What is token burning, and how does it work?

Token burning is a strategy followed by cryptocurrency projects to influence the price of a token, or coin, in the market. This is done by permanently removing some tokens from circulation.

It is typically performed by the development team which can also buy back tokens and burn them. It involves parts of the supply that are already available, such as unallocated tokens or those that are stored in the team’s Treasury.

By the law of supply and demand, if an asset decreases in quantity, its intrinsic value per unit increases scarcity and a finite, deflating supply are therefore bullish catalysts for a token price

For instance, Binance has a target of burning 100 million BNB tokens, while there are similar practices for both USDT Tokens (issued by Tether) and XRP coins (issued by Ripple).

Also, in the summer of 2021, Ethereum introduced a burning token system to the network to solve the eternal problem of high gas fees. By November, 1 million ETH were burned Meanwhile, unlike Bitcoin, Ethereum doesn’t have a limited supply, but it does have an annual maximum supply of 18 million ETH.

How does token burning work?

The goal of token burning is to remove a certain quantity of a token from the circulating supply and this is done by the following methods;

• One of the most popular ways crypto projects carry out a burn is to buy a certain amount of tokens from the market to get it out of circulation. These tokens are then transferred into a frozen private address called a Burn address. It’s a one-way address with no known private keys and thus the inability to reverse the transaction or withdraw the coins. In other words, the asset no longer exists; it has been “burned”.
• An example of a common burn address is Ethereum 0x0, which contains more than $900 million worth of ERC-20 tokens. In 2021 one of Ethereum's co-creators, Vitalik Buterin, burned his SHIB tokens which had a value of $6.74 billion using this method, which helped push the price of SHIB and made it one of the coins to keep an eye on.
• Using the burn function that is included in the smart contract that issued the token. For instance, the Binance network regularly carries out a buyback and burn each quarter, whereby the Binance team decreases the amount of BNB tokens in circulation. Its 20th quarterly burn for example was completed in July during which 1,959,595.29 BNB were burned. When BNB was launched in 2017, the total supply was 200 million – as of September 2022 that is now just about 163 million, an almost 20% reduction. In December 2021 an auto-burn protocol was implemented to make the deflation rate even more transparent for traders.

Why Do Companies Burn Cryptocurrency?

In general, it's the developers that burn tokens. This reduces the supply, which theoretically acts to increase the currency's price and benefit investors

Ripple, a top digital asset, does this but uses a different method. It reduces the number of transactions allowed on its network, limiting the possibility of a DDoS attack (which disrupts the normal traffic of service, server, or network). Another way is by taking the fees used as “gas” to make a transaction happen faster than usual. This reduces the supply of XRP circulating in the market on every transaction done.

Stellar, another cryptocurrency company, proceeded with a token burn of 55 Billion XLM to increase the coin’s value. This burn effectively reduced XLM supply by over 50%. The price effect on XLM was quickly noticeable in the short term, moving from $0.069 to $0.088 in a day (around 25% from November 5th to November 6th).

Even stablecoins like USDT, GUSC, USDC and HUSD have conducted burns of over $2.8 billion. This provides transparency of the reserves once funds are added or retired. When there is a deposit in reserves, tokens are minted. The burning happens when the coins minted into the reserve are withdrawn, regulating the circulating supply and keeping the balance stable.

What are the benefits and use cases of token burning?

Deflationary purposes

It is used to influence the price of a coin, such that If the supply is reduced and the demand remains the same or increases, the price goes up. However, if the demand decreases, coin burning may not help much. For example, when OKEx launched OKChain in February 2020, the company decided to burn the 700 million unissued OKB tokens to make it a completely deflationary currency and the first fully circulating platform token.

The XLM example is another good reference. The corresponding increase in the value of each XLM unit demonstrates that token burns impact the price of a coin, at least in the short term. Like many tokens, however, XLM fell during the Coronavirus crash, but since late April 2020 the token stabilised, reaching the $0.10 mark in July of the same year.

Also, in the case of XRP, the constant burning keeps a steady value of the token and also bets for a long-term price rise. Using metrics from the same period and considering the same crash factor, the price remained around $0.28 to $0.31 from November 2019 to August 2020.

To incentivize token holders

As a coin becomes more valuable, holders are incentivized to keep them. To achieve this, exchanges like Binance, KuCoin, Huobi, and OKEx burn tokens periodically.

In October 2021, the KuCoin team decided that in order to increase the process of KCS burning and adapt to the market development more efficiently, the period of KCS buyback and burn from every quarter was changed to every month.

Apparently, token burns are a form of airdrop due to the value of community holders’ tokens increasing. For example, Project X conducts a token burn. Afterwards, the supply reduces and the value of the token appreciates by 10%. Accordingly, this has made every community holder’s token more valuable than it was before the burn. Hence, Mr Y who holds 1,000 units of Project X tokens would have had the value of his holdings appreciated by 10%, even though he still holds his original 1,000 units. In essence, Project X just did an airdrop to every token X holder who didn’t need to spend a dime to increase the value of their holdings. Perhaps, this is one of the reasons community members are endeared to projects that announce they will conduct periodic token burns. Many projects even employ this as one of their marketing tactics.

To maintain the price peg of stablecoins

In this case, coins are burned to keep the price of an asset at a near-constant level.For example, in order to mint 1 TerraUSD, 1 USD worth of the reserve asset, LUNA, must be burned.

Correction

This use case enables a project to correct a mistake. For instance, when Tether created $5B in USDT by accident, these tokens had to be burned to prevent the new supply from destabilizing the 1:1 peg with the US dollar.

Effective consensus mechanism

The proof-of-burn mechanism is a consensus algorithm implemented by a blockchain network. It is used for validating transactions on the blockchain.

For example, Slimcoin, a virtual currency network that uses this consensus mechanism, lets a miner burn coins that offers them the right to compete for the next block. On top of that, it also offers them the chance to receive blocks during a longer time period, for at least a year.

Final Thoughts.

Token burning is a catch-all term/aspect of Tokenomics that is essential to consider before investing in a crypto project. Ultimately, every project should design a thoughtful incentive plan for buying and HODLing their native assets long-term, as a shortfall in doing so increases the likelihood that users will abandon the protocol after the token price pumps, dump the assets onto the market, and then leave the ecosystem to become stale. In other words, poor Tokenomics are unsustainable over the long term.

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