24 March 2021 | ZebPay Trade-Desk
A token is said to be burned when it is removed from the cryptocurrencies’ existing pool in circulation. The sole purpose of this is to protect the value, and integrity of the tokens’ network, and is a process that is done periodically and intentionally by the governors of the particular network on which the token resides. Hence, generally, this is a practice done for deflationary purposes. While larger blockchains like that of Bitcoin and Ethereum do not employ this mechanism, most smaller altcoins certainly do. This helps to provide the holders of these altcoins an incentive to further investment and promote these tokens, as its diminishing supply tends to drive the value in a favorable fashion.
Burning is a technique unique to the cryptocurrency ecosystem. Traditional and fiat currencies do not engage in any such form of control, as they are entirely managed by central banks across the world, and are highly centralized, thus regulated. Probably, the most direct comparison could be that of a traditional share buy among publicly listed companies. When PLC’s initiate a share buyback, they regain more control, but also limit the number of shares available to the public. In that sense, when tokens are burned, the circulation of it reduces, leaving less for the general public to buy, which in turn drives premiums.
The process of burning a token is fairly straightforward but can be done in multiple ways. In essence though, burning a token doesn’t mean destroying it. The developers buy the tokens back in circulation, and then store these tokens in a public wallet, commonly known as the ‘eater wallet’. The tokens stored in these wallets are deemed unusable for the future, as once deposited into the wallet, they become irretrievable. This reduces the supply of the said token, in circulation. Tokens can be burned right after it’s ICO (initial public offering), which is usually a one time dump, but can also be done periodically, which is often the case. Binance for example, burns its native BNB token, periodically on a quarterly basis. The number of tokens burned is at the discretion of its developers, and can change from time to time. Ripple on the other hand, burns its native token, XRP, gradually with each and every transaction. The fees paid on transactions do not go to any central authority, instead the fees act as a burning mechanism in case of Ripple. Regardless of the mechanism, burned tokens are deposited into an eater wallet, post which they are removed from circulation and rendered irrelevant.
The main purpose of burning tokens is to maintain their integrity and value. It’s to protect from deflationary pressures, and incentives investors to further develop and promote the growth of the asset. By reducing the supply, the value of the token is likely to increase, just based on pure economics, as fewer tokens are available to buy across exchanges. Hence, most tokens have a finite supply, even Bitcoin for that matter. Many developers burn unsold tokens from an ICO, for the same reason cited above, as it helps to protect the value of the asset for investors and traders alike. For dividend tokens however, the incentive mechanism is slightly different. It could be thought of as a share buyback, and some parallels can be drawn. Token burning works a lot like the buyback of shares by PLC’s. Coins are repurchased at fair rates and then immediately burned. This increases the value of the holder’s existing token amount. Sometimes, tokens are repurchased at their respective market price, in which case investors could even earn a significant profit based on their original purchase price. Finally, some projects use token burns to avoid spam transactions and to add a layer of security.
While we have covered the larger picture, as to why token burns are valuable, there are a few more innate mechanisms that some project developers employ. One such popular mechanism that has recently gained traction is the proof-of-burn (PoB) consensus, which allows users to destroy their tokens in exchange for mining rights. However, this consumes a significant amount of energy, it is also very expensive. PoB controls this by limiting the amount of tokens that can be burned, and hence limiting the potential for mining activity to take place. PoB is similar to PoS (proof of stake), as both require users to lock their existing assets to gain the privilege of mining. Unlike PoB though, stakers can take their coins with them if they choose to stop mining. To ensure that early adopters do not have an unfair advantage, the PoB system has implemented a mechanism that only allows the periodic burning of coins to maintain mining power. The power of burnt coins “decays” or reduces partially every time a new block is mined. This helps to promote regular mining by miners, instead of a one-time, and one-off early investment. To maintain a competitive edge, miners must periodically invest in better technological advancements and equipment to further reduce the need for energy and cost associated with the burning of coins in this setting.
Token burning is an in-built mechanism that resides at the heart of many projects, designed to provide value to both developers and investors alike. In most cases, burns help to stabilize a coin’s value and curb the effects of price inflation. This inherent stability provides investors a greater incentive to hold the coins at favorable prices, which in turn keeps network uptime and bandwidth healthy. Token burns also boost a sense of confidence and reliability, especially at the early stages of the asset’s life cycle. Moreover, burning unsold tokens after an ICO gives investors greater transparency and security. In the case of projects like Ripple, token burning adds security for users and lets them safely expedite their transactions, as there is no other incentive to charge higher fees except for the faster execution it assures, which gives users confidence that the network will be used more responsibly.
Of course, there are some risks associated with coin burning, too. Firstly, burning coins provides no guarantee that the remaining coins in circulation will gain in value. It does not necessarily even reduce the total number of tokens outstanding in circulation, as the supply of tokens in circulation seems to fluctuate considerably from time to time.
Disclaimer : This report is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. The Company has prepared this report based on information available to it, including information derived from public sources that have not been independently verified. No representation or warranty, express or implied, is provided in relation to the fairness, accuracy, correctness, completeness or reliability of the information, opinions or conclusions expressed herein. This report is preliminary and subject to change; the Company undertakes no obligation to update or revise the reports to reflect events or circumstances that arise after the date made or to reflect the occurrence of unanticipated events. Trading & Investments in cryptocurrencies viz. Bitcoin, Bitcoin Cash, Ethereum etc.are very speculative and are subject to market risks. The analysis by Author is for informational purposes only and should not be treated as investment advice