What is token burning and why is it important?

Intermediate
March 29, 2023
Read time:
7m

Cryptocurrency burning is a process of transferring tokens to an address from which they can no longer be retrieved. This mechanism is used for various purposes, such as eliminating tokens after an Initial Coin Offering (ICO) or burning coins from an old blockchain during forks.



The process differs depending on the specific blockchain or cryptocurrency but generally involves a few necessary steps:

1.  The project decides to burn a fixed amount of tokens. This fact should be publicly announced, and the burn details should be included, along with its reasoning.

2. Tokens are sent to a specific address, usually achieved by a cryptographic hash function that cannot be reversed - rendering the tokens permanently unusable

3. The transaction is recorded on the blockchain and can be viewed by anyone. This provides transparency and ensures the total supply is updated to reflect the reduced number of tokens.


Ways of burning tokens

  1. Burning coins that were not sold during the ICO – to remove them from circulation.
  2. Regular burn - at fixed intervals. For example, Binance Coin is burned quarterly.
  3. Burning with each transaction - the burning procedure occurs every time a transaction is executed. Typically, a participant can set the number of coins they would like to burn when the transaction is completed.

What is the point of burning tokens?

Reducing the token supply and increasing the value of remaining tokens  

Token burning can reduce the total supply, which helps maintain (or increase) the value of remaining tokens. It may be beneficial for investors, as it may increase the scarcity of tokens, potentially leading to higher demand.

Implementing a deflationary monetary policy

Some cryptocurrencies are designed to have a deflationary monetary policy, meaning the token's total supply will decrease over time. Token burning is one way to implement this policy.

Rewarding token holders

Token burning may also be utilized as a way to reward token holders. For example, a portion of the transaction fees generated by the network may be used for buybacks and burn tokens, which can boost the value of the remaining tokens.

Burning from investors’ and traders’ points of view

Burning may be considered beneficial for investors who want to hold their assets as they can potentially increase in value. However, from a trader's perspective, burning can reduce the liquidity of the cryptocurrency in the short term. This may lead to price fluctuations as supply and demand dynamics change in response to the burn.


Additionally, let's suppose the token burn was unexpected or not communicated sufficiently. In this case, traders may be caught off guard, leading to panic sells or other reactions that can further impact the cryptocurrency's price.


Moreover, whether token burning is beneficial depends on various factors, including the given cryptocurrency, reasons for the burn, and how it is communicated to the public. Both traders and investors should carefully consider the risks and rewards associated with token burning before making investment decisions.

Proof-of-Burn

Proof-of-Burn (PoB) requires miners and users to regularly burn some of their coins. Proponents of this method consider it an efficient way of verifying transactions because it does not use real-world resources. Simply put, miners reach consensus by burning the asset's units.


The Proof-of-Burn mechanism differs from PoW or PoS, as miners burn (rather than mine) tokens to gain access to mine cryptocurrency and add blocks at a much lower cost than usual. The PoB consensus is also energy-efficient, as it disposes of cryptocurrency rather than generating it.


Summary

Token burning permanently removes tokens from circulation. This process can reduce the total supply of tokens, increase the value of the remaining ones, and implement a deflationary monetary policy. Token burning can be beneficial for long-term investors but may negatively impact traders in the short term by reducing liquidity and causing price fluctuations.

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