Connect with us

Digital Assets 101

What is Token Burning and Why Does it Matter?

mm

Updated

 on

The cryptocurrency industry cannot be called new anymore, given the fact that it has been around for over 13 years now. However, its appeal is still new to a lot of people who never participated in it before. This makes these newcomers unfamiliar with plenty of its concepts since many of the concepts themselves are quite unique to the crypto space.

Take token burning as an example. Someone who has not been a part of the crypto world until now would probably be confused by the terminology, given that the crypto industry doesn’t have physical tokens that can be burned in a fire. And, even if you could burn tokens, why would you do it? What is the benefit?

These, and other questions regarding token burning will be answered below, so if you wish to learn more about this activity in the crypto space and find answers to some of your questions, keep reading.

What is token burning?

Let’s start with the big one — what is token burning and what does it mean to burn tokens?

To put it as simply as possible, token burning is a process that is used for removing coins and tokens from circulation.

Most coins in the crypto industry have a limited total supply, starting with Bitcoin itself. Even the first cryptocurrency ever created has a fixed supply of coins, so this is not a new concept. In fact, this limited supply, which guarantees that new coins cannot be created, and therefore devalued.

This is not a unique approach to finances, as it was invented a long time ago by central banks to prevent problems like inflation. However, when it comes to paper money, you can always print more. You can’t even fully rely on gold, as a massive new deposit might be discovered at any time. However, with Bitcoin and other fixed-supply cryptos, you can be certain that there can never be more than what their max supply clearly states right at the start of the project’s lifetime.

But, there can always be less, and this is achieved through token burning. Once tokens get burned, they are out of circulation forever, which increases the scarcity of the remaining circulating supply, thus making each token more valuable, simply because the number of tokens is down, while the number of users remains the same or increases.

How does cryptocurrency burning actually work?

Given that cryptocurrencies are digital — a piece of code, really — they cannot exactly be smelted like gold or burned like paper money. They can’t even be deleted, thanks to the fact that they operate on blockchain technology, which makes all information stored on top of it immutable and resistant to manipulation or deletion.

So, how does burning work? What does it look like?

Simply put, cryptocurrency burning is nothing more than making transactions to wallets from which they cannot be retrieved under any circumstances.

You see, wallet addresses work similarly to emails, or bank accounts. You can send the coins in, just like you would send in emails to your email address, or money to your bank account. You can also send it out of your wallet — again, similarly to emails or traditional currencies — whenever you make a transaction.

However, there are some wallet addresses that can only receive coins. These are known as “eater” or “burner” addresses. So, whenever coins and tokens are sent to these addresses, they are removed from circulation. They still exist, as cryptos cannot be deleted, but they can never be retrieved to be used for payments of any kind, so they are forever gone from circulation. As such, they may as well be considered destroyed, and that means that the remaining circulating supply is permanently diminished by the amount that gets locked away.

Do all projects burn cryptocurrencies?

No, cryptocurrency burning is not mandatory, and not all projects out there are doing it. Some do, such as Binance, the largest crypto exchange by trading volume. The exchange is quite transparent about it, too.

Binance regularly hosts its Quarterly Burns, during which it burns a certain amount of its native BNB tokens. These quarterly burns were a part of the exchange’s plan from the start, and the exchange is committed to burning a total of 100 million BNB tokens, which represents 50% of its supply. To date (January 18th, 2022) Binance has held 18 token burns, with the latest one being its first quarterly BNB auto-burn.

So far, the exchange has burned nearly 35 million BNB tokens, and since its total supply is 166,901,148 million BNB, the token burns will continue for quite some time.

Another well-known project that burns tokens is Ripple’s XRP. The company behind the token uses a different method, however. Its way of addressing the situation is to reduce the number of transactions allowed on its network, thus limiting the possibility of DDoS attacks. Ripple also commonly takes the fees used as “gas” to make transactions happen faster, but in doing so, it also reduces the circulating supply of XRP in the market for every processed transaction in its network.

Many other projects in the crypto industry are burning their tokens, although, as mentioned before — not all of them practice this. Some have very small total supplies, so there is no real need to do it. Take Bitcoin as an example. It only has 21 million coins, and not all of them have been released in circulation as of yet. Plus, there is a lot of BTC stored in wallets belonging to people around the world, and many of these coins were not touched in over a decade.

Some undoubtedly belong to wealthy investors who are waiting for the right opportunity to use them, but many belong to people who forgot or lost their private keys, or may have even passed away, and no one will likely never be able to access their cryptos again. These coins may as well be considered burned, which removes the amount of circulating BTC on its own.

How does token burning help?

So, now that you know what token burning is and how it works, the only remaining question is — why do it?

There are a few reasons why someone would engage in this practice, with the main one being the reduction of supply for the purpose of increasing the value of the remaining coins. Just like companies tend to engage in stock buybacks to reduce the number of circulating stocks, crypto projects tend to burn their own tokens to increase the value of the remaining coins by making them more scarce.

If many people want something, and there isn’t too much of it out in the world, it stands to reason that the remaining supply would automatically become more valuable. At least, this is the theory behind the burning. It doesn’t always work that way, of course, as it is very difficult to manipulate the markets in the desired way.

Another reason behind token burns can be the promotion of mining balance. Obviously, when a project emerges, not everyone knows about it immediately, and if it is a project that distributes its coins and tokens through mining, not everyone starts mining it right away, either. In fact, most people will never engage in mining at all.

So, in order to prevent the possibility of unfair advantage for early adopters, some projects have developed a so-called Proof-of-Burn mechanism. It is one of several consensus mechanism algorithms that blockchains use to ensure that all participating nodes would agree to the true and valid state of the blockchains. This mechanism is similar to Proof-of-Work, only it doesn’t require so much power, so it is more eco-friendly. The way it works is that it allows miners to burn the tokens. In exchange, they are granted the right to mine blocks in proportion to the amount they burned.

So, to prevent early adopters from gaining an unfair advantage, this system implemented a mechanism that promotes the periodic burning of cryptocurrencies. In doing so, it manages to maintain some kind of balance between early adopters and new users.

Is token burning good or bad?

So, in the end, is burning cryptocurrency a good thing or not? Unfortunately, there is no clear answer, as each case of burning produces a different reaction.

Just like stock buybacks, crypto buybacks and burning can have positive or negative effects. It all depends on the investor and user sentiment, or how the new supply and demand dynamics influence the prices.

Burning itself is not a good or bad mechanic — it is a way of reducing the circulating supply. As such, it is just a mechanic that can be used as part of the project’s long-term plan for increasing the value of its token.

We mentioned previously that not all projects have a fixed supply — some can simply be mined indefinitely. One popular example is Dogecoin (DOGE), a joke cryptocurrency that somehow managed to remain popular for nearly a decade, even though it was originally only expected to last a few months, at best.

Projects like these may conduct token burning to maintain a value of their coins/tokens, and as such, burning can be used as an anti-inflation tool. There are many reasons why token burning can be useful, and in the end, it all depends on each individual project, its circumstances, plan, and other aspects, so keep that in mind when researching a new cryptocurrency that you may wish to mine, invest in, trade, and alike.

Ali is a freelance writer covering the cryptocurrency markets and the blockchain industry. He has 8 years of experience writing about cryptocurrencies, technology, and trading. His work can be found in various high-profile investment sites including CCN, Capital.com, Bitcoinist, and NewsBTC.

Advertiser Disclosure: Securities.io is committed to rigorous editorial standards to provide our readers with accurate reviews and ratings. We may receive compensation when you click on links to products we reviewed.

ESMA: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Investment advice disclaimer: The information contained on this website is provided for educational purposes, and does not constitute investment advice.

Trading Risk Disclaimer: There is a very high degree of risk involved in trading securities. Trading in any type of financial product including forex, CFDs, stocks, and cryptocurrencies.

This risk is higher with Cryptocurrencies due to markets being decentralized and non-regulated. You should be aware that you may lose a significant portion of your portfolio.

Securities.io is not a registered broker, analyst, or investment advisor.