Bitcoin’s scarcity is one of its key features and is often paraded through the enforcement of its hard cap. As per consensus, there will only ever be a maximum of 21 million Bitcoins in circulation, with the last Bitcoin mined roughly 2140. However, the true circulating supply will likely be unknown since we don’t have perfect insight into how many people lose or burn their keys that lay claim to a certain amount of Bitcoin.
While you can still audit the supply and see the entire UTXO set on-chain, none of us know how much of that Bitcoin is accessible. Each year, Bitcoiners make mistakes and lose access to coins, pulling supply off the market.
These unplanned losses, along with the hard cap, drive up the scarcity of Bitcoin as fewer are available for purchase, which is one of the reasons why it makes Bitcoin attractive to investors and users as a store of value. Another is Bitcoin’s issuance rate is known and predictable. This means that investors can accurately predict how many Bitcoins will be added into circulation at any given time. This predictability is important for investors who want to make informed investment decisions.
While Bitcoin can provide you with a fully auditable supply and known inflation rate, crypto projects don’t often subscribe to these hard rules and take a more liberal approach to their “tokenomics”.
As other token projects wrestle with interventionist policies to try and balance inflation issuance, rewarding network participants and balancing demand, you’ll often see projects talk about ‘burning’ coins, but what is the practice and why does it happen? But if a coin has value, why would you want to burn it purposefully?
What is token burning?
Token burning refers to the process of permanently removing a specific number of tokens from the supply in circulation. The act of burning tokens is permanent, meaning those assets are destroyed forever and cannot return to circulation; it is normally marked in an unaccessible wallet where the amount of burned tokens can be audited.
Token burns can be made part of the protocol, where transaction fees are burned/diverted to the burn wallet instead of being redistributed to miners or validators. Alternatively, burning events can occur when individuals, companies, or communities decide to burn a certain amount of tokens. Token burning events are usually coupled with some marketing event to try and drum up interest or to unlock some service.
Token burning is not without controversy, with some people arguing that it is a good way to increase the price of tokens and others arguing that it is a form of manipulation.
What is the point of token burning?
Token burning is sold to systematically drive scarcity with use, as these supply-reducing events are intended to have a deflationary impact on the value of an asset. The idea is that by removing coins from circulation, eventually, there will be fewer coins available for trade, boosting its value by having fewer coins servicing a certain demand.
Token burning applies the theory that an asset will hold a higher value in the future as current use erodes supply and the scarcity of that asset is maintained.
Another reason to burn tokens is to control inflation. If a project has a large supply of tokens in circulation, the value of each token may decrease over time. By burning tokens, the project can reduce the overall supply and help to maintain the value of the remaining tokens.
In this case, the token burning isn’t meant to increase the price but rather stop further devaluation as more coins are brought onto the market without an equal demand to acquire them.
Is token burning important?
Token burning isn’t essential for a network to function, as is proven with Bitcoin; there is no need to remove supply for it to attract users and demand purposefully. However, for coins competing with Bitcoin, they require gimmicks to try and attract users to their ecosystem instead.
Promises of higher scarcity or higher coin removal, lower inflation rates than Bitcoin, or the claim of “ultra-sound money” are all talking points used to drum up interest.
If these token-burning methods worked as advertised, surely, over time, there would be increased demand for that network, the market cap in fiat would increase, and the unit price of a token in Bitcoin terms would increase.
Certain proponents of token burning will tell you that it is too early to see the effects now and to continue to buy, hold and use the token. Eventually, the incentives structure will provide a dividend, but the only ones bagging dividends are those selling the dream as they get out of their positions.
Regulatory scrutiny
Since token burning impacts an asset’s price action, it could draw the attention of regulatory bodies eager to address manipulation and fraud, especially if they are frequent and coupled with predator marketing.
The degree of scrutiny depends on the jurisdiction, and project owners should consider the regulatory environment before proceeding with a token burn.
Messing with network incentives
Token burns are often seen as a way to incentivise existing users to stay involved while attracting newcomers to the project. Existing users might see the value of their token holdings rise as a token burn causes prices to increase, nudging them to continue holding for the long term, but the effects can reduce rather than increase over time.
To get the same or a stronger reaction, developers might need to change parameters and take more risks, which can change the incentives of the entire network or even open up new vulnerabilities.
Examples of token burning
Token burning can come in many forms; as I mentioned, some can be based on special one-time events, while others can be systematic like:
Buyback and burn (Binance Coin)
Binance coin (BNB) burn schedule involves a buyback and burn mechanism whereby Binance uses part of its revenue or profits to buy back tokens from the market and burn them.
When BNB was launched in 2017, a commitment was made to remove 100 million BNB (half of its total supply) from circulation through a burning process.
Fee burn (Ethereum)
When Ethereum transitioned to its proof of stake (PoS) consensus algorithm from proof of work (PoW), they also pushed through the EIP-1559 update, introduced in August 2021, which burns ether from the fees gathered from validating and verifying the network.
The designated burn address is 0x0000000000000000000000000000000000000000 and does not have a private key, which means any tokens sent there are effectively destroyed.
Proof of burn
Proof of burn is an alternative consensus mechanism blockchain networks can use to ensure that all participating nodes come to an agreement about the true and valid state of the blockchain network. This algorithm enables miners to burn coins to mine a block and earn income from block rewards effectively.
Bitcoin burns with Counterparty.
Token burns aren’t only for altcoins but also have a history with Bitcoin.
Counterparty is an open-source protocol created to bring Smart Contracts to the Bitcoin blockchain, but to run these contracts, you require a native currency called XCP. These tokens were originally issued using a provable method called “proof of burn”. This method involves sending bitcoins to a special address that permanently unspendable the coins.
During January 2014, 2125.63 bitcoins were sent to 1CounterpartyXXXXXXXXXXXXXXXUWLpVr
One burn way pegs
Spacechains, a proposed scaling solution, makes use of coin burns as a one-way peg into the network. If you wish to use a Spacechain, you would need to burn a Bitcoin and render it unspendable on the mainchain to unlock it on the Spacechain.
If you wanted to return to the base chain, you would need to find someone willing to trade your Spacechain Bitcoin for a main chain Bitcoin, but this would only be viable if the Spacechain itself has enough market demand that people want to move in and out of it.
If some Spacechain doesn’t catch on and you burned Bitcoin to peg into it, no one would want to swap back, and you would be stuck in the Spacechain with worthless tokens.
You will be the one getting burned.
Token burning is not necessarily a scam, but it can be used for nefarious purposes, primarily as a way to market an asset to those who aren’t sophisticated enough to understand the limited impact of token burning.
Token burning can be used to deceive investors by creating a false sense of scarcity. When a project burns tokens, it reduces the supply of tokens in circulation. This can make the remaining tokens more valuable, which can entice investors to buy them. However, if the project is not actually valuable, then the price of the tokens will eventually fall, even if the supply is limited. Don’t be fooled by fancy graphs and trendlines, regardless of the burning, if you do not increase demand and use of your network, it will die and the native asset will depreciate versus networks that are successful.
Another way that token burning can be used to deceive investors is by raising money without delivering on promises. Some projects will burn tokens to generate hype and excitement but never deliver on their promises. While fewer tokens might be available for circulation, this means very little if there is little to no demand for the remaining tokens, which can leave investors with worthless tokens.
Finally, token burning can be used to manipulate the market. By burning tokens, a project can drive up the price of its remaining tokens. As the coins of users in circulation erode through burning, those who have yet to use their tokens can sell into any additional or sustained demand. This can make it easier for the project to sell its tokens profitably without necessarily providing any value to the ecosystem.
