Coin or token “burning” is a mechanism used to decrease supply of a coin. In this guide we explore token burning, why it happens, and what impact it has on the respective token or coin.
For those who are yet to be initiated into the crypto space and all it entails, the term “token burning” can seem a bit bizarre. After all, if cryptocurrencies or tokens have any value, why would anyone set a march to a pile of tokens or coins? And if crypto and tokens are digital, how do you go about setting them on fire? Well, the burning process is not as literal as you might think.
Just as you would expect any burnt physical notes to be rendered useless, the token burning process is a method used by crypto projects to remove a given amount of tokens from circulation. Token burning is quite common in the crypto space. Just recently, Vitalik Buterin who is the founder of Ethereum burned 410 trillion Shiba Inu tokens worth a whopping 6.5 billion at the time.
Even though Shiba Inu is a meme token similar to Dogecoin and more of a joke than an investment, Vitalik reduced the number of Shiba Inu tokens in circulation effectively increasing the value of the token. You can think of a coin or token burn event as a deflationary measure designed to increase the value of certain cryptocurrencies or manage their supply and demand over the long term.
In this article, we will explain what token burning entails in detail and why it matters.
Token or coin burning involves the removal of a specified number of tokens from circulation to introduce a deflationary measure to the token economy of a cryptocurrency.
The token burning process aims to maintain a fine balance between market demand and token supply. It can be compared to share buybacks in traditional finance where a company will buy back a percentage of its shares in circulation to reduce the number of stocks available to the public and therefore maintain the value of the stock.
Token burning is mostly practiced on small altcoins that offer billions of tokens initially as major cryptocurrencies like Bitcoin and Ethereum have built-in deflationary measures given the limited number of their tokens in circulation. In the case of Bitcoin, apart from its limited supply, Bitcoin also features an additional deflationary mechanism where the number of Bitcoin rewards received by miners who maintain the network is cut by half every four years. This is the Bitcoin halving process and although it’s not a token burn event, it achieves the same purpose of introducing deflation to the network.
Different cryptocurrencies are programmed to achieve the token burning process in different ways. However, in all cases, the objective remains the same and that is to introduce deflation to the token’s economy by permanently removing a specified number of coins from circulation. This can be done periodically or as a one-time event.
If you are familiar with blockchain, you know that its underlying protocol enables immutability where every data published to the distributed digital ledger remains fixed. Therefore, since the blockchain does not allow any changes to data published on its ledger, coins or tokens created and broadcasted to the blockchain cannot be destroyed.
So, if they forever remain on blockchain’s distributed digital ledger, how can a token burn even achieve success? Well, the tokens are programed or sent to an irretrievable wallet called an “eater wallet or eater address”.
Just as you would lose all your cryptocurrencies if you sent them to the wrong wallet, the token burn process operates as a deliberate effort to lose the specified set of cryptocurrencies. The developers will create an eater wallet then send those tokens to that wallet where they will remain irretrievable. So far, there are billions worth of burnt tokens on Ethereum’s network.
To ensure integrity, the entire process is published on the blockchain. While everyone will be able to see the burnt tokens in the eater wallet, the tokens remain irretrievable as no one (even the developers) owns the wallet’s private keys.
Another method for token burning is to program a token burn function into the smart contract that issues the token. Once the conditions for the token burn are fulfilled, the smart contract will execute the function automatically. This is considered more transparent as the process is automated by an impartial smart contract.
There are no universally accepted token burn processes, and just as cryptocurrencies come in all shapes and sizes, not all token burning events are similar. Since the objective remains to make the tokens permanently inaccessible, some token projects (especially security tokens) will deploy a strategy similar to share buybacks where the project’s developer team will buy back a number of the tokens in circulation and send them to an eater address.
In other cases, a cryptocurrency project will perform a one-time burn right after the initial coin offering (ICO). In such a case, the coins that remain unsold after the public sale are sent to an eater wallet. This also serves as an incentive to holders of the token as the coins that remain in circulation increase in value.
Other tokens will burn coins periodically with every transaction as is the case with Ripple XRP. Whenever you make a transaction, the fees charged by the network are sent to an eater wallet instead of miners on the network.
Crypto projects can also perform periodic token burn events as is the case with Binance, MakerDAO, and Bitfinex where a token burn event is performed quarterly or annually depending on the project’s goal.
Token burning is quite popular among stablecoins. Since each stable coin is backed by a dollar on a ratio of 1:1, projects such as Teather or USDCoin will create tokens when they make a deposit to their vaults and burn tokens when they make a withdrawal. For instance, if they deposit one $1 million, they will have to create 1 million USDT tokens to match the funds deposited. Upon withdrawing the $1 million from the vault, 1 million USDT will be burned.
While a token burn and a share buyback might have some similarities, the two are not the same and for a couple of reasons. To begin with, a share or stock buyback involves a company buying back its shares. Oftentimes, these shares are already trading in the open markets.
Crypto or token burns, on the other hand, happens mostly with coins that are not in circulation. For instance, when a cryptocurrency exchange such as Binance decides to burn a percentage of its coins, the Binance team does not buy back the tokens from token holders. Instead, the Binance team will burn tokens that were held in vaults and scheduled for burning. On some projects, coins scheduled for burning usually belong to developers of the project or stakeholders who volunteer to burn a share of their tokens.
Unless you are dealing with security tokens, another reason that sets share buybacks apart from token burns is the fact that shares represent equity in a company while coins and tokens do not. This means that share buybacks have a direct impact on the price of the shares as opposed to coin and token burns. When a company decides to buy back shares, it reduces the shareholder’s liability as each share is attached to the company’s future cash flow. While cryptocurrencies and tokens burns might result in a slight spike in price, most of the value gained comes from the project’s increased popularity or functionality.
Therefore, as much as the token burn process seems similar to a share buyback where prices are set to increase after the event, many token burn events have had an ephemeral effect on a token’s price increase as tokens and cryptocurrencies are not considered securities.
For instance, while Bitcoin’s 4 years deflationary cycle correlates to an upward spike in its value, other coins such as Binance, XRP, or Stellar lumens show uncertain correlations between token burning events and price increase.
To understand who controls the token burn, let’s first look at how cryptocurrencies are managed. Right from the start, Bitcoin set the pace for cryptocurrency management. As the first and largest cryptocurrency, Bitcoin’s growth and development was shaped by its community on a decentralized management structure.
Other crypto projects such as Ethereum have since picked up this decentralized approach where each project has an open-source organization dedicated to managing the entire network.
Therefore, most cryptocurrency burns will not have a central entity control the token burn. Either the community will vote and reach a consensus for the token burn, or a dedicated team of experts voted into governance will make the decision.
At its core, the main benefit of token burning is its ability to control supply and demand for a cryptocurrency or token. For instance, while Bitcoin’s halving process is not a token burn event, it is designed to limit the supply of Bitcoin in circulation thereby increasing the value of Bitcoin over time. With less Bitcoin in circulation, demand increases, and Bitcoin’s price increases. Other cryptocurrencies use token burning to achieve the same goal of restricting supply to increase the value of their token over time.
Another benefit of token burning is added security. For instance, XRP burns its tokens with every transaction as a security measure to avoid spammed transactions since the token does not have a proof of work consensus protocol like Bitcoin or Ethereum. By burring tokens with every transaction, XRP’s network removes the incentive for network congestion as is the case with Ethereum, while enabling protection against a DDoS attack.
Some crypto projects will benefit from token burning as it creates a consensus protocol for their network through a Proof of Burn (PoB). As concerns over Proof of Work’s energy consumption continue to rise, other projects are using PoB as an energy-efficient method for achieving consensus on a decentralized network. The process works such that user’s looking to verify and publish transactions on the blockchain have to produce proof of the number of tokens they have burned to gain mining rights. Therefore, the more tokens a user burns the more they gain in terms of block mining rights. While some criticize this technique for its tendency towards centralization as miners who can afford to burn larger quantities of a token gain disproportionate capacity, others praise it for its resource-efficient solution.
To solve PoB’s tendency towards centralization, some projects implement a decay rate to the total mining capacity of a miner such that the miner’s mining capacity reduces with every transaction. This maintains a competitive environment as each miner will have to re-invest in burning tokens to maintain their position.
One of the most recent and popular token burns is Binance’s 14th burn that took place in January 2021. During the event, Binance burned over 3 million BNB tokens equivalent to more than $165 million at the time. With the 14th burn being one of the project’s biggest burn ever, the company’s CEO said that they plan to accelerate the burning process towards their goal of burning half of BNB’s total supply.
Another recent token burn that had crypto enthusiasts excited is that of PancakeSwap in April 2021. Market analysts anticipated a bullish trend for the CAKE token as the community behind the project voted for a 2.2 million CAKE burn over a given period.
FTX (a crypto exchange) also joined the buy and burn craze in April 2021 with a token burn event that destroyed over $6.4 million worth of FTT tokens. The price of the token increased from $52.5 per token to $56.8 as a result of the hype among traders concerning the token burn event. However, the price later on retraced previous levels.
Whether you are looking at a meme coin such as Shiba Inu, an exchange coin like Binance or a market leader like Bitcoin, deflationary measures are necessary as they mitigate the risk of hyperinflation.
Amid the rapid printing of fiat currencies, token burning events have become one of the biggest attractions towards crypto, especially for investors looking to hedge against the global economy.
Even though many tokens are designed with an initial token burn at launch, a lot of crypto projects have integrated token burning as part of their DNA to maintain the value of their token or add security to their platform.