Token Burning: Reasons Why Burning Tokens Is Important

Beginner’s Guide / 03.05.2020

What is Token Burning?

Token burning or coin burning is an intentional action taken by the coin’s creators to “burn,” i.e., 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.

What actually happens in a coin burn is that the tokens are algorithmically taken out of circulation by sending the outputs to a public address known as an ‘eater address.’ The keys to this public address are hidden and cannot be obtained by anyone. And so, once the tokens are sent to this address, they are unrecoverable and can never be used as no one has the private keys to access them.

Decrease to Increase

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 that is viewable by all nodes but perma-frozen. The status of these coins is published on the blockchain so that the entire network can be aware of the process and so that the senders can be transparent about it. If anyone knows the private key, the network will know about it as soon as they try to withdraw.

In the short time since it reached mainstream, the token burning process has proven itself to be an effective method of maintaining a balanced crypto-ecosystem. With time, it is rational to think that future cryptocurrencies will certainly adopt this mechanism giving its numerous benefits, especially in a coin’s infancy stage.

So Why Are Tokens ‘Burned’?

There can be several reasons why holders choose to burn coins, but the most cited reason as of now is to remove tokens out of circulation so that the tokens that remain become scarce. Since the tokens have now decreased in supply, there can be an increase in the tokens’ unit price.

Decreasing Supply to Increase Demand

Although larger blockchains like Bitcoin and Ethereum don’t usually employ this mechanism, altcoins and smaller tokens are often used 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.

Token Burn as Proof of Work Done

One popular mechanism that evolved from token burning is proof-of-burn (PoB) consensus based on users destroying their tokens to gain mining rights. Proof-of-work remains a popular choice, especially due to Bitcoin’s advocacy, but it consumes significant resources and can be unfeasibly expensive. PoB attempts to address this issue by restricting the number of blocks miners can verify (and attach new blocks to the blockchain) to match the number of tokens they’ve burned. Essentially, they create virtual mining fields that can grow larger as they burn more tokens.

Indirect Dividend Payment

Dividends are profits by a project or company distributed back to its shareholders. Holders of security tokens have the option of receiving dividends from the developers of that project. But what happens to other token holders who do not necessarily hold security tokens? Token burn offers a solution to pay dividends to token holders indirectly. By removing a part of the supply by either buying back tokens and burning them or removing existing tokens held by the company, developers are putting deflationary pressure on the token. History shows that most token burns usually associate with a future price increase. This price increase can act as an indirect payment of dividends paid by the company. The Binance periodic token burn mechanism, referred to below, is a form of indirect dividend payment.

Other Reasons

  • In some cases, token burns can result from error correction, such as 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.
  • ICO/IEO unused token burning – when an ICO or an IEO has tokens leftover from its token sale, developers can choose to burn those tokens instead of holding them as an additional responsibility.

Famous Token Burning Events

Stellar Lumens Supply Halving

The general thesis circulating the cryptocurrency community is that token burns are enormously effective at increasing value, and that is exactly what the Stellar Foundation did. During the Stellar Meridian conference on Monday, November 4, the Stellar Development Foundation CEO Denelle Dixon disclosed that they had burned 55 billion Lumens (XLM) tokens, half of the overall cryptocurrency supply. The foundation believes that this massive burning of more than 50% of XML’s total token supply will make the Stellar ecosystem more efficient.

The action of removing over half of the total token supply had an immediate impact on the XLM price, which surged almost 20% higher on the news, even touch $0.09 from 0.061 just a few days before the conference.

Periodic Binance Token Burn

In January 2020, the major cryptocurrency exchange – Binance conducted its 10th Quarterly token burn. Binance’s native token – the BNB was issued as a security token for the exchange. Users can buy, sell, and even use BNB to pay their fees on Binance. Since its inception, Binance has been periodically burning a huge chunk of their BNB earnings from the exchange to reduce the supply. This periodic burning done quarterly has done laurels for the BNB token price, as it has seen a monumental price rally, even though the rest of the market was quite stagnant.

Sudarshan M is a long time crypto-enthusiast. Pulled in by bitcoin early on, it did not take long for Sudarshan to divert all of his academic attention from business studies to blockchain by doing his Masters and eventually pursuing his PhD in the subject.