Token Burn 101 : What Does Burning In Crypto Mean?

Blocksurvey blog author
Written by Priya M
Jan 18, 2023 · 15 mins read
Token Burn 101 : What Does Burning In Crypto Mean?

Introduction

In the crypto world it is a common practice, where tokens are sent to an address with no private key associated with it, effectively destroying the tokens and removing them from circulation. To ‘burn’ these tokens, their signatures are sent to a black hole (or “eater”) address.  This is done to reduce the total supply of tokens and increase their value. This can be done on a regular basis or as a one-time event. The specific details of how token burning is implemented can vary depending on the project.

In this blog, we will explore the concept of token burning, the different types of token burning, and the potential benefits and drawbacks of token burning. We will also discuss the implications of token burning on the cryptocurrency market, how it can be used to create a more secure and stable cryptocurrency ecosystem and alternative proposals for token burning. Finally, we will look at some of the most popular token burning projects and how they are impacting the cryptocurrency market.

What is token burning?

Token burning is a process by which a certain number of tokens are permanently removed from circulation by the project developers. The objective is to,

  • Reduce the total supply of tokens, which can increase the value of the remaining tokens in circulation.
  • Align the interests of token holders with those of the project, or
  • Meet the requirements of regulatory authorities.

Token burning can also be used to reward users for their loyalty and participation in the project. It incentivize the holders and rewards the developers. It rewards early adopters and creates a deflationary system.

Types of token burning

There are several different types of token burning, and the specific type used can depend on the goals of the company or project and the specific circumstances. Some common types of token burning include the following:

1. Regular token burning

This involves the regular and systematic removal of a certain number of tokens from circulation, typically at regular intervals, such as monthly or quarterly. This can be done in order to decrease the overall supply of tokens and potentially increase their value.

2. Token burning as a reward

In this type of token burning, tokens are burned as a reward for certain actions or activities. For example, a company may burn tokens as a reward for users who complete certain tasks or achieve certain milestones.

3. Token burning as a penalty

In this type of token burning, tokens are burned as a penalty for certain actions or activities. For example, a company may burn tokens as a penalty for users who violate the terms of service or engage in certain behaviors that are detrimental to the community.

4. Token burning to align interests

In this type of token burning, tokens are burned in order to align the interests of different stakeholders. For example, a company may burn tokens held by the development team in order to ensure that their interests are aligned with those of the token holders.

Can we understand what actually happens in a burn?

Tokens are algorithmically taken out of circulation by sending the outputs to a public address known as an ‘eater address.’ The keys to this public address are hidden and cannot be obtained by anyone. And so, once the tokens are sent to this address, they are unrecoverable and can never be used as no one has the private keys to access them.

Is burning a closed or transparent process?

It depends on the context in which the burning is taking place. In some cases, burning may be a closed process, meaning that it is not visible or accessible to the public. viz. a company might burn tokens as part of its internal accounting processes, and only make the results of the burning available to a select group of people.

In other cases, burning may be a transparent process, meaning that it is open and visible to everyone. viz., a project might publicly announce that it is burning a certain number of tokens, and provide proof of the burning on a public blockchain. In general, it is important for the process of burning tokens to be transparent in order to maintain trust and confidence among token holders.

Mechanism to promote periodic burning - Proof-of Burn

A critical part of any blockchain, required if it is to function properly, is some sort of consensus algorithm that both secures the blockchain and ensures it works efficiently. One such is the proof-of-burn mechanism that users are required to “burn” or make permanently unavailable some mined proof-of-work cryptocurrency.

Though Proof-of- Burn (POB) and traditional Proof-of-Work (POW) are both consensus algorithms used by cryptocurrencies, they work in different ways. Below is the key difference.

In proof of work, miners compete to solve complex mathematical problems in order to create new blocks and earn rewards. This requires a significant amount of computational power, and the difficulty of the problems is adjusted based on the total amount of computational power being used to mine the cryptocurrency.

In contrast, proof of burn uses tokens that have been permanently removed from circulation, known as "burning," in order to achieve distributed consensus. In this system, miners show proof that they have burned a certain number of tokens, and the more tokens they burn, the higher their chances of mining a new block and earning rewards. This creates a scarce resource, as the tokens are no longer available for use, which can then be used to achieve consensus in a decentralized network.

Another key difference between the two algorithms is that proof of work requires a significant amount of computational power, while proof of burn only requires tokens that have been permanently removed from circulation. This means that proof of burn can potentially be more energy efficient than proof of work, as it does not require the same amount of computational power. However, proof of burn also relies on the availability of tokens that can be burned, which may not always be the case.

Potential benefits of token burn

Supply and demand are one of the core aspects affecting the price of cryptocurrencies. The need for traders and investors drives a sizable percentage of the cryptocurrency market, and the supply-demand equation is vulnerable to fluctuations and volatility.  A token’s price may hurt slightly or even dramatically if demand declines while supply increases.

However, burning tokens can sometimes aid in price recovery but only in certain cases. The explanation for this is quite uncomplicated: we know that burning reduces the number of tokens in circulation. Reduced supply creates more scarcity, which raises demand and raises the value of the coin. Following are the potential benefits of a token burn.

1. Increasing the value of remaining tokens:

By reducing the total supply of tokens, burning can increase the value of the remaining tokens. This is because the same amount of demand for the tokens will now be spread across a smaller number of tokens, which can drive up their price.

2. Enhancing the reputation of the token:

Token burning can demonstrate to potential investors that the team behind the token is committed to its long-term success. This can enhance the reputation of the token and make it more attractive to potential investors.

3. Improving the token's utility:

In some cases, token burning can be used to improve the utility of a token. For instance, a platform that uses a token as a means of payment may burn tokens that are not being used, which can increase the value of the remaining tokens and make them more useful as a means of payment.

4. Reducing inflation:

By removing tokens from circulation, token burning can help to reduce inflation and keep the value of the remaining tokens stable over time. This can be particularly beneficial for tokens that are designed to be used as a means of payment or as a store of value.

5. Indirect dividend payment:

A token buyback can result in an indirect dividend payment in several ways. First, by decreasing the supply of tokens in circulation, a buyback can potentially increase the value of the remaining tokens. This can benefit token holders by increasing the value of their holdings.

Additionally, a token buyback can also align the interests of different stakeholders by reducing the number of tokens held by certain parties, such as the development team. This can create a more favourable environment for token holders, as the interests of the development team will be more closely aligned with those of the token holders.

Furthermore, a token buyback can also be used to fund the development of new products or services, which can provide additional value to token holders and potentially increase the value of their holdings.

Overall, while a token buyback is not a direct dividend payment, it can still provide benefits to token holders in the form of increased value and alignment of interests.

However, there are some important considerations to keep in mind when using token burning as a way to pay dividends. First, it is important to ensure that the burning of tokens is done in a transparent and verifiable way, so that token holders can trust that the tokens are actually being burned. Second, the amount of tokens burned and the resulting increase in value should be carefully calculated and communicated to token holders. It is also worth noting that the use of token burning as a way to pay dividends may not be appropriate for all types of tokens or all types of organizations.

Drawbacks of token burning

No system comes without drawbacks and so is the case with token burn as well. Following are the drawbacks:

  1. Token burning can reduce the overall liquidity of the affected tokens. This is because burning tokens permanently removes them from circulation, which means they can no longer be traded or exchanged. This can make it more difficult for token holders to sell their tokens, which can reduce their ability to generate liquidity from their investments.
  1. It can create a mismatch between the supply and demand for the affected tokens. This is because burning tokens reduces the overall supply of the token, but it does not necessarily change the underlying demand for the token. If the demand for the token remains the same or increases after the burn, it can lead to an imbalance between supply and demand, which can lead to volatility in the token's price.
  1. It also creates potential issues with token distribution and ownership. For example, if a large number of tokens are burned, it can disproportionately impact the ownership stakes of early adopters and large token holders. This can lead to conflicts and tensions within the community, and it can potentially create barriers to entry for new investors who may not be able to acquire a significant number of tokens.
  1. Project developers can mislead their community by claiming that coins are being burned while, in reality, the coins are being sent to a wallet which they control. Once the price increases, the developers could sell off their coins and walk away with a hefty profit, leaving remaining stake holders with worthless tokens. This is just one variation of a rug pull.

There are several ways to reduce the risk of being scammed in the crypto space, but the best method is to conduct as much research as possible into the founding members, smart contracts, and whitepaper of a project. The crypto community is relatively new and being well informed can protect you from bad actors who lurk in the shadows. Additionally, it is best to join crypto-related forums and ask questions in order to gain a better understanding of the project. It is important to carefully consider the potential drawbacks and evaluate the potential risks and implications before implementing a burn.

Potential effect of token burning

Implications vary depending on the context and goals of the burn. In general, token burning can have several potential effects on the market as discussed below:

One potential effect of token burning is an increase in the price of the affected tokens. This is because burning tokens permanently removes them from circulation, which reduces the overall supply of the token. As a result, the remaining tokens may become more scarce and more valuable. This can also lead to an increase in demand for the token, as investors may see it as a good opportunity to acquire a potentially more valuable asset.

Another potential effect of token burning is an alignment of the interests of token holders with the long-term success of the project or platform associated with the token. This is because burning tokens can be seen as a commitment by the project or platform to support the value of the token and to ensure its long-term viability. This can help to increase investor confidence and trust in the project or platform, which can have a positive impact on the market.

Additionally, token burning can also have broader implications for the overall crypto market. For example, if a large number of tokens are burned, it can potentially lead to a reduction in the overall supply of tokens in the market. This can have a deflationary effect on the market, which can lead to an increase in the overall value of the crypto assets that remain in circulation. This can also help to support the long-term stability and growth of the crypto market.

What are the alternatives to burning tokens?

Buybacks are a fine way to socialize profits to capital-token holders, but burning limits the network’s ability to reinvest in itself.

This is similar to demonetization of currency or buyback in the public equities world.

In the public equity world, a buyback, also known as a "repurchase," is when a company buys back its own outstanding shares in the open market. This can be done for a variety of reasons, such as to reduce the number of outstanding shares, increase the ownership stakes of existing shareholders, or to improve the company's earnings per share (EPS) ratio.

For example, a company with a high EPS ratio may be seen as more attractive to investors, as it indicates that the company is generating a significant amount of profit relative to the number of outstanding shares. Buybacks are typically conducted using the company's own cash reserves, and the shares are typically bought back at the current market price.

A table showing comparative study of Buyback and burn vs. Buy back and make as below:                

S.No

Particulars

Buyback and Make

Buyback and Burn

1.

Meaning

Buyback and make, on the other hand, refers to the process of a company or project repurchasing its own tokens and then using them to create new products or services. This can be done in order to provide additional value to token holders and to stimulate the growth of the project.

 

Buyback and burn refers to the process of a company or project repurchasing its own tokens from the market and then permanently removing them from circulation, also known as burning. This can be done in order to decrease the supply of tokens and potentially increase their value.

 

2.

 

Use case

It is a way for a company or project to use its own tokens to create additional value and stimulate growth, while also providing additional benefits to token holders.

It is a way for a company or project to decrease the supply of tokens and potentially increase their value, as well as to align the interests of different stakeholders.

 

3.

 

Example

A company that has issued its own tokens may decide to buy back a portion of those tokens from the market and then use them to create a new product or service that will be available exclusively to token holders. This can help to increase the value of the tokens and encourage more people to hold them, which in turn can help to support the growth of the company or project.

 

Let's say that a company has issued one million tokens, but over time the demand for the tokens has decreased and the value has fallen. In order to increase the value of the tokens and make them more attractive to potential buyers, the company may decide to buy back a portion of the tokens from the market and then burn them. This would reduce the overall supply of tokens and potentially increase the value of the remaining tokens.

What are some notable burn events in the past?

Despite being a relatively new practice, token burn practices have already been implemented by some of the prominent blockchain projects.

One such burn event in the past was the burn of 50% of the total supply of Binance Coin (BNB) in July 2019. Binance Coin is the native cryptocurrency of the Binance platform, which is one of the largest cryptocurrency exchanges in the world. The burn was part of Binance's ongoing efforts to reduce the total supply of BNB and align the interests of BNB holders with the long-term success of the Binance ecosystem. Initial supply of BNB tokens was fixed at 200 million with 100 million out of this supply being distributed during ICO. BNB tokens are used to pay any fees on the platform, such as exchange fees, withdrawal fees and others. Using BNB tokens to pay fees allows getting a significant discount during 4 years — in the 1st year (50%) and in the 4th year — 6,75%. Every quarter Binance uses 20% of their profits to buy back BNB and destroy them. All buy-back transactions will eventually destroy 100 million BNB, leaving 100 million in circulation. Current BNB ROI since ICO is over 13 000% and it takes 2nd rank by market cap among tokens.

Shiba Inu burn is one of the latest in recent times, wherein a burning mechanism was implemented  as the ultimate strategy to raise prices near US $ 1. It burnt millions of tokens with three special addresses viz., Genesis address and two dead wallets. The SHIBA army expected that this will help to increase the demand by reducing the supply. Shiba Inu has officially announced the schedule of the Shiba Inu burning mechanism. They have already burnt around US$25,000 SHIB through 260 billion Shiba Inu tokens to reach US$0.00002445 with an increase of 5.22% and a market cap of US$13.45 billion. The total supply is one quadrillion with a circulating supply of 549,146,987,315,505.4. Meanwhile, 410,328,990,023,453 Shiba Inu tokens are total burned.

Conclusion

Finally, have any of you purchased any Proof-of-Burn cryptocurrencies? Do you think token burning is better than buyback? I would love to hear your thoughts. If you have any query, feel free to drop a line at [email protected] .

Further reading

A Beginner’s Guide to Crypto Private and Public Keys (cryptoadventure.com)

Does token burn increase price? - Everything about blockchain and cryptocurrencies is simple (blockochainfaq.com)

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blog author description

Priya M

Priya is the CFO of BlockSurvey. A year ago she made a career change and left the traditional finance world as a Chartered Accountant to work full time at BlockSurvey. She is specializing in “Tokenomics” in Web 3 space.

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