Explained: Fractional NFTs (F-NFTs) and How They Work
NFTs, or non-fungible tokens, represent a new era of asset ownership that’s decentralized and transparent. One of the key defining features of NFTs is their guaranteed exclusive ownership. An NFT can’t be replicated or forged; it’s essentially a one-of-a-kind token.
However, this exclusivity severely limits what NFT holders can do with their assets. This has led innovators in the space to push the boundaries of what’s possible for NFTs, including opportunities for fractional ownership.
Fractionalization allows crypto investors to own a fraction of a big pie with little to no chances of getting ripped off. The concept is similar to owning shares of a company. It opens up NFT ownership to small- and mid-tier investors, instead of just whales with fat bank accounts.
So, what exactly are fractional NFTs, how do they work, and what are their benefits for investors? Read on to find out.
What Is a Fractional NFT?
A fractional NFT is simply a whole NFT that has been divided into smaller fractions, allowing different numbers of people to claim ownership of a piece of the same NFT. The NFT is fractionalized using a smart contract that generates a set number of tokens linked to the indivisible original. These fractional tokens give each holder a percentage of ownership of an NFT, and can be traded or exchanged on secondary markets.
Non-fungible tokens (or NFTs) are ERC-721 tokens created by an indivisible smart contract on the Ethereum blockchain. Since the tokens are indivisible and impossible to replicate, they are the perfect medium for individual intellectual property tracing.
NFT assets experienced a meteoric rise in 2021 thanks to multiple record-setting auctions of NFT projects. These virtual assets run the gamut from digital art, in-game items, virtual real estate and countless others.
So far, the largest was the auction of digital artist Beeple’s work Everydays: The First 5000 Days, which sold for $69 million at Christie’s auction house in February 2021. That historic sale opened the door for several more NFT projects, including NFT avatars by CryptoPunks and Bored Ape Yacht Club, some of which are now trading for millions of dollars on secondary markets.NFT art by Beeple broke records after it sold for $69,346,250 in March 2021. Image source: Christie’s
Making NFT Ownership More Accessible
As a burgeoning asset class, NFTs have greatly increased in popularity. Some collections have become so valuable that the price of owning a single NFT has become prohibitively expensive. While not every NFT collection has acquired the infamy of Beeple’s art or cartoon ape avatars from Bored Ape Yacht Club, the ones that are worth collecting can still be quite pricey. It also doesn’t help that NFTs are one-of-a-kind tokens, which means acquiring them on crypto markets can be difficult, due to a lack of liquidity.
With such high barriers to entry, fractionalization is a potential solution to all of these problems. Breaking down an NFT into smaller pieces democratizes this new market, allowing interested parties with limited funds to affordably invest. This not only benefits investors, but also NFTs in general, because it brings liquidity to the market. Fractional NFTs inject the market with a large number of affordable tokens that offer percentage ownership of popular NFTs.
Essentially, buyers with limited funds are able to buy fractional NFTs for a small proportion of the total market value. This enables multiple investors to each gain partial ownership of the same asset.
The mechanics behind fractionalization are pretty simple: Take a whole NFT and create a set number of shares (1,000, 10,000, even 10 billion) which are sold at a fixed price. These shares can be bought and sold on secondary markets without affecting the value of the original NFT. A famous example of fractionalization within this space is the sale of NFT art by musician Grimes called Newborn 1 & 3, which was auctioned on Otis in July 2021 with prices starting from $10 per share.One of the works from the “Newborn 1 & 3” collection by musician Grimes was sold as fractional NFTs on Otis at $10 per share. Image source: Otis
Another famous example is the sale of an NFT of the iconic “Doge” meme that led to the creation of the meme cryptocurrency Dogecoin. An NFT of the meme sold for $4 million in June 2021 (it’s now valued at several hundred million dollars). The buyer, a collective known as PleasrDAO, fractionalized the NFT 17 billion times, allowing anyone to own a piece of it for just pennies.
Fractional ownership of assets isn’t a novel idea. The concept has been used with great success in numerous industries, ranging from real estate to fashion, and for all kinds of physical assets, including stock, designer goods, and luxury assets like yachts and private jets.The Doge NFT was fractionalized into 17 billion tokens called DOG. Image source: Fractional.art
In the real estate industry, fractionalization is commonly used by groups of people as a way to affordably purchase vacation homes. Unlike with a timeshare, which only guarantees a set amount of time at a property every year, owners who purchase fractional ownership of a property receive a deed representing their share.
Fractional owners take on all of the benefits and losses that come with the possession of property. The co-owners share the income, usage rights and access to the shared property, proportionate to the percentage of the asset that they hold. If the vacation home grows in total value over a decade, then the value of individual shares will also appreciate. Of course, that also means if the property’s value depreciates, then the value of the shares will decrease accordingly.
How Does NFT Fractionalization Work?
At its core, an NFT is really just a token that uses Ethereum’s ERC-721 standard. Before the NFT can become fractionalized, it’s first locked in a smart contract, which is simply a program stored on the blockchain that’s coded to automatically execute when predetermined conditions are met.
The smart contract then splits the ERC-721 token into multiple fractions in the form of ERC-20 tokens based on the instructions provided by the NFT owner. The owner outlines the number of ERC-20 tokens that will be created, their price, metadata, and other properties. Each fraction, or ERC-20 token, represents partial ownership of the entire NFT. The fractions are then put up for sale at a fixed price for a set period of time, or until they’re sold out.
Imagine if we could fractionalize Norwegian artist Edvard Munch’s iconic work The Scream, which sold for nearly $120 million at Sotheby’s in 2011. An NFT representing the artwork would be prohibitively expensive, and only a very small number of wealthy investors could bid for it. However, if an NFT of The Scream was fractionalized into 10,000 ERC-20 tokens using a smart contract, then it would be possible to own a fraction of the famous artwork for just $12,000 apiece, which is much more affordable and would attract buyers more easily.
It’s important to note that NFTs and fractionalized NFTs aren’t just limited to the Ethereum blockchain. Fractionalization can work on any blockchain network that supports smart contracts and NFTs. Alternative networks such as Polygon (MATIC), Cardano (ADA) and Solana (SOL) all support smart contracts, and can facilitate the creation and transfer of NFTs. These networks have the added benefit of fast transaction times and no gas fees.
What’s the Difference Between F-NFTs and Traditional NFTs?
Fractionalized NFTs, which are sometimes called F-NFTs, represent percentage ownership or fractions of a complete NFT. The difference between the two is obvious: An NFT is a whole, while F-NFTs are simply fractions of the whole.
It’s important to point out that the fractionalization process can be reversed, and F-NFTs can be transformed back into a whole NFT. The smart contract that fractionalizes an NFT typically has a buyout option which allows an F-NFT investor to purchase all of the fractions and unlock the original NFT.
An F-NFT holder can initiate the buyout option by transferring a specific number of the ERC-20 tokens from a collection back to the smart contract to trigger a buyback auction, which will run for a fixed period of time. This gives the other F-NFT holders time to make a decision. If the buyout goes through during that period, the fractions are automatically returned to the smart contract and the buyer gains full ownership of the NFT.
Why Are Fractional NFTs Necessary?
There are three core reasons why F-NFTs are needed:
- Democratization: The exorbitant prices of some NFTs can prevent smaller investors from participating. Fractionalizing an expensive NFT lowers ownership costs and makes it more accessible to a broader range of investors. It’s important also to note that when the price of an NFT rises, then the value of all of its fractions increases proportionately. If its value unexpectedly tanks, which is common in the crypto market, then the value of all the fractions go down as well.
- Price discovery: Fractionalized NFTs can provide price discovery mechanisms that determine how much a particular NFT is worth. Since the fractionalized ERC-20 tokens are sold on the open market, their prices can help provide a reasonable valuation of a tokenized asset’s price.
- More liquidity: The biggest defining feature of NFTs is that they’re one-of-a-kind tokens which can’t be replicated or divided. This uniqueness limits access to NFTs, especially valuable ones, to only a few wealthy investors. F-NFTs address this lack of liquidity, since the ERC-20 tokens can be easily traded in secondary markets. Instead of waiting for weeks or months for one NFT to sell, numerous investors may be more willing to buy up fractions of an NFT immediately, at a reduced price, thereby addressing market liquidity issues.
How Do Fractional NFT Owners Benefit?
The biggest benefit for fractional NFT owners is that they get to own a percentage of a larger, and more expensive, whole NFT. Depending on the NFT and the platform where the fractional NFT was purchased, the holder may gain some local governance rights on the platform with respect to a particular fraction set.
For example, there are only 10,000 CryptoPunks NFTs in existence, and due to their expensive price tags, they have relatively few sales. In April 2021, a collection of 50 CryptoPunks was fractionalized into 250 million tokens, each representing part of the collection.50 CryptoPunks were tokenized into 250 million uPunks on Unicly. Image source: Unicly
These fractional NFTs, called uPunk tokens, had a collective market cap of $12.9 million in February 2022. Holders of uPunk tokens have the option to bid on any CryptoPunk in the collection. If 50% of the 250 million vote to unlock the collection, then each of the NFTs will be awarded to their highest bidder.
Some F-NFT projects support staking, and enable holders to earn a passive income in addition to voting rights. For example, Mutant Cats is a collection of 9,999 NFT avatars which are similar to the ape avatars by Bored Ape Yacht Club, except the Mutant Cat avatars feature colorful, mutated cartoon cats. The project has fractional shares, called $FISH, which represent fractional ownership of the NFTs. Each Mutant Cat NFT holder can stake them to earn 10 $FISH per day. They also gain exclusive access to the Mutant Cat DAO community, as well as voting rights over the DAO’s assets.
Where Can I Buy A Fractional NFT?
Several platforms have emerged where users can create and purchase fractionalized NFTs, including:
- Otis: Otis is an NFT investment platform where users can invest in NFT collectibles and art, manage their NFT portfolio and participate in real-time trading via the Otis app. Investors can use the platform to acquire fractional interests in crypto assets.
- Unicly: Unicly is for investors looking to transform their NFT collection into a tradable asset with guaranteed liquidity. Investors can use the platform to tokenize NFTs and create tradable collections of any size.
- Fractional.art: Fractional.art is a platform where investors can buy, sell and mint fractions of NFTs. NFT holders can use the platform to create NFT fractions, or to become owners of fractionalized NFT collections they couldn’t otherwise afford.
Are Fractional NFTs a Good Investment?
Fractional NFTs are undoubtedly a good investment. They’re helping to unlock liquidity for NFTs, while also increasing inclusion and participation in the booming NFT space. They expand the NFT market’s new opportunities by bringing liquidity, price discovery and democratization.
That being said, fractionalized NFTs aren’t without risk: They face all of the same issues — such as publicity rights, contracts and intellectual property rights — which plague NFTs in general. Additionally, while the sale and purchase of whole NFTs as digital collectibles may not raise issues with securities laws, F-NFTs are more likely to raise red flags with financial regulators, because their creation could be viewed as unauthorized initial coin offerings (ICOs).
During the Security Token Summit 2021, SEC Commissioner Hester Peirce warned that the agency may consider fractional NFTs to be securities. However, the SEC (US Securities and Exchange Commission) has yet to release any formal legal and regulatory guidelines concerning NFTs.
As the market for NFTs and F-NFTs continues to grow, legal rules around the assets will also evolve. For now, investors and owners in NFT-related ventures should remain cognizant of any legal issues that might arise.
The Bottom Line on NFT Fractionalization
The NFT market continues to explode in popularity and demand and we are certain to see more interesting developments and use cases as blockchain technology evolves even further.
The concept of fractional NFTs is still nascent, but it looks like it’s going to be the next big trend in the ever-growing crypto industry. NFT fractionalization enables greater liquidity and by extension endless possibilities for investment strategies. It opens up the market to a significantly wider pool of investors, ensuring that the next wave of monetization of digital assets will be powered by F-NFTs. To find out more about investing in NFTs, find out about how NFT loans work or NFT staking.