What is token burning in crypto

You often see crypto projects talking about “burning” coins, but what is this practice and why does it happen?

In a nutshell, a cryptocurrency burn is the process of permanently removing a certain number of tokens from circulation. The act of burning tokens is permanent, meaning the assets are destroyed forever.

The token burn is intended to have a deflationary effect on the value of an asset, increasing its value by reducing supply. Essentially, burning tokens applies the theory that the value of an asset will be higher if its scarcity is maintained. But that is not all.

Here, we will look at the rationale and technical mechanics of token burns, look at the advantages and disadvantages of this type of activity, and also recall some notable cases of token burns in the past.

What is Cryptocurrency Token Burning?

As the name implies, the burning of cryptocurrency tokens is a targeted action to constantly “destroy” a certain number of tokens in order to remove them from the general circulation. More specifically, this happens by creating a “burner” or “devourer” address to which the tokens are sent. This address is unique and specially designed to receive only cryptocurrencies. The wallet cannot return the private key - the so-called seed phrase - which makes it impossible to access its assets, spend them or send them to other addresses. Thus, the coins sent to the wallet are actually destroyed: they are locked in a place where no individual or legal entity has the right to own them, which effectively excludes them from circulation.

The burning of cryptocurrencies is considered a significant event, since the act of destroying tokens is irreversible. According to many, the token burn is indicative of a project owner’s long-term commitment to their roadmap.

What is the point of burning tokens?

There are many reasons for burning tokens - some are scheduled, others are reactive. In essence, burning tokens changes the balance of supply and demand, and since assets are withdrawn from circulation, which creates their scarcity, the value of this asset should theoretically increase. Project owners can use this approach to increase the value of their tokens. In conventional finance, this motivation is analogous to a share buyback by a public company to reduce the number of shares outstanding.

There are other reasons why token burns can occur.

Boosting market sentiment

Some projects may use token burns as an opportunity to promote their offering by exploiting the potential price movement of their tokens after the burn. The anticipation of burning tokens and the resulting interest can capture the attention of the community, raising the spirits of traders, developers, and other industry participants.

Contribute to mining balance

Early adopters of tokens may have an unfair advantage over newcomers as the rate of coin creation with proof-of-work (POW) slows down with each new block. Token burning helps maintain a fair balance for new users by encouraging regular miner activity. Here miners have to burn early coins and mine new ones. This process makes it difficult for early adopters with large mining infrastructure to keep the majority of the coins in circulation.

Rewarding token holders

Token burning is also a way to reward those who have supported the project for a long time and are holders of “native” tokens. When the supply of tokens decreases, the proportional share of the holder increases - as well as the value of all assets that he owns.

Increasing the utility of tokens

By reducing the supply of tokens through burning, project owners can also increase the utility of the remaining tokens. This is because as scarcity increases, the remaining tokens play a more valuable role in enabling transactions, staking, and other platform functions.

Benefits of burning tokens

Token burning is often used strategically to benefit the project itself and its native token holders. At the same time, the so-called proof-of-burn (POB) consensus mechanism is used to allow users to participate in the network by burning a certain number of coins.

Blockchains based on the PoB mechanism use it to confirm transactions. Moreover, by participating in the PoB, users demonstrate their commitment to the network by donating some of the tokens they have. By burning tokens, users are essentially investing in a consensus process that keeps the blockchain stable and secure. Many consider PoB to be more environmentally friendly than other consensus mechanisms such as proof-of-stakebecause it consumes less power.

The broader benefits of burning tokens are as follows:

Price recovery

In situations where the price of the token has fallen and the project owners want to reverse this movement, burning the token can be used to restore the price of the asset. As explained above, this is a simple case of burning coins to reduce supply, which (theoretically) should lead to higher prices. However, this requires burning a large number of tokens. However, if the volume of circulating supply approaches the maximum, developers may not decide to burn tokens.

Stability

Like a price recovery, burning tokens can help provide stability during a period of token volatility. First, if the token burn causes the price of the asset to rise, then the positive sentiment generated by that rise could stop a period of downward pressure on the token sale. Secondly, token burning is often seen as a positive sign of a developer's commitment to a project. This could be another boost to the growth of positive sentiment around the project, which will further reduce volatility.

User stimulation

Token burning can also incentivize existing users to continue participating in a project while attracting newcomers to it at the same time. Existing users may see the value of their tokens rise as token burns drive up prices, which encourages them to continue participating in the project in the long term. Since burning tokens is considered by many to be indicative of a developer’s long-term commitment to the project, it may encourage more people to own tokens in anticipation of future growth in the value of the asset.

Disadvantages of burning tokens

One of the main disadvantages of burning tokens is the potential for perceived price manipulation. Because token burns can have a positive effect on price dynamics, a burn event can be considered manipulative if the reasons for it and the expected results are not clearly explained. In an industry where transparency and accountability are vital, any perceived deception on the part of a project owner can be harmful.

It is advisable for project owners to consider other disadvantages before deciding to burn tokens.

Regulatory oversight

Since token burning affects the price dynamics of an asset, it can attract the attention of regulators seeking to combat manipulation and fraud. The degree of control depends on the jurisdiction, so project owners should study the regulatory framework before embarking on a token burn.

Limited Benefits

Many believe that the benefits of burning tokens are limited and only manifest in the short term. While burning tokens can sometimes be effective in providing stability in times of price volatility, creating a sustainable crypto project requires a carefully designed and implemented strategy, one of which can be burning tokens.

It's irreversible

The burning of tokens is irreversible - once the assets disappear, they disappear forever. This raises the risk that incineration will be detrimental to the project and cannot simply be cancelled. That is why strategic planning and transparent communication with the project network is critical before making a decision.

High-profile cases of burning tokens in the history of cryptocurrencies

Given their persistence and potential long-term impact on the project, it's easy to see why some token burnouts in the history of cryptocurrencies made headlines.

Vitalik Buterin destroyed $6 billion in SHIB

Ethereum co-founder Vitalik Buterin attracted attention in 2021 by burning over 410 trillion Shiba Inu (SHIB) coins worth $6,7 billion. These coins were donated to Buterin by the project's creators as a marketing gimmick. After refusing to participate in the project, Buterin sent 90% of the coins to the “dead” blockchain address in order to withdraw them from circulation. As a charitable move, the remaining 10% of donated coins were donated to the Indian COVID-19 Relief Fund, set up by Polygon founder Sandeep Nailwal.

Terra Algorithmic Experiment

The meteoric rise and equally monumental fall of the Terra protocol was driven by what many considered one of the most transformative algorithmic developments in cryptocurrency to date.

Terra's company, TerraformLabs, launched TerraUSD (UST) in September 2020. UST differed from other stablecoins in that its peg was backed by algorithms rather than massive stocks of cash or debt. The algorithm is based on the related coin LUNA.

Here, users (with the support of the algorithm), in fact, bought UST and burned LUNA, or bought LUNA and burned UST. This token burning process kept UST at $1, theoretically keeping the coin stable.

The uniqueness of the LUNA algorithmic experiment contributed to the skyrocketing prices of LUNA and UST until April 2022. In May 2022, everything ended abruptly. The large withdrawal of liquidity from UST set off a chain reaction of panic selling that eventually led to the depegging of UST and the collapse of the project.

EIP-1559 Burn Strategy in Ethereum

In August 2021, Ethereum Improvement Proposal 1559 (EIP-1559) was enacted, the latest of the Ethereum standards updates that define new features or processes for the blockchain.

EIP-1559 made a significant change to the Ethereum fee market by introducing the fee burn feature. With the fee burn feature, ETH is burned every time the Ethereum network is used, causing the asset to deflate. Developments were significant. In the year following the implementation of EIP-1559, ETH inflation was 2,2%. If EIP-1559 had not been implemented, this rate would have been almost double. Deflation is considered positive for the cryptocurrency as it encourages long-term ownership of the asset and encourages the currency to be accepted as a store of value.

Сonclusion

Token burning has become an important activity in cryptocurrencies: many projects use it as a tactic to stabilize the value of their token, encourage long-term ownership, reward loyal users, etc.

However, problems and risks remain, as token burns can lead to volatility in both the project and its underlying token. Therefore, we believe that before entering into a project, users should do their own research and understand the nature of the asset and the project, including the incineration strategy.