Token burning, explained

What is token burning?

As a seasoned crypto enthusiast with years of experience navigating the digital asset landscape, I can confidently say that token burns have become one of my favorite mechanisms to keep tabs on. Having witnessed numerous projects come and go, it’s comforting to see a sustainable approach like token burning that helps build trust and confidence in the community.

As a crypto investor, I’d put it this way: “When tokens are burned, it means that a specific number of these digital coins are permanently taken out of the market, thus lowering the overall amount in circulation.

Picture a well-known eatery subtly altering its ambiance by removing some dining tables to create an intimate, high-demand setting. In much the same way, token burning in cryptocurrency serves to decrease the overall supply of tokens available, which could potentially boost the worth of those that survive.

In simpler terms, a project renders its tokens unusable by transferring them to a specific wallet address that’s only capable of receiving but not sending tokens. This is similar to locking away the tokens in an untraceable, secure, and tamper-proof digital wallet whose private key remains a mystery.

Normally, the team or group chooses an address for the project that is secure against hacking, unpredictable, and impossible to access. As no one can recover or use these tokens, they are deemed as having been destroyed forever.

In simpler terms, token burning – a practice exclusive to cryptocurrency projects – serves to limit the supply and increase scarcity, which can attract investors and help maintain market stability. This is similar to what traditional firms do when they repurchase their own shares, thereby reducing the number in circulation. However, token burning is unique to the crypto realm and demonstrates a project’s dedication towards achieving long-term objectives.

Through permanently taking some units out of circulation, a process known as “burning,” each token becomes more valuable, much like exclusive items become more appealing as their supply diminishes. This scarcity can draw investors in while potentially increasing the value for existing holders, symbolizing the project’s dedication to long-term aspirations.

In simpler terms, token burning is viewed as a tactical approach to boost a token’s worth by altering the supply-versus-demand equation. Not every token uses this technique, but it’s quite common among smaller or recently launched token projects, aiming to stabilize their market and win over investor trust.

How token burning works

Destroying tokens isn’t merely a ceremonial act; it’s a meticulously managed procedure that renders them non-transferable forever.

The token burn procedure is made up of several stages, each of which is essential for rendering the tokens unusable and removing them permanently from the market supply, thus making them impossible to trade.

Step 1: The decision to burn tokens

Initially, the decision to destroy tokens is often made by the project creators or those in charge. They might choose to destroy tokens as part of a financial plan aimed at enhancing scarcity, or as a reaction to feedback from the community.

Certain projects implement a gradual decrease in token availability by periodically destroying tokens, known as deflationary mechanisms. Alternatively, some tokens come equipped with an inherent destruction feature, like burning a specified portion of transaction costs or staking earnings.

Projects can eliminate tokens in various methods: Some employ regularly scheduled burns, such as Binance’s quarterly token burns, which are adjusted based on trading activity. Alternatively, some use transaction-based burns, where fees are permanently eliminated from circulation with each transaction. For instance, Ripple disposes of a portion of its transaction fees as part of its strategy to deter spam on the network, thus differentiating it from projects using scheduled token burns like Binance’s.

Unlike other cryptocurrencies, stablecoins such as Tether’s USDt (USDT) have their value tied to real-world currencies or assets, which necessitates equivalent reserves. When users cash out USDT for real money, those tokens are destroyed to preserve a 1:1 ratio, meaning they can no longer be used. On the other hand, when new funds in the form of fiat currency are deposited, an equal number of new tokens are issued. This system keeps the supply of stablecoins consistent with the underlying reserves, thus maintaining stability and fostering trust in the pegged value.

Step 2: Identifying tokens to burn

After a decision has been reached, the team determines the quantity of tokens to take out of circulation. This figure could either be a specific number or a proportion of the overall supply, contingent upon the objectives of the burn operation.

In this case, the smart contract associated with the blockchain verifies whether the requester possesses sufficient tokens in their digital wallet to carry out the token destruction (burn). Additionally, the system guarantees that the specified quantity is both positive and non-zero. The token burn process will not proceed if the requester lacks sufficient tokens or if the provided amount is deemed invalid.

Step 3: Sending tokens to burn

When tokens get burned, they are usually directed towards a designated wallet, sometimes referred to as a “destruction address” or “black hole address.” Once there, these tokens are essentially rendered immovable and unreachable for good.

In simpler terms, when it’s time to destroy some tokens in a project, we say the project “invokes” or “triggers” a “burning mechanism” within the blockchain. This action instructs the network to carry out the burning process. The amount of tokens to be destroyed is determined and specified at the time this function is activated.

Step 4: Verifying the burn on the blockchain

The burn process is transparent. Once tokens are sent to the burn address, the transaction is recorded on the blockchain, where anyone can verify it. 

In addition to sharing details about their projects, some platforms may disclose “destruction phases” to the public, ensuring transparency. This transparency builds trust among the public and enables them to monitor these destruction events on the blockchain, confirming that the tokens have indeed been removed from circulation.

Did you know? “Burn rate” is a metric sometimes used to measure projects’ health. A higher burn rate can indicate that a project is actively reducing supply to increase scarcity, but it could signal an unsustainable economic model if it’s too high.

Why do projects burn tokens?

Although it might seem contradictory, the process of destroying tokens (also known as token burning) serves multiple valuable functions that contribute to a project’s development, security, and stability. Each reason has its distinct role in fostering the success of the project.

Burning tokens primarily serves to enhance value by decreasing the total amount available, but its advantages go much further than simply creating rarity.

Improving investor confidence

Frequent token burns can foster trust and reassurance within a project’s community, as they indicate a dedication to stability and sustainable development. This action often signals to users that the company is serious about its commitment to the project’s longevity. By demonstrating a decreasing supply of tokens over time, projects can alleviate investor worries related to inflation or market saturation.

Error correction

Occasionally, burning tokens serves as a useful method for addressing oversupply caused by unintended token creation or technical glitches. For example, if an error results in extra tokens being produced, destroying these excess tokens can help maintain the stability of the currency and prevent it from becoming destabilized.

Stabilizing algorithmic stablecoins

In the context of algorithmic stablecoins, token burning serves a distinctive purpose. These digital currencies are crafted to maintain a consistent value, usually tied to real-world fiat currencies. By implementing token burns, developers can eliminate excess tokens from circulation. This process ensures that the stablecoin’s worth remains balanced relative to its pegged value.

The system could create additional tokens when the price of an algorithmic stablecoin surpasses its goal. Conversely, if the price drops, tokens may be destroyed as part of a reduction in token supply, which helps raise its value again.

Enhancing security and reducing spam

As a crypto investor, I’ve noticed that token burns serve as a safeguard for the network. For instance, certain blockchains incinerate a minimal portion of tokens from each transaction fee. This deters spam transactions and shields the network from potential overloads or DDoS attacks. By imposing a cost on every transaction, projects lessen the likelihood of malicious actors overwhelming the system for swift gains or to sabotage it.

Gaining mining rights with proof-of-burn

In some blockchains, a distinctive method known as Proof-of-Burn (PoB) is employed within their consensus process. In this system, miners destroy a certain amount of their tokens in order to be permitted to mine new blocks and receive rewards. By destroying tokens, miners display their dedication to the network, which aids in maintaining security and balancing resource usage without the exorbitant energy costs associated with Proof-of-Work (PoW) systems.

Have you heard that some initiatives employ “tokenholder-decided token burns”? This means that the tokenholders get to decide collectively whether or not to destroy tokens, thereby influencing the project’s direction directly.

Token burn vs. minting

Managing the number and worth of tokens within a blockchain system is achieved through two fundamental procedures: minting and burning.

Creating new digital tokens for use on a blockchain is referred to as “minting.” This process occurs in several ways, including the issuance of tokens during initial coin offerings, as incentives for network contributors like miners and validators, or for financing projects under development.

Ensuring a sufficient token supply is crucial, especially as the network expands or requires additional tokens for various purposes. The process of minting facilitates this.

On the contrary, burning refers to the act of taking tokens out of circulation. The aim is to achieve an optimal balance – between minting and burning – where just the right amount of tokens are minted to fulfill demand, without causing inflation in the supply.

Simultaneously, burning helps prevent oversupply, ensuring a steady value for both users and investors.

As a crypto investor, I’ve come to appreciate the intricate dance between minting and burning in various token economies. For instance, these mechanisms could be employed to issue tokens as a form of user rewards or to facilitate liquidity, yet they might also serve to ‘retire’ or burn tokens, thus combating inflation and preserving scarcity. The act of burning tokens can instill deflationary pressure, potentially boosting the token’s worth as the supply diminishes. This delicate balance is crucial for projects aiming to reward users while maintaining a steady economic environment.

Certain blockchain networks incorporate the practice of “fee incineration” within their transaction costs, which essentially involves destroying a segment of these fees. This mechanism assists in regulating the supply by: