Coming newly into cryptocurrency, you probably have heard the term “burning” once or twice. Of course, burning is a destructive term, so you must wonder, what exactly is burning? And why is it often paraded as good news?
“Burning” in cryptocurrency is the event where a certain amount of a token supply is permanently removed from circulation. Hence, these tokens cannot be bought, sold, staked, or used in any transaction. To do this, the tokens to be burnt are sent to a “burn address,” which is a one-way wallet address that can only receive tokens but cannot send out any. As a result, tokens sent to the burn address are “destroyed” forever and can never be retrieved.
Why Do Crypto Projects Burn Tokens?
Cryptocurrency is money, and the idea of “destroying money” somewhat sounds weird. However, in reality, it is a great move to bolster the economy of a crypto token.
From basic economics, it is known that “when a commodity’s supply is surplus, then it will be cheap; conversely, when a commodity is scarce, then it will be expensive.” Hence, crypto projects primarily burn tokens to manually reduce the token supply in the market. By doing this, the remaining tokens in circulation will become more valuable for holders.
For example, if all the gold bars in the world are cumulatively 1 million pieces, and you have 20,000, it means that you have 0.02% of the world’s gold. However, suppose 80% of the total gold bars are destroyed forever, leaving only 200 million pieces. In that case, you will have 10% of the world’s gold. Of course, you may argue that your total amount of gold remains the same; however, there is now a huge scarcity in the gold market, and provided the demand for gold remains constant, the price of one gold bar you would have probably sold for $80 would be considered cheap at $1,000 because fewer people are willing to sell. Hence, you still have 20,000 gold bars, but the worth of each has astronomically increased because there are more buyers than sellers.
The same concept holds water in all cryptocurrencies. With steady or increased demand, burning crypto tokens will lead to a massive increase in value. For example, after an ICO event, the issuing company is often expected to burn the unpurchased tokens to assure investors that the worth of their investments won’t be affected by excess token supply in the market.
What are Buybacks and Burning Events?
Buyback and burning events are pretty common with crypto companies that have a native token (most commonly exchanges). These companies allocate a certain percentage of their profits to buy tokens from the marketplace and burn them to reduce supply and increase value for holders.
This idea was borne from stock buyback, which occurs when an issuing company buys back shares from the stock market and reabsorbs the portion of its ownership that was made public. As a result, the publicly available shares reduce, and the stock value of each shareholder increases.
Although both concepts aren’t exactly the same, the operation mode and end game are very similar.
What is Proof-of-Burn?
Like common consensus mechanisms (e.g., Proof-of-Work and Proof-of-Stake), Proof-of-Burn (PoB) is used to maintain a blockchain’s activity by validating transactions and adding new blocks.
Proof-of-Burn is slightly similar to Proof-of-Stake, where validators are required to permanently lock up a certain amount of tokens to validate transactions. However, in the PoB consensus mechanism, validators are required to permanently destroy a certain amount of tokens.
A PoS validator can retrieve their tokens after the staking period, but a PoB validator cannot retrieve burnt tokens. However, it is expected that the tokens earned from the validation activity will be more valuable since the PoB miners have burnt several tokens.
Some cryptocurrencies that employ this consensus algorithm include Slimcoin (SLIM), Factom (FCT), and Counterparty (XCP).
Advantages of Burning
1. The most apparent advantage of Burning is that it helps to increase the value of a cryptocurrency
2. An increased value leads to high-value transactions, reducing the chances of a dust attack.
3. Proof-of-Burn (PoB) is an efficient way to assign network validators without expending heavy equipment or consuming enormous energy like PoW.
Crypto burning is an effective way of providing value to token holders; however, coin burning on its own doesn’t assure you of a price increment. Coin burning in the absence of demand will seem futile, as there is no buying pressure to showcase genuine scarcity. Similarly, when analyzing crypto projects for investment, you shouldn’t view scheduled burning events as the only positive metric, balance the pros and cons, and make a well-informed investment decision.
Lastly, coin-burning evets are always verifiable on the blockchain. Always ensure that the coins are sent to a one-way wallet that cannot spend tokens to ensure that developers aren’t trying to trick people by holding an ample token supply, only to dump and leave investors hopeless.
If you are a newbie, kindly check out our cryptocurrency beginners’ guide, and visit the CCTIP Blog for more detailed guides on cryptocurrency and blockchain technology. Also, follow our social media communities: