Join Review Game to learn “What is ERC-404? How does ERC-404 work? What makes ERC-404 tokens useful? How does ERC-404 differ from ERC-20 and ERC-721?” through the article below.
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What is ERC-404?
The ERC-404 is an experimental token standard that combines the elements of the ERC-20 and ERC-721 token standards to generate a token with the properties of both fungible and nonfungible tokens.
In February 2024, two pseudonymous creators — “ctrl” and “Acme” — developed a new experimental token standard that combines the properties of two established token standards: ERC-20 and ERC-721. The ERC-404 GitHub site states that the two standards it intends to combine “are not designed to be mixed,” but the effort aims to merge them in “as robust a manner as possible while minimizing tradeoffs.”
The ERC-20 token standard is designed to create a “fungible token.” Fungibility is the ability to swap a token for something of equal worth. One of the key features of ERC-20 tokens is their divisibility, which allows them to be broken down into smaller units.
Meanwhile, the ERC-721 token standard, commonly known as the nonfungible token (NFT) standard, is created to offer unique, non-interchangeable tokens. Unlike ERC-20 tokens, each ERC-721 token represents a single digital asset or collectible, which is indivisible.
The ERC-404 token standard, named after the well-known web page error code “Error 404,” enables NFTs to be fractionalized within the constraints of the Ethereum network. This is achieved by enabling the fractional division of an NFT by linking it to a fungible token.
The team behind the ERC-404 token standard developed Pandora as the first project to implement the ERC-404 concept through the PANDORA token and corresponding “Replicant NFT.” ERC-404 is not yet an official Ethereum token standard and is executed by smart contracts.
What makes ERC-404 tokens useful?
Prior to ERC-404, only third-party protocols could fractionalize NFTs. When users shared their NFTs with these protocols, it would lock their NFTs in a wallet and issue tokens against them.
The problem users faced was trusting the third party to keep their NFT tokens secure and grappling with potential gaps between the value of the NFT and the token, resulting in a loss. ERC-404 gets around this by linking the NFT directly to the token’s value using a decentralized smart contract. Thanks to the mechanism, the token’s value reflects the real-time price of the underlying NFT, doing away with price errors and eliminating the need for third parties.
ERC-404 tokens make the NFT ecosystem more liquid, giving users the ability to trade fractions of NFTs through liquidity pools, which are controlled by smart contracts. User funds get locked within the smart contract, enabling the issuance of tokens against assets without the involvement of intermediaries. When the holder of an ERC-404 token sells the token, it is identical to selling the associated NFT.
How does ERC-404 work?
A unique “mint-and-burn” mechanism works under the hood in ERC-404, enabling the fractional ownership and transfer of NFTs.
When one purchases a whole ERC-404 token, the smart contract automatically mints a corresponding NFT and sends it to their wallet. The NFT denotes their ownership of the asset underneath the token. If anyone buys enough fractions of an ERC-404 token to complete a full token, the smart contract mints a new NFT for them.
On the other hand, when the holder sells fractions of their ERC-404 token, the associated NFT is burned, or destroyed. The protocol transfers the fractional ownership to the buyer(s) of those fractions. The NFT exists only when a person holds a complete ERC-404 token.
Imagine a token that can be both a unit of currency (like a dollar bill) and a one-of-a-kind collectible (like a rare baseball card). The ERC-404 standard allows tokens to switch between these functions depending on how many are held.
How does ERC-404 differ from ERC-20 and ERC-721?
The ERC-404 token standard differs from ERC-20 and ERC-721 by allowing NFTs to be fractionalized within the Ethereum protocol, enabling shared ownership and enhanced liquidity for unique digital assets.
The table below states how the experimental ERC-404 token standard compares with the ERC-20 and ERC-721 token standards:
What are the use cases of ERC-404?
Even if it is experimental, the ERC-404 token standard use cases span across industries, allowing fractionalized access to real estate, digital art, gaming, etc.
Asset tokenization
One potential application for ERC-404 is the tokenization of physical assets. It involves fractionalized ownership of expensive possessions like luxury goods, real estate and artwork. Fractional ownership lowers the entry barrier for investors and makes these industries liquid.
DeFi
By enabling the usage of assets that are nonfungible, the ERC-404 standard broadens the reach of applications related to decentralized finance (DeFi). Fractional shares allows ERC-404 token owners to access assets that were primarily inaccessible.
Gaming
ERC-404 tokens can represent game assets, such as avatars or weaponry. Fractionalization opens up new opportunities for gameplay progression and asset evolution while also improving accessibility to rare in-game objects. Players can exchange small amounts of assets, introducing them to new ways to monetize their assets.
What are the challenges faced by ERC-404?
The ERC-404 token standard is facing challenges due to its experimental nature, lack of official approval by the Ethereum Foundation, potential vulnerabilities for exploitation and uncertainty in market adoption.
Official recognition
Unlike ERC-20 and ERC-721, the Ethereum Foundation does not officially recognize ERC-404 tokens. The lack of recognition raises security and integrity concerns, as the standard yet lacks vetting. Assets created using ERC-404 have a risk factor, as the standard hasn’t been rigorously tested.
Experimental aspects
ERC-404 is still in the experimental stage, which presents potential risks for early adopters. This standard is relatively new, so it is likely to undergo substantial changes or improvements, thereby creating challenges in its adoption.
Market status
While ERC-404 tokens have gained initial traction, their long-term market acceptance and stability remain uncertain. Speculative trading activity can cause token prices to sharply fluctuate. The inaugural ERC-404 token PANDORA dropped from its peak of $30,144.97 on Feb. 9, 2024, to around $3,730 on May 16, 2024.
Potential exploits
The experimental nature of ERC-404 creates opportunities for malicious actors to exploit it. They could try to take advantage of vulnerabilities, posing security risks to assets built on ERC-404.
Source: Cointelegraph.com