The precipitous rise of DeFi is introducing tokenomics and to a broader audience, but practices like coin burning still remain mysterious to many investors.
When cryptocurrencies are burnt, they are taken out of circulation—either by being sent to an invalid wallet address that is not accessible and has no private key, or being locked in an inaccessible fund for later use.
Why burn coins?
The motivation for burning tokens is simple; to support the price by reducing supply and increasing demand. As coins get destroyed, the total supply of the cryptocurrency drops, and the law of supply and demand ensures that price rises.
Increasing price is usually the main goal of a coin burn, but burning coins also supports other goals within the crypto-economy.
Maintaining long-term value and rewarding investors
By regularly burning coins, the total supply of a cryptocurrency or token is gradually reduced over time. This makes holding the coin attractive from a long-term perspective because it can keep the price buoyant even as demand drops.
Reducing the supply of a token through burning also mimicks a process used in the corporate world—share buybacks.
Share buybacks are when companies buy back their shares from the market, which often causes the price of the shares to appreciate. So instead of paying dividends to shareholders directly, the project rewards investors indirectly by reducing the supply to increase the value of their assets.
Mining company BHP for example, has recently announced plans to buy back $5.2bn of its shares. This comes after a business slowdown led shareholders to exert pressure to boost investor returns.
Binance Coin (BNB) is one such token that implements a quarterly burn to help preserve value as part of its deflationary economic model.
Destroying Unsold Tokens
Most projects set a limit on the number of tokens that they are going to sell during their initial offering, but when the sale is over, some unsold tokens might remain in the company coffers.
Although some projects will just sell these tokens at market for profit, other projects will burn all the unsold tokens. This ensures the income generated from a token sale is justified by the actual demand for tokens, and investors can trust that the sudden sale of large amounts of tokens by the owners won’t crash the market and reduce their returns.
Paying For Transaction Fees
Some cryptocurrencies—like XRP—burn a tiny percentage of every sum that is transacted. This aims to marginally increase the price over time, and to deter spammers from clogging the network with transactions.
Technical problems might mean that more tokens than intended are issued into public circulation, or that faulty tokens are issued that are impossible to transact. If a mistake is made when issuing tokens, then burning can be used to make amends by taking those tokens out of the circulating supply.
What is Proof-of-Burn?
Some cryptocurrencies are also experimenting with burning as a consensus mechanism.
This is where burning is used as a way to ensure that all participating nodes on the network come to an agreement about the true and valid state of the blockchain network, to avoid any possibility of the same coins being spent twice.
Instead of performing complex calculations like in Proof-of-Work consensus, miners just need to show proof that they have burned some coins —that is, sent them to an address that is known to be inaccessible. Due to the transparent nature of blockchain, anyone can confirm that this has actually happened by taking the TX ID and entering it into an explorer to check for themselves.
This might be expensive, depending on how many coins are burned, but unlike Proof-of-Work it consumes no resources other than the burned asset.
At the moment, Proof-of-Burn is still very experimental, and most proof-of-burn cryptocurrencies still need to use Proof-of-Work to actually mine the cryptocurrency rather than just confirming transactions.
About the Author
Written by Kieran Smith, cryptocurrency analyst contributing to eToro, OneZero, and Brave New Coin among other publications. He provides content strategy and copywriting services for cryptocurrency companies at Bitcopy.