Published
December 9, 2021

An Introduction to NFT Fractionalization

An Introduction to NFT Fractionalization

As early as 2017, the notion of fractional investing in high-end artwork from the likes of Warhol and Picasso captured the collective attention of the analog art world. Leveraging the power of blockchain technology, startups building tools around co-ownership of classic art promised to democratize the pastime of art collecting. While this concept of fractionalization did not necessarily live up to expectations in the traditional art world, it has begun to increasingly gain traction in the world of NFTs. 

This article will introduce the concept of NFT fractionalization and discuss some of the leading solutions. In particular, the following subjects will be covered:

  1. What is NFT Fractionalization?
  2. Fractionalization Protocols and Marketplaces
  3. NFT Fractionalization by the Numbers
  4. The Legal Implications of Fractionalizing

What is NFT Fractionalization?

As presently constructed, NFT markets are rife with accessibility issues. Beyond some relatively convoluted onboarding processes and an over-saturation of low-effort copycat projects, arguably the most problematic aspect of the markets revolves around high valuations combined with low liquidity. For one, the prevailing market sentiment around NFTs throughout 2021 has been almost uniformly bullish. The upshot of this has been that unique and trend-setting projects – CryptoPunks and Bored Ape Yacht Club being among the most prominent – have attracted inflated valuations and thereby left many interested buyers priced-out. High valuations have also been a scourge for investors seeking to diversify their portfolios but lacking adequate capital to do so. This matter has also fed into liquidity issues for the holders of high-value NFTs, who are left with little choice to realize passive returns on their investments and thus are forced to keep their tokens idle.

Fractionalization remedies many of these valuation and liquidity issues by allowing for a sort of shared ownership of tokens. In essence, the process allows NFT holders to fractionalize their ownership in NFTs and sell shares to interested buyers. The direct and mutual benefits of this are unequivocally clear. From the holder’s perspective, selling fractional shares allows them to realize liquidity on their tokens without having to formally dispose of them. From the standpoint of an investor, buying only a small share of a high-value token can grant them exposure to the most coveted markets without having to expend obscene sums. Thus, interested buyers are no longer priced-out and can more feasibly diversify their portfolios.


Fractionalization Protocols and Marketplaces

Several specialized NFT marketplaces have emerged to serve the needs of investors looking to buy, sell, or mint fractional shares of high-value tokens. Such marketplaces provide a unique service that could not otherwise be enjoyed via general aggregators such as OpenSea or curated platforms such as SuperRare.

fractional.art

The leader in the world of fractional marketplaces, fractional.art – or Fractional for short – represents a decentralized protocol which allows NFT holders to fractionalize their tokens on an individual or pooled basis. The Fractional platform has enjoyed some noteworthy support from crypto venture capitalists. After raising a USD$500K Pre-Seed Round led by Robot Ventures in March of 2021, the platform raised an additional USD$7.9M in an early-August Seed Round led by Paradigm. 

What is Fractional?. Fractional is a decentralized protocol… | by Fractional  | Fractional.art | Medium

In essence, the process of fractionalization begins with interested NFT owners choosing to lock-up their tokens in so-called ‘vaults’, which are audited smart contracts that comprise part of the Fractional protocol. It is worth noting that holders can at-once lock-up either a single token or a diversified portfolio of tokens. After configuring the parameters of the fractionalization, including the number of individual shares to be minted, the holder transfers custody of their NFT(s) to the vault and in return receives 100% of the fractional shares in the form of ERC-20 tokens. It is then the holder’s prerogative as to how they distribute the fractional shares to prospective buyers, if at all. As a sweetener for using the Fractional protocol, holders can also earn annual curator fees as a percentage of their asset’s fractional supply.

On the buy-side, Fractional allows investors who have purchased shares in a vault to vote on the reserve price for the underlying token(s). As is the case on other NFT marketplaces more generally, the reserve price represents the minimum bid that must be made on a token in order to initiate an auction; any bids below the reserve price are ignored. At the time the auction concludes, whichever party has made the highest bid is entitled to the NFTs at stake. In the case of Fractional, proceeds from the auction are distributed on a pro rata basis among fraction owners, and the ERC-20 tokens which represented part-ownership in the token(s) are burned by the protocol.

Unicly

Another of the more popular fractionalization protocols, Unicly was designed to address some of the pain-points identified in earlier attempts to fractionalize NFTs. For one, the issue of only being able to fractionalize single NFTs at a given time was a major limiting factor to predecessor protocols. The ability to fractionalize entire collections would expose the shareholders of the tokens to a more diversified array of markets and would also position them for significantly more upside than what may be achievable from owning shares of a single token. Further, the matter of un-fractionalizing NFTs – or determining the rightful owner of a fractionalized token – has been a historically difficult problem to solve. 

Unicly Litepaper - Unicly

The implementation of Unicly’s fractionalization protocol differs markedly from that of Fractional in some respects, but is directly comparable in others. For instance, to address the limitation of only being able to fractionalize single NFTs, Unicly introduces the ability to fractionalize diverse collections in much the same way as Fractional. Unicly also issues fractional shares in the form of ERC-20 tokens, referred to on the platform as uTokens. In contrast, where Fractional only offers fractionalization for ERC-721 tokens, Unicly expands its offering to also include ERC-1155 tokens. 

Ad-Hoc Approaches to Fractionalization

In addition to the aforementioned protocols which were purpose-built for fractionalizing NFTs, there exist other, less rigid approaches to achieving co-ownership of high-value tokens. While not technically equivalent to the process of sharding NFTs and distributing ownership shares as fungible tokens, these ad-hoc approaches are in substance comparable to fractionalizing NFTs.

One popular vehicle by which NFT investors have pooled their capital to acquire high-value tokens is DAOs. Briefly, DAOs are organizations represented by a web of smart contracts which enable members to vote on operational and investing activities through ownership of DAO tokens. At the intersection between NFTs and DAOs, several such organizations have been formed with the express purpose of using funds contributed by members of the DAO to acquire expensive, culturally significant NFTs that would not otherwise be affordable for individual members. One popular example of these NFT-centric DAOs is PleasrDAO, which made headlines in April of 2021 for its USD$5.4M acquisition of Edward Snowden’s Stay Free NFT. Members of the DAO then collectively share in the acquired token’s ownership. Famously, PleasrDAO fractionalized the original Doge NFT – which it had acquired for USD$4M in mid-June – through the Fractional marketplace. 

Exploring PleasrDAO and the Edward Snowden NFT - Ivan on Tech Academy

Another method for achieving collective ownership over high-value NFTs comes in the form of the PartyBid protocol. Through PartyBid, prospective investors can create parties and invite the participation of others to pool their resources and collectively bid on NFT auctions. In effect, anyone can start or join an existing party to target auctions on different NFT marketplaces. Bidders contribute ETH in their collective action to win the auction and acquire the NFT, and any excess funds not used in the auction can be retrieved by their original contributor. Upon winning an auction, members of the party who contributed towards the winning bid are rewarded with ERC-20 tokens which represent their pro rata share of the underlying NFT. Interestingly, the PartyBid protocol leverages Fractional’s smart contracts to implement this mechanism of shared ownership.

PartyBid

NFT Fractionalization by the Numbers

In examining the price trends of popular NFTs which have been fractionalized on the Fractional marketplace, some less than impressive observations can be made. Among the most popular tokens currently available on Fractional are the original Doge NFT (DOG) that was purchased and fractionalized by PleasrDAO as well as the Feisty Doge NFT (NFD) and iteration #72 of the Etherrock collection (PEBBLE). The price trends of the ERC-20 ownership tokens which were minted as part of the fractionalization for each of these NFTs have tended to decline substantially from the highs exhibited shortly after the mint. This has proven true for both fractionalized Doge NFTs. The price trend of PEBBLE has not followed a similarly steep decline, although its performance has consisted of an extended plateau followed by a modest return around late September. These price trends may be the result of there not yet being an especially active market for fractionalized NFTs.

Perhaps more indicative of the increasing interest in NFT fractionalization is the overall market capitalization of the most popular sharded tokens. DappRadar’s Sharded Market Cap (SMC) tracker lists 34 fractionalized NFTs across the Fractional and NIFTEX platforms, aggregating their individual market capitalizations to derive a proxy for the overall size of the fractionalization market. The 3 aforementioned ownership tokens (DOG, NFD, and PEBBLE) represent the highest market capitalization tokens as listed by the tracker. Combined, they account for just over USD$200M, representing over 83% of the wider SMC index. For perspective, that figure eclipses the 3rd highest market capitalization in the cryptocurrency market (Cardano) and represents over 50% of the market capitalization of Ethereum. The relative scale of the fractionalized market paints a potentially more representative image of the amount of interest in the concept.

The Legal Implications of Fractionalizing

Fractional ownership shares in NFTs pose many of the same legal ambiguities as the trading and ownership of the NFTs themselves. One such legal challenge deals with the matter of intellectual property rights and who ultimately can claim ownership over the underlying token’s artwork. This issue is further muddied by the fact that multiple individuals technically have simultaneous ownership of a fractionalized NFT, making the matter of determining a single copyright owner exceedingly difficult. The existence of fractional shares also poses questions with respect to taxation, particularly on the matters of sourcing capital gains and timing the imposition of tax.

That said, there is perhaps no greater legal implication of fractionalized NFTs than the question of whether or not they could be deemed as securities. In the realm of securities laws, the determination of whether an asset is a security is often done by assessing that asset’s alignment with the 4 basic criteria of an investment contract. The US Supreme Court has formally defined investment contracts to be:

… a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party

Though it is challenging to definitively say whether fractional shares of NFTs constitute investment contracts, the determination would likely be more straightforward for fractions than it would be for NFTs in general. This is on account of their more accessible prices and their potential for creating mass markets characterized by more active trading. 

In fact, the US Securities and Exchange Commission’s Hester Pierce – who is known in the crypto world as among the government’s most ardent stewards of blockchain technology and is affectionately referred to as ‘Crypto Mom’ – has publicly cautioned tokenholders and marketplaces about the legal risks of selling or facilitating the exchange of fractionalized NFTs. In her comments, she noted that NFTs are inherently difficult to classify as securities given their non-fungible nature. However, the sale of fractional interests in NFTs represents a perversion of those non-fungible properties, thereby exposing sellers to greater complications under securities laws. 

Overall, the legality of fractional NFTs is not significantly clearer than the legality of digital assets in general. While speculation and FUD will no doubt continue, only time will reveal the government’s authoritative stance on the matter.

Closing Remarks

The concept of fractional ownership in the analog art world has been met with a lukewarm reception, with a dismal 19% of art professionals expressing interest in the idea. In contrast, fractional ownership of NFTs has exploded, with DappRadar reporting a market capitalization for popular fractionalized pieces in excess of USD$240M. While this valuation may be a mere product of a manic market, the tangible pain-point addressed by NFT fractionalization protocols suggests that the concept will continue to be favoured by token holders and buyers alike.

References

Adam, G. (2019, October 30). Piece by piece: the issues with fractional ownership of art. Retrieved from The Art Newspaper: https://www.theartnewspaper.com/2019/10/30/piece-by-piece-the-issues-with-fractional-ownership-of-art

Fractional. (2021, March 17). What is Fractional? Retrieved from Fractional: https://medium.com/fractional-art/what-is-fractional-dd4f86e6458a

Garnett, K. J., Neuburger, J. D., & Zarb, F. (2021, April 22). NFTs Are Interesting but Fractionalized Non-Fungible Tokens (F-NFTs) May Present Even More Challenging Legal Issues. Retrieved from The National Law Review: https://www.natlawreview.com/article/nfts-are-interesting-fractionalized-non-fungible-tokens-f-nfts-may-present-even-more

Genc, E. (2021, April 19). Why This DAO Bought Snowden's NFT for $5.4 Million. Retrieved from Decrypt: https://decrypt.co/66933/why-this-dao-bought-snowden-nft

Haig, S. (2021, March 26). SEC’s ‘Crypto Mom’ warns selling fractionalized NFTs could break the law. Retrieved from Cointelegraph: https://cointelegraph.com/news/sec-s-crypto-mom-warns-selling-fractionalized-nfts-could-break-the-law

Kane, I. (2021, September 9). Shared Ownership over Valuable NFTs Reaches $290 Million Market Cap. Retrieved from DappRadar: https://dappradar.com/blog/shared-ownership-over-valuable-nfts-reaches-290-million-market-cap

Skyers, E. I. (2021, September 28). Fractionalized Everything. Retrieved from FWB: https://www.fwb.help/wip/fractionalized-everything






Share on:
Hungry for
more insights?