“ERC-404” is a novel and unofficial term coined by developers behind Pandora, which aims to combine ERC-20 and ERC-721 to bring fractionalization and liquidity to NFTs.
On Feb. 2, 2024, a new and mysterious token launched on the Ethereum mainnet, with talk about it only within certain circles. Mere days later, it took the crypto community by storm, as the token price surged from the low hundreds to around $32,000, an incredible 40X in just under four days. This new narrative also triggered a wave of copycats attempting to replicate its success, spiking gas fees on the Ethereum mainnet. We are talking about Pandora here - the first token that brought “ERC-404” to everyone’s attention.
But what are “ERC-404s” and what is the hype behind them?
What Is “ERC-404”?
It's important to note that “ERC-404” is not an official token standard. Token standards like ERC-20 have been proposed in Ethereum Improvement Proposals (EIPs) and accepted before they are recognized.
“ERC-404” on the other hand is a term coined by developers behind the experimental Pandora project. The token standard seeks to combine characteristics from the ERC-20 token standard, which governs fungible tokens, and the ERC-721 token standard, which governs NFTs.
In its current state, NFTs only exist in whole tokens, meaning that a user is unable to purchase 0.5 NFTs or 2.5 NFTs from a collection. This is unlike traditional ERC-20 tokens, which can be bought in fractions such as buying 0.1 ETH or 1.69 ETH in a single trade.
While there are projects that seek to provide liquidity through NFT fractionalization, these projects often require locking the original NFT and even with successful fractionalization, these fractionalized NFTs often deviate from their expected value due to lack of liquidity.
Pandora’s ERC-404 seeks to provide native fractionalization to NFTs to overcome the friction of traditional fractionalized NFTs. In essence, ERC-404 attempts to build in the features of fractionalization into the NFTs themselves, without relying on a third party to do it for them.
How Does “ERC-404” Work?
ERC-404 tokens exist in two forms, the token and the NFT forms, which are intrinsically linked. The ERC-404 token standard allows for the creation and transfer of fractionalized shares of NFTs, which is achieved through a technique known as ‘pathing’ where information relating to token amounts and IDs are stored in a lossy encoding scheme. Essentially, these fractionalized shares store data about the token in a compressed manner.
When a user purchases a full ERC-404 token, a NFT is minted to the same wallet. Similarly, when a user sells a full ERC-404 token, the corresponding NFT is burnt. ERC-404 tokens can set a limit to the minting of NFTs on their collection, such as Pandora, which sets a limit of 10,000 NFTs on their token. From the NFT perspective, selling the NFT also results in removal of the respective token from your wallet.
As such, ERC-404 facilitates the fractionalization of NFTs, but perhaps more importantly, democratizes NFT trading for all users as users can obtain exposure to an NFT collection at any price point without being priced out. Additionally, having a liquid token tied to the NFT creates an accurate and liquid gauge of the floor price of the NFT collection which aids valuation of NFT collections.
Drawbacks of ERC-404 Tokens
Despite the benefits provided by ERC-404 tokens, they are not without their risks.
Firstly, the ERC-404 token standard is not an officially approved standard like the ERC-20 or ERC-721 standards, which have gone through the rigorous process via an Ethereum Improvement Proposal (EIP), which could take up to months to be accepted formally into the Ethereum’s officially recognized token standards after debates and edits from editors and reviewers.
As ERC-404 tokens are transferred, the contract has to check if NFTs have to be minted or burnt, based on whether the sender or recipient loses or gains a full ERC-404 token in the process. This results in each transfer being significantly more expensive than regular token or NFT transfers.
Moreover, the ability to mint and burn NFTs via transfers creates an issue where holders can “re-roll” the traits on their NFTs until they receive a rare NFT by only paying gas. This diminishes the significance of actual rare NFTs.
DN404: An Improved Version?
As with any novel technology, chances of exploits or overlooked details in the code are high. Developer “0xQuit” laid out some of these issues in a thread, mainly pointing out that a token depositor could potentially exploit and withdraw NFTs from an NFT depositor:
0xQuit, together with other developers like “0xCygaar,” “optimizoor,” “0xjustadev,” “AmadiMichaels” and “PopPunkLLC,” launched a “Divisible NFT” standard termed: DN404.
Aiming to improve on ERC-404 and prevent potential exploits, the DN404 standard uses two contracts, a base ERC-20 and mirror ERC-721. Essentially, the main trading of tokens will be done on the base contracts, while NFTs will be burned or minted on the mirror contract.
So far, the code has yet to be audited, and the team have warned developers to proceed with caution.
ERC-20721: An Alternative?
Similar to ERC-404, another project has also been targeting the same problem from a different angle. Enter ERC-20721, another experimental token standard devised by the NFT project, Cellmates. ERC-20721 attempts to adhere more strictly to the token standards on which it is based, that is, ERC-20 and ERC-721, as opposed to ERC-404, which makes several tradeoffs on either token standard.
As opposed to direct fractionalization of the NFT, ERC-20721 only allows for trades of full tokens (i.e., 1 full NFT). This token is still tradable on a decentralized exchange (DEX), but in a whole number of tokens only. To achieve a similar effect to ERC-404s, they enable a fractionalized token version to trade alongside the NFTs, which enable smaller players to gain exposure to the token. Using Cellmates as an example, the full token is CELL and the fractionalized token is wCELL, which is obtained from fractionalizing a pool of CELL tokens.
This implementation keeps the NFT collection unchanged through trades and transfers, which preserves the rarity of specific traits in the collection as it removes the issue of re-rolls. Additionally, due to its implementation, ERC-20721 transfers cost less gas than ERC-404s as it removes the need to check for NFT mint and burns during transfers.
Conclusion
With the meteoric rise of Pandora, all eyes are locked on the burgeoning sub-sector, with similar projects sprouting on other chains such as Arbitrum and Solana, attempting to replicate Pandora’s success as the first movers on their respective chains.
Despite the lack of an official token standard yet, centralized exchanges, Binance and OKX, have already announced support for ERC-404 tokens on their respective wallets.
Furthermore, with Pandora’s push towards increased legitimacy through better standardization and optimizations to their original code as well as smart contract audits, the ERC-404 space will likely continue to capture the attention of the space and further innovation in the space between NFTs and fungible tokens.
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