These developers are mashing ERC-20 tokens and NFTs together: Will it work?

It was around 9am in Toronto, Canada, when a designer and crypto trader stopped by ctrl on X – his real name is Arya Khalaj – thought he had stumbled upon something brilliant.

The project was called Emerald and claimed to combine ERC-20 tokens with NFTs in a way that could solve NFT liquidity problems for good. It seemed to be the solution to many problems that ctrl had encountered while working with various crypto projects.

He went all in. While chatting online with a friend pseudonymously known as Searn, they started throwing in snippets of ether. During this time, the graph only continued to rise. Once they ran out of ether, they poured their investments into other projects and soon found themselves at about $60,000 each.

Then, without warning, the project was exploited and the bottom fell out of the graph.

Ctrl — who had holed up in a small Airbnb because his lease had expired during a three-month trip to Tokyo — was devastated. “We were sitting there, completely shocked, thinking, what just happened?” he told The Block in an interview.

The two crypto traders spoke to a friend and former Coinbase engineer, pseudonymously known as Acme, about the situation. They contacted Emerald’s developer and asked if they could help fix the project and bring it back to life. Still, the developer didn’t seem interested in any help, they said, and planned to restart with a quick patch anyway. Acme looked at the code and said it was barely designed to work in the first place and would need to be completely rewritten.

So that’s what they did.

“We’d been up all night,” Ctrl said. “After that we stayed awake for about 26 hours. So we’ve been at it for two days now and built this thing in a single sprint.”

By the end, they had built a working implementation of a token standard that combines ERC-20 tokens and NFTs. They called it ERC-404, named after the common error message on websites.

“We thought it was an appropriate name because the whole thing was so experimental and we knew it would confuse a lot of protocols and dapps when we launched it because it has both ERC-721 and ERC-20 functions,” said ctrl.

What is an ERC-404 token?

While ERC-20 tokens are fungible tokens that can be replaced by any other token, NFTs are unique tokens that are non-fungible and cannot be exchanged in the same way. ERC-404 combines both ideas to create what the team calls a semi-fungible token.

The team recognized that this creates a Frankenstein’s monster. “It’s just a matter of actually understanding how to mix two things that have never been mixed and are not designed to be mixed together – and are actually contradictory,” ctrl said.

In practice, it looks like this: For example, a project can offer 100 tokens and 100 NFTs, with each token tied to an NFT. If someone buys less than a whole token, the NFT will be burned and they will only have a fraction of a token. If they combine this with more fractions of a token, an NFT will be hit back into their wallet.

The core idea is that it allows people to buy and sell NFTs, as well as parts of an NFT, with the parts represented as tokens. Since two halves of a token can be combined to create an NFT, the tokens should in theory retain the value of the underlying NFT potential even if it is temporarily gone. Two half tokens are worth half of a whole token because they can be combined at will to create the whole token with its corresponding NFT.

The only problem is that combining two tokens does not produce the same NFT, so its value can be a bit variable – but this will also depend on the specific project in question, as each project can implement the token standard in its own way; choosing how many NFTs they want per token and how the NFTs are regenerated. For example, a project may generate new NFTs every time they are created, or it may be that all NFTs look the same.

With NFTs constantly being minted and burned, this raises the question of whether the token design will lead to many expensive transaction fees. A developer known as quit on X noted that the current system is more expensive than current NFT projects. The team acknowledged this is a potential problem, but said they were focused on optimizing it.

Opening Pandora’s Box

The team of four – consisting of ctrl, Searn, Acme and another person known as Hohenheim named their project Pandora and created the first token under the ERC-404 token standard on February 2. It’s worth noting that even though they’ve done some testing, it’s still unchecked and poses some risk.

Pandora has created 10,000 NFTs called replicants, which are tied to 10,000 Pandora tokens. The NFTs take the form of boxes of five different colors, each with different levels of rarity – which may later reveal other works of art.

Anyone who buys a token gets an NFT – and if they spend half of that token, the NFT is destroyed. When new NFTs are minted, they are randomized, meaning the distribution and rarity may change over time. This means users must be careful not to accidentally destroy their own rare NFTs, which can be replaced with more common NFTs.

“[ERC-404] allows you to do things that were never possible with ERC-721. And so there are a lot of different implementations, a lot of different ways that you can approach the concepts. Of course we only had to choose one,” says ctrl. “But people do all their own things.”

At launch, 7% of the offering was allocated to the team and early contributors. At launch, the team purchased 23% of the total supply to use to provide additional liquidity through market makers or for token listings.

So far the project has seen $100 million in trading volume on decentralized exchanges. The token has reached a price of around $12,800, giving the project a fully diluted valuation of $125 million, while the NFTs have reached a similar price floor.

Some projects are testing the waters

Since its launch, a number of projects have started experimenting with it. On-chain index project Peopods Finance has added the Pandora token so it can be packaged and used to generate yield. Credit platform Teller has added it so that it can be used as collateral for loans. Furthermore, trading platform Wasabi Protocol has listed it, allowing perpetual trading of the token.

In the short term, the team plans to propose an Ethereum improvement proposal – something that, if accepted, would make Ethereum better designed to support these types of token standards. Hohenheim said the team didn’t want to give a firm timeline, but said it would be a number of days, not weeks, before this happens.

The team is also preparing to launch a protocol very soon that could accelerate the adoption of ERC-404 tokens, according to ctrl. It would provide creators and developers with the tools and infrastructure to build products using ERC-404 tokens.

“What we’re doing now is we’re focusing less on the usual NFT gimmicks and more on building actually functional, usable, user-centric products, that also integrate with our collection and make people want to keep our collection because of the incentives they get,” he said.

Why create ERC-404 tokens?

While understanding how ERC-20 tokens and NFTs can be combined is one thing, another question is why anyone would want to do that.

The Pandora team said there are two main reasons why this makes sense. The first is that it could help with the liquidity of NFTs. Ctrl said any NFT built on the ERC-404 standard would have liquidity as long as there is a liquidity pool. This means that any NFT can be sold at any time without the need to find a buyer counterparty.

“People get angry when people reach their 40s [NFTs] at the same time. Well, now you essentially have a token price that reflects a floor price in real time, and there is no such thing as a fat or third floor because there is actual native liquidity,” he said.

The second reason is that it can provide native fractionalization of NFTs. Currently, to fractionate an NFT you have to lock it up and create a number of tokens that represent the overall NFT – something that is tricky to settle and put back together.

By providing native fractionalization, the idea is that ERC-404 tokens can provide a better user experience. “That’s why native fractionalization is so important, I think, because it’s actually a built-in feature,” says ctrl. “People don’t have to feel like they have to do some weird four-step process and get this kind of legitimate NFT that’s a derivative of that.”

Ctrl also noted that NFTs using the ERC-404 token standard can be applied in the gaming industry, especially when it comes to the gamification of destroying and recalling NFTs with a randomization factor. If successful, it would encourage more trading of these tokens, something that could drive wider adoption.

Although we assume that humans will be able to work around semi-fungibility.