The Theory of Burning in Crypto Tokenomics

By July 21, 20214 minute read
The Theory of Burning in Crypto Tokenomics

Note: This blog is written by an external blogger. The views and opinions expressed within this post belong solely to the author.

One of the fundamental qualities that distinguish Cryptocurrencies as the ideal substitute for cash is their ability to predetermine the entire supply and control it as and when necessary. Burning is a term that refers to the simple principle of restricting supply to preserve the value of an item. The theory is nearly as old as economics itself, and it has been massively popularized by the Cryptocurrency industry.

While economics is a crucial component of a developed human civilization, it has always been relatively innovative. At present, the most popular domain for economic innovation is the Cryptocurrency space. As a byproduct of Cryptocurrency experimentation, “Burning” has emerged as a countermeasure for inflation.

Do Cryptocurrencies actually get burnt?

The term “coin burning” conjures up images of an investor lighting a match to real money. Of course, because digital currencies are only available in virtual form, this is not physically viable. Token burning is an intentional action performed by the coin’s developers to “burn” or remove from circulation a certain number of tokens from the total available supply. Burning tokens serve various purposes, the most common of which is to reduce inflationary pressures in the market.

Indeed, this approach is very comparable to that of a publicly traded corporation repurchasing stock. Such enterprises employ cash in hand to purchase common equity shares, which reduces the total outstanding shares. This procedure helps strengthen the value of those outstanding shares, which can also help improve earnings per share. The ratio of net profits to shares goes higher.

While more prominent blockchains like Bitcoin and Ethereum usually don’t use this approach, other altcoins and smaller tokens often resort to burning to control the circulating supply, which provides more incentives to investment.

How do developers burn a virtual currency?

Token burning can be done in various ways, even though the premise is simple. The objective is to lower the total quantity of accessible tokens.

You can’t physically incinerate a Cryptocurrency, but you can render it completely unusable in the future. To do this, the signatures of the tokens are stored in an irretrievable public wallet dubbed as an “eater address” that is viewable by all nodes but is perma-frozen. The blockchain publishes the status of these currencies.

There are numerous ways for projects to burn tokens, and they vary according to the process’s objective. Some will use a one-time burn mechanism once its ICO (Initial Coin Offering) is completed to remove any unsold tokens from circulation as an incentive for participants. Others prefer to burn coins at fixed or variable intervals and volumes regularly. Binance, for example, burns tokens quarterly to help retain the value of its native BNB tokens.

Some projects, like Ripple, burn tokens gradually with each transaction. When parties deal via XRP, one party may charge a fee to expedite the transaction, but such costs are not returned to any central authority. Instead, they are sent to an eater address immediately after a transaction clears. 

Stablecoins, such as Tether (USDT), generate tokens when funds are deposited in their reserves and burn the corresponding amount when funds are withdrawn. It makes no difference which mechanism is used; the result is the same: burned tokens are rendered unusable and are thus essentially removed from the market.

What else can be achieved via the token burn process?

Proof-of-burn consensus (PoB) is a common technique that emerged from token burning and is based on users destroying their tokens to earn mining rights.

Source: DataDriveInvestor

While Proof-of-Work (PoW) continues to be the most popular option, owing partly to Bitcoin’s endorsement, it uses a substantial amount of resources and can be prohibitively expensive. PoB addresses this issue by limiting the number of blocks miners can verify to the number of tokens they’ve burned. On the surface, it creates a virtual mining field that can grow in size as more tokens are burned.

So do investors benefit from the token burns?

While it may appear as though token burns are used to offer projects a competitive edge, the reality is that the mechanism benefits both developers and investors. Burning tokens helps stabilize a coin’s value and mitigate price inflation. 

The stability gives stakeholders more motivation to hold the coins and keeps prices lower, which helps maintain network uptime and capacity. Additionally, token burns convey a sense of confidence and dependability, particularly during the early phases of a coin’s development.

A big reason why projects burn unsold tokens after ICOs is to increase transparency. An enterprise that sells undistributed tokens on an exchange can generate additional profit but could face accusations that it operates for profits alone. The assurance that projects would only use the funds raised for business activities – demonstrates a commitment to investors and places a higher value on their tokens.

Token burning increases security for users and allows them to safely speed up transactions without unintended consequences for projects like Ripple. Users can trust that the network will be used properly because there is no motive to demand more fees other than for faster execution.

Overall, Burning is a viable attempt to bring an economy back into balance. However, burning as a technique is not intended to work with all forms of Cryptocurrencies. This is because some are better suited to serve as a medium of exchange, while others are more suited to serving as a store of value.

Author: Rony Roy

Rony Roy is an electrical engineer who turned tech author in the Cryptocurrency space. He got block-chained in 2012 and fell in love with tech and its use-cases and has been writing his way through problems since 2016.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.
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