Token Burning, Explained
What is token burning?
Token burning refers to the permanent removal of existing cryptocurrency coins from circulation.
The practice of burning is common in the industry and is quite straightforward. Token burning is an intentional action taken by the coin’s creators to “burn” — or remove from circulation — a specific number from the total available tokens in existence. There are several reasons to burn tokens this way, but generally the move is for deflationary purposes. Although larger blockchains like Bitcoin and Ethereum don’t usually employ this mechanism, burning is often used by altcoins and smaller tokens to control the number in circulation, providing greater incentives to investors.
The burning mechanism is unique to cryptocurrency, as regular fiat currencies are not usually “burned,” though the flow of available currency is otherwise regulated. Token burning is similar to the notion of share buybacks by publicly owned corporations, which reduce the amount of stock available. Even so, token burning has several unique uses and serves different purposes.
How does token burning work?
Although the concept is straightforward, token burning can be accomplished in different ways. The goal is to reduce the existing number of tokens available.
Although it sounds extreme, burning tokens doesn’t disintegrate them literally, but it does render them unusable in the future. The process involves the project’s developers repurchasing or taking available currency out of circulation by removing them from availability. To do so, the tokens’ signatures are put into an irretrievable public wallet known as an “eater address” that is viewable by all nodes but perma-frozen. The status of these coins is published on the blockchain.
There are different ways projects burn tokens, and they vary depending on the purpose of the process. Some will employ a one-time burn once its (initial coin offering) ICO is completed to remove any unsold tokens from circulation as an incentive for participants. Others prefer to burn coins periodically at either fixed or variable intervals and volumes. Binance, for instance, burns tokens quarterly as part of a commitment to reach 100 million BNB tokens burned. The volume of coins changes based on the number of trades performed on the platform each quarter.
Others, such as Ripple, will burn tokens gradually with each transaction. Whenever parties transact through XRP, one party can set a fee at its convenience to prioritize the execution, but those fees are not returned to any central authority. Instead, they are burned by sending them to an eater address as soon as the transaction clears. Stablecoins, such as Tether (USDT), will create tokens when they deposit funds into their reserves and burn the equivalent amount as funds are extracted or withdrawn. Regardless of the mechanism, the result is the same: Burned tokens are rendered unusable and effectively erased from circulation.
Why do companies burn tokens?
Regardless of how it’s accomplished, token burning is usually a deflationary mechanism. Most projects use it to maintain a stable value and keep incentives for traders to hold their coins.
There are multiple reasons why a company would choose to burn tokens, and all of them have value for token holders. The most common reason is to boost the value of each token by reducing existing supply. In theory, fewer coins available for sale and on exchanges means that each individual token will be more valuable. Indeed, this is why most cryptocurrencies have a finite amount either in circulation or in future supply (such as Bitcoin’s eventual limit).
By holding their hand on the figurative faucet, projects can increase the value of each token holder’s existing supply and create incentives for ongoing support. This is a major factor behind Binance’s periodic burn, for instance, and why many companies will burn unsold tokens after their ICOs end. In some cases, token burns can be the result of an error correction, such as was the case for Tether. The company accidentally created $5 billion in USDT and had to burn it to avoid destabilizing its 1:1 peg with the United States dollar.
In the case of security tokens, which entitle holders to dividends from a project, token burning works much like the buyback of shares by corporations. The coins can be bought back at fair rates and then instantly burned to increase the value of each holder’s existing token amount. If tokens are required to be repurchased at market price, investors could even stand to profit based on the price at which they purchased originally. Finally, some projects use token burns to avoid spammed transactions and to add a layer of security. In Ripple’s case, the company burns fees from every transaction to remove the incentive to overload the system for a quick profit and to protect against DDoS attacks.
Can token burning be used for anything else?
In short: Yes, it can. One use some projects have found for token burning is to create a more reliable consensus mechanism for verifying and appending transactions to the blockchain.
One popular mechanism that evolved from token burning is proof-of-burn (PoB) consensus, which is based on users destroying their tokens to gain mining rights. Proof-of-work remains a popular choice, especially due to its advocacy by Bitcoin, but it consumes significant resources and can be unfeasibly expensive. PoB attempts to address this issue by restricting the number of blocks miners that can verify (and attach new blocks to the blockchain) in order to match with the number of tokens they’ve burned. Essentially, they create virtual mining fields that can grow larger as they burn more tokens.
In theory, the burning of tokens will reduce the number of miners at any given time and decrease the need for resources as competition is lowered. In practice, this mechanism would give large miners, who can burn vast volume of tokens at once, a disproportionate capacity. To combat this, many PoB implementations use a decay rate that reduces the total mining capacity of a miner whenever it verifies a transaction, so that each must constantly invest more tokens to burn and thus remain competitive. PoB is also similar to proof-of-stake, since both require users to lock up their existing assets to gain the privilege of mining. Unlike PoB, however, stakers can take their coins with them if they choose to stop mining.
Do token holders really benefit from token burning?
While projects themselves gain significant advantages from burning their tokens, the process isn’t a zero-sum game. Token holders also benefit in several ways from the process.
It may seem like token burns are designed to give projects an edge, but the reality is that the mechanism is beneficial to both developers and investors. In many cases, burning tokens can help stabilize a coin’s value and curb potential price inflation. The stability gives investors a greater incentive to hold the coins and keeps prices at more favorable rates, which therefore keeps network uptime and bandwidth healthy. Token burns also project a sense of confidence and reliability, especially at early stages of a coin’s development.
Another major reason why projects burn unsold tokens after ICOs is to give investors greater transparency. A company that sells undistributed tokens on an exchange might gain an additional profit but might open itself to allegations that it exists for profits alone. On the other hand, the promise that projects will only use the funds raised for business operations shows a commitment to investors and values their tokens at a fairer price.
For projects like Ripple, token burning adds security for users and lets them safely expedite their transactions without perverse incentives. Because there is no incentive to charge higher fees other than for faster execution, users can trust that the network will be used more responsibly.