The Broken Mirror // An Overview of NFT Fractionalization 🪞🧩
// An Overview of NFT Fractionalization
Table of Contents 🕹️
The Benefits of Fractionalization 🧩
Use Cases 🛠️
Mirror, Mirror 🪞
Further Down the Rabbit Hole 🕳️
“What does a mirror look at?”
— Frank Herbert,
This issue is sponsored by…
NFTfi is a simple peer-to-peer marketplace for collateralized NFT loans. It allows borrowers to put up assets for a loan and lenders to make offers in exchange for interest. The NFT is held in escrow while the loan is active so lenders know for sure that they will either get their money back with interest or receive the NFT in exchange.
If you would like to borrow using an NFT for collateral, you can go to NFTfi and post your desired terms. If someone likes those terms, they can extend a loan to you. Alternatively, if you would like to provide a loan to individuals in exchange for favorable interest rates or the potential of scoring a specific NFT, you can do that too!
I. Introduction 👾
NFTs are shocking the world, bringing about what many are heralding a renaissance in Internet culture.
Collectibles, art, domain names, essays, memes, and more have all been transformed into NFTs, and this will likely continue as the technology helps create an ownership layer to our digital infrastructure. This new emerging sub-asset class within the crypto ecosystem is transforming how value accrues and is distributed across the web.
This far along in the cycle, I would expect most of you to have a solid understanding of what an NFT is, so instead let’s turn to one of the newest emerging trends within NFTs: fractionalization.
Fractionalized NFTs are NFTs that have been locked in a smart contract and split into a quantity of ERC-20 tokens. Each token represents partial ownership of the NFT. Governance over the NFT is then delegated to a broad community of fraction holders, who can collectively vote on buyout mechanics for the NFT that would piece it back together.
In this issue, we highlight some potential benefits and use cases for fractionalization, review some of the major players in the space, and discuss some existing criticisms.
II. The Benefits of Fractionalization 👾
NFT fractionalization solves many of the core problems of existing NFT infrastructure and markets.
NFTs are usually thinly traded, making valuation difficult. Since there aren’t liquid secondary markets, price discovery is limited to past sales history, auction outcomes, or some form of interpolation. While these mechanics are useful, they are rather limited.
NFT fractionalization enables the creation of ERC-20 tokens that can then be sold on the open market via a decentralized exchange. This introduces free market mechanisms that can hone in on valuation in real time.
Liquidity is the biggest concern for NFTs. Many investors have elected to participate at the floor of NFT collections as the floor is where most liquidity is. While a high value NFT might hold the largest gains, it is also limited by having to find another large investor willing to purchase at those price levels. NFT fractionalization opens up the same level of liquidity as the floor for high-value NFTs.
But that isn’t the only liquidity benefits seen by fractionalization. Fractionalization into ERC-20s also paves the way for the NFT to be used in DeFi. NFTs could be sold on DEXs, used as collateral for loans on lending platforms, staked to receive governance power in DAOs, imported into games, or more.
Democratization of Ownership
Prices for rare NFTs can be astronomical, leaving smaller collectors/investors on the sidelines. The value of any NFT is ultimately driven by its community, so limiting community involvement due to high purchase prices can be a negative to a project’s valuation.
Breaking NFTs into ERC-20s means that anyone can own a fraction of a rare NFT and participate in the community. Interestingly, it appears from early experiments that the NFT actually climbs in implied value once fractionalized. Is there a negative value discount applied to high-value NFTs solely due to their high price tags and illiquidity?
III. Use Cases 👾
Art & Collectibles
The most obvious use case for fractionalization is art and collectible NFTs. While there is a vibrant crypto art market forming, let’s discuss this through the lens of traditional art markets.
Art as an investable asset class has been recognized for quite some time. For example, the British Rail Pension Fund invested $70mm (or about 3% of its portfolio) into fine art and collectibles between 1974 and 1981 to large success. The public’s attention was captured by the art market following the sale of da Vinci’s Salvatore Mundi in 2018 to the tune of $450.3 million. The art market itself is full of consultants, wealth managers, lawyers, and more, making it ripe for disruption in the Web3 era.
It is extremely easy to purchase art, but selling is much more difficult. Auction houses tend to favor proven artists and avoid reselling, the consignment process is notoriously difficult, and title, authenticity, and condition issues could leave the owner with a work unfit for market. For an example of the illiquidity, 52,105 living and deceased artists appeared at auction in 2017 according to The Art Market report from Art Basel and UBS. Only one percent of names accounted for 64% of the total sales, revealing a winner-takes-all dynamic that leaves many pieces illiquid for long durations.
NFT fractionalization can solve illiquidity as discussed above. But it also enables the creation of investable indices for art and collectibles, something that has yet to be successfully done in traditional markets given lack of transparency, valuation difficulties, and low turnover.
The meme-ification of finance and culture may soon be an investable asset class with NFTs and fractionalization as well.
To the cat’s point, $DOGE and countless dogecoin forks have billions of dollars in market-cap but no provenance to the original meme. This shows that memes can derive value from their cultural relevance, but they can be endlessly forked into new forms. However, fractionalization represents a new evolution in the meme coin.
Cryptopathic began this experiment with the fractionalization of the Fiesty Doge meme that was purchased from the OG meme creator and dog-owner earlier this year into $NFD. It has since been announced that PleasrDAO will fractionalize the original Doge meme from the same auction (future Doge meme indices?).
$NFD has gone on a roller-coaster of a ride, typical of any memecoin, but there is no denying its provenance over competitors like $SHIB and $AKITA. It is yet to be seen how the $DOG token from PleasrDAO will do.
However, it seems safe to say that transforming meme NFTs into fractionalized tokens may just be the next wave of cultural investing.
Crowd-Funding / DAO Formation
Arguably one of the most fascinating examples of NFT fractionalization has been the use of crowdfunding using PartyBid from PartyDAO. PartyBid is a decentralized application that enables groups of people to pool capital in real-time to bid on NFT auctions together. Upon successfully completing an auction, the NFT is placed into a Fractional smart contract and fractionalized into ERC-20 tokens that are then distributed pro-rata to bidders in the party. This is particularly interesting since it effectively creates a coordination mechanism for forming NFT-based DAOs instantly.
Nouns DAO is one successful experiment following this model to date. Nouns are on-chain avatar NFTs that allow holders a single vote in Nouns DAO governance. A new noun is created everyday and auctioned off for eternity. Proceeds from each auction go to a community-owned treasury that Noun holders can vote to deploy however they see fit. Nouns have thus far gone for exorbitant amounts, pricing out many who would like to join the DAO. To counter this, Nouns DAO has partnered with PartyBid to offer Nouns on the platform for crowdfunding purposes. A party can bid on a Noun and if they win, they receive fractional shares that can be used to vote within Noun DAO.
An NFT is just a form of ownership certification much like property titles for real assets (e.g. real estate, vehicles). If we see increased amounts of on-chain titles for real-world assets, it isn’t difficult to imagine the extension into fractionalization.
The sharing economy has birthed new models of shared ownership that will likely extend to our web3 future. Some thought experiments:
Autonomous vehicles that perform ride-sharing services with holders of the fractionalized title receiving a pro-rata share of income. This could be extended to any robotic services performed autonomously for revenue.
Real estate properties could be collectively owned and shared by fractional holders. While this is effectively a timeshare, the infrastructure would be significantly updated: accumulate/sell positions on liquid secondary markets, connect wallet with tokens to an application to verify ownership and book times, the elimination of middlemen and legally binding contracts, etc.
As an expansion to the last idea, fractionalized real estate properties could be rented out with cash flows channeling through smart contract to fractional holders. The ingrained buyout clause mechanic of fractional NFTs would allow individuals the ability to acquire ownership in a property over time before triggering the clause.
Private Capital Investments
Typically illiquid and inaccessible private capital investments could be ripe for disruption via fractionalization as well. Early-stage crypto projects are sometimes funded by VCs pre-token launch using a contractual agreement known as a SAFT, or “Simple Agreement for Future Tokens”. In this arrangement, a VC will provide an injection of capital to the project in exchange for a block of pre-listed tokens issued at a discount. This agreement usually includes a lock-up period to align long-term incentives.
But in the world of DeFi, there is no such thing as illiquidity. A SAFT could be wrapped in an NFT and fractionalized. The ERC-20s could then be placed into a liquidity pool on an AMM, making it tradeable to anyone. The VC could offload any liquidity they desire, and the fractionalized token holders would be provided an opportunity to invest in a previously inaccessible asset class.
Illiquid investments are standard fare for accredited investors in traditional finance. Will fractionalization democratize the asset class?
Finally, a fun idea for the Bitcoin maxis. Deflationary assets like Bitcoin could ultimately become prohibitively expensive to convert into during the latter half of a hyper-bitcoinization era given increasingly worthless fiat currency. While divisible down to a sat, what if that isn’t enough? One solution could be minting a Bitcoin sat as an NFT and fractionalizing it, making Bitcoin itself infinitely divisible.
IV. Protocols 👾
Existing protocols for NFT fractionalization come in two primary flavors: pure fractionalization and tokenized liquidity pools. Here are a brief synopsis of some of the majors in the space.
Fractional is a decentralized protocol where NFT owners can mint ERC-20 tokenized fractional ownership of their NFTs. These tokens have governance over the NFT that they own, with the ability to vote on potential buyout offers.
Curators can elect to receive a curator fee for fractionalizing the NFT, which is an annual supply inflation of the NFT fractions. Fractional NFT owners can purchase however much of the NFT they want (up to the maximum amount).
All NFTs custodied by Fractional are held in a smart contract and can only be released upon a successful buyout or if someone owns 100% of the fractions. For the former, a successful buyout entitles fraction holders to their share of the ETH used in the purchase.
Unicly is a permissionless, community-governed protocol to combine, fractionalize, and trade NFTs. Users can create uTokens, an ERC-20 token that represents a collection or bundle of NFTs, by depositing and locking any number of ERC-721 or ERC-1155 tokens into a smart contract. Every individual NFT in the collection is treated separately, allowing collectors to bid on any of the NFTs with proceeds from a sale going to all holders of the corresponding uToken. Similar to Fractional, the uToken holders can vote on accepting bids for NFTs within the collection.
Unicly employs learnings from DeFi to create liquidity, such as yield farming the UNIC governance token and a DEX interface for trading uTokens.
NIFTEX is a permissionless on-chain service where anyone can fractionalize NFTs into ERC20s by locking them in a smart contract in exchange for fractions. The user determines how much of the NFT they would like to fractionalize it, custodies it in the contract, and begins a live auction to sell the fractions along a bonding curve.
NIFTEX supports all existing NFTs, including early non-standard contracts like Cryptopunks and Cryptokitties. Once an NFT is fractionalized, the user is able to combine smart contract modules to distribute, govern, and/or recover the NFT.
NFTX uses a tokenized pool model to create liquidity. Users deposit their NFTs into an NFTX vault in order to mint an ERC-20 token that represents a claim on a random asset in the vault. Anyone can create a vault, and vaults already exist for a wide variety of NFT projects.
Because of the vault mechanism, NFTX vaults will theoretically reflect liquid floor prices on the NFT project. If a high value NFT was placed in a vault, users would likely arbitrage it out of the pool.
NFT20 is a decentralized exchange and protocol for tokenizing NFT projects as ERC20 tokens, making them tradable on decentralized exchanges such as UniSwap or Sushiswap. When a user deposits an NFT into the appropriate NFT20 pool, they receive 100 ERC20 tokens representing their claim.
If a user would like to deposit a high-value NFT, they can perform a dutch auction via the NFT20 interface in order to receive a higher amount of the project tokens. The impact of this is that each pool should theoretically reflect closer to the average price of an NFT in the project.
A user can withdraw any NFT from a project pool for 100 tokens, or elect to exchange directly for ETH.
Nftfy is a decentralized protocol that enables NFT fractionalization. Users lock their NFT into a smart contract after setting an Exit Price that someone needs to pay to extract the NFT. Upon locking, the user receives one million ERC-20 tokens that can be used throughout DeFi. The NFT can be redeemed using a combination of fractions and ETH. If it is bought out, the remaining fraction holders can exchange their fractions for a proportional amount of the buyout.
NFT fractionalization is not without criticism.
While it is true that liquid secondary markets are a benefit of fractionalization, it should also be noted that it is exit liquidity for the NFT holder. Demand and speculation can create initial hype conditions that ultimately results in the NFT holder, who is providing liquidity via an exchange, selling out of their position with massive gains, effectively dumping on subsequent purchasers.
The probability of rugs is notably higher with fractionalization as well since the initial holder of the NFT owns all/most of the supply from the start. Liquidity could be purposefully manipulated along certain prices or even removed altogether.
Finally, fractionalization creates a community much like a DAO, but with none of the existing infrastructure for governance. While we would expect vibrant communities to form around these cultural artifacts, the starting point is different from a typical DAO, so the community must be more grassroots than ever for it to survive and thrive.
Even with these criticisms, it is very likely that NFT fractionalization is here to stay. As such, please remain vigilant when participating in these types of investments.
VI. Mirror, Mirror
NFT fractionalization is a defining moment in the crypto space. We are witnessing the merging of two dominant themes: DeFi and NFTs. Underlying this merger is the tokenization and financialization of DeFi derivatives coupled with the cultural renaissance that powers NFT adoption.
Art, collectibles, memes, and other cultural artifacts are like a mirror held up to our society, reflecting our values and beliefs. Fractionalization is a breaking of the mirror, so that it can be shared by everyone.
VI. Further Down the Rabbit Hole 🕳️
150 Minutes of NFTs with Jake Brukhman by Delphi Digital
Why Investing in Fine Art is Different Than Investing in Traditional Asset Classes by Doug Woodham
A Piece of Art by rekt
Accelerated Capital is a weekly publication exploring how cryptoassets, DeFi, virtual reality, and other exponential technologies are transforming our economy, society, and culture.
Be sure to subscribe to this newsletter below and follow us on Twitter.