing user experience and increasing liquidity. Additionally, some projects are exploring ways to improve NFT liquidity through collateralized lending and NFT fragmentation, such as breaking NFTs into ERC-20 tokens for liquidity mining on decentralized exchanges. The emergence of the ERC-404 protocol provides a promising solution.

In summary, ERC-404 introduces a new concept of "hybrid tokens," breaking the barriers between fungible and non-fungible tokens, and opening up new application scenarios for the Web3 ecosystem. However, as an experimental standard, ERC-404 is still in the early adoption phase, undergoing rigorous testing to ensure its robustness and reliability, and whether it will be adopted by the mainstream remains to be observed further.