Burning crypto may sound like a cyberpunk concept like a machine gun Tom Hardy uses to bring death upon his enemies. But in cryptocurrency terminology, crypto burning has a different meaning: making specific coins unusable through the blockchain. But why would anyone want to destroy valuable assets?
Well, if you’re familiar with financial systems in general, it wouldn’t surprise you to hear that in all kinds of financial markets, be it the fiat currency market or the stock market, there are mechanisms to keep the supply in check.
Crypto burning is a supply control mechanism in the cryptocurrency market. Crypto burning may sound counterintuitive since there is a huge industry solely dedicated to mining digital currencies, but there are certain situations where coin burning might be useful to some parties.
In this article, we are going to explore the reasons why cryptocurrencies are destroyed and how it affects the crypto market.
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Cryptocurrency Token Burning
Cryptocurrency burning is the act of making coins unretrievable by sending them to a dead-end wallet address that can only receive transactions. It doesn’t actually destroy the coins, but makes them unreachable, like a helium pinata with no strings attached. Removing crypto from circulation or reducing the supply of a cryptocurrency in circulation has a direct effect on the market value, i.e. price of that currency. For this reason, crypto burning can be used as a value distribution tool.
How Does Coin Burning Work?
Every crypto holder has a wallet address that they use to send and receive assets. You have the public key that you use to receive transactions and a private key which you use to prove your ownership over your coins and to give outgoing orders. But there are different kinds of wallets on the blockchains, and some are only eligible to receive transactions. You might encounter these addresses being referred to as burner addresses or eater addresses.
These wallets have a public key that lets them receive crypto coins but they don’t have private keys, which means it’s impossible for anyone to prove ownership over these coins or send them out, thus permanently removing them from circulation. This is how the burning mechanism works – it’s pretty straightforward. But why would anyone want to get rid of valuable assets?
Why Would Anyone Burn Cryptocurrency?
As a crypto investor, you might not have burned any crypto before (at least intentionally) and the concept may sound almost radical at first, but it’s an essential part of the cryptocurrency ecosystem and serves the community when used correctly. Here is a list of reasons why one might want to burn cryptocurrency.
Stronger Consensus Mechanisms: Proof of Burn
Let us introduce you to a brand new consensus algorithm: Proof of Burn (PoB). Even though there are several versions of this algorithm, the most praised one is modeled by Ian Stewart as a more sustainable alternative to the Proof of Work (PoW) protocol.
How Does PoB Work?
In general terms, PoB works similarly to PoW but much more efficiently in terms of energy consumption. Why? In Ian Stewart’s words, “Burned coins are mining rigs!”
If you are into crypto mining, you would know that back in the day when Bitcoin (BTC) was first invented, it was straightforward to mine Bitcoin with a regular CPU-based computer. However as mining crypto became more and more profitable, the competition for computing power in the market skyrocketed with the rising price of cryptocurrencies. Today, we allocate much more energy to mining and sustaining blockchains than we actually need to. This is because the PoW consensus mechanism is designed to reward the miners with heavier mining rigs.
So remember, crypto burning occurs when some amount of crypto is sent to a dead-end wallet. In PoB systems, those dead-end wallets are used as investments to validate the block transactions. Not direct investment in the sense that they are used as capital in building the blockchain, but as symbolic investments to prove commitment to the blockchain.
In such a system, miners prove their commitment to the network by burning crypto and, this way, they become eligible to mine cryptocurrency. The PoB consensus mechanism is environmentally-friendly because it doesn’t amp up the competition on hash power. Instead, it keeps on running a reasonable amount of hash power, rewarding whoever burns more crypto in the meantime with virtual mining equipment. Thus, the miners don’t invest in heavy mining rigs such as ASIC miners, but instead, they invest in virtual mining rigs by burning crypto tokens.
So, in short, miners contribute to a virtual mining pool by burning the native token of the blockchain they are mining on, and in return, they have a higher chance to be eligible to validate the next block and claim the block prize. And let us reiterate, the system doesn’t use the burned coins as means of capital, it’s just a tribute to the blockchain to get a greater chance to mine the next block. Because the coins are unreachable, the PoB blockchains continuously reduce the circulating supply of the cryptocurrency, which creates scarcity and consequently has a positive effect on the price of that currency.
Advantages of PoB
PoB-based blockchain technologies have quite a few advantages over PoW-based ones, the most prominent one being energy efficiency – they are less of a burden on the environment because they reduce power consumption and the demands on the mining hardware. As we have just mentioned, they deduct the circulating supply and encourage a less centralized mining industry.
Disadvantages of PoB
However, PoB systems also have downsides. For example, they are not as well tested as Proof of Stake (PoS) or PoW mechanisms and we don’t know if they work effectively on a large scale. Moreover, the block validation on PoB is said to be slower due to technicalities. Plus, because the technology is quite new, it hasn’t had enough time to prove its worth in terms of mining eligibility. The question of who is eligible to mine new coins is a bit ambiguous at this point.
Besides opening up a new window for consensus mechanisms, crypto burning may also be helpful for implementing economic decisions regarding the project’s financial plans, as it’s a very effective way of manipulating s cryptocurrency token supplies.
Burning ICO Leftovers
For example, when there is an initial coin offering (ICO), the projects don’t always end up selling all of the hard cap they initially envisioned. If the ICO ends up with unsold tokens, the project may decide to burn the excess supply of coins to increase the value of the sold ones. Because such action is intrinsically community-driven, projects that chose to do so are generally praised by their community.
Stellar, Shiba Inu, and Binance Coin Dividend Payments
When you purchase a stock, you become eligible for some portion of the company’s profits, depending on your contract. Is there a way to implement this idea in the cryptocurrency environment? Definitely. When a token burning takes place, the decreasing supply dictates increasing market values. Thus, when a company wants to distribute dividends to their token holders, they can decide to burn some of their coins.
Regular token burning is a long-term strategy adopted by Stellar Lumens (XLM), to increase the coin’s value. So far, Stellar has effectively reduced its supply by 50%.
Another coin that has been benefiting from coin burning is Shiba Inu (SHIB). The coin was initially launched on the Ethereum (ETH) network as a joke after an internet meme. And befittingly, it became viral among crypto investors. But the coin doesn’t have a maximum supply cap, and as more and more tokens are being mined, the project faces the risk of crashing. Nevertheless, the mysterious founder of SHIB has announced there will be a huge coin burn to keep the supply of the coin in check.
This is the case with regular Binance coin burn events that are being held by the exchange giant itself. When the 18th BNB burn took place on January 17, 2022, Binance effectively burned 1.3 million BNB tokens, which was worth 729 million US dollars at the time, significantly reducing the total supply of BNB in the market. It’s hard to calculate its direct effect on BNB price isolated from everything else, but classical economic theory dictates that reducing the number of tokens will eventually have a positive effect on the market price, distributing some of the revenue back to BNB holders.
Ever wondered how stable coins like Tether (USDT), USD Coin (USDC), or HUSD (HUSD) keep their market prices at the level of another currency? It’s thanks to the fact that the market price of a token is driven by its supply and demand dynamics. Even though we don’t have a control mechanism for market demand, we can manipulate the supply directly to adjust the prices of these coins.
When you buy stablecoins, the demand increases, and new coins are mined to meet that demand. When coins are withdrawn, i.e. sold for fiat, the blockchain burns the equivalent amount of coins to keep the balance stable.
A Few Words Before You Go…
So overall, cryptocurrency burning is not necessarily a horrible thing to do to valuable tokens. It is a market mechanism that is used to regulate the supply, distribute dividends, and adjust prices. It can even be an efficient consensus mechanism.
However, one thing to always keep in mind regarding blockchain technology is that cryptocurrency coins are much more different than traditional fiat money, and thus have much different dynamics. When we talk about burning cryptocurrency, we don’t mean destroying existing tokens. We are not hitting the delete button on the blockchain, rather, we are sending the coins to one-way addresses from which they can’t be sent out ever again. There is no delete button on the blockchain, on the contrary, it keeps a record of every movement, irreversibly, all the time.