Cryptocurrencies were first introduced as an alternative to fiat currency-based economics. There are many issues related to the fiat currency economy such as the money supply that makes the case for cryptocurrency applications.
To improve the cryptocurrencies, the developers have ingrained some important features in the blockchain such as Token Burning. This article is going to discuss in detail what token burning in crypto means and why it is necessary.
What is Token Burning in Crypto?
The people who are invested in cryptocurrencies and part of the international trading community come across new terms every so often. One of these terms is the phenomenon of token burning. Just like cryptocurrency mining does not entail mining in the physical world, the same manner, token burning is also a process that does not mean setting cryptocurrencies on fire in real life.
Token burning is the act of reducing the total amount of cryptocurrencies from the main circulation. Every blockchain can issue infinite or finite amounts of cryptocurrencies based on its core programming structure.
However, the circulatory supply of a cryptocurrency is the total amount that has already been mined and is under public use. The price of a cryptocurrency is often determined by the total amount of the cryptocurrency quantity that is present as its current circulatory supply.
The token burning process aims to manage the forces of demand and supply that determine the prices of a cryptocurrency. For token burning, the core developers can designate a burning address, where the excess amount of cryptocurrencies can be sent.
Once a cryptocurrency has been sent to a burn address it is wiped out of the main circulatory supply for good.
How does Token Burning Work?
When it comes to token burning, different blockchains can adopt different mechanisms. One of the most common ways to commence token burning is to create a burn address as mentioned before. A blockchain may contain smart contracts that automatically send a designated amount of cryptocurrencies to the burn address at regular intervals.
On the other hand, there are some cases where cryptocurrency investors or validators also have the option to send required amounts of cryptocurrencies to the burn addresses at their discretion.
Most cryptocurrencies have specified policies in place to ensure that token burning is a safe and useful process. For example, the percentage of total amount of token burns per digital address is allowed by the blockchain. In this manner, a whale investor cannot pump the prices of a given cryptocurrency at the expense of the rest of the investors.
Some cryptocurrencies use the burn function to perform token burning. Furthermore, some blockchains offer rewards for the users in exchange for burning tokens.
The smart contracts that are used to standardize burning run a check to see the details of the token burn request before execution and carry it out only after checking the particulars such as correct quantity and subtract value etc. In most cases, once a cryptocurrency is sent to a burn or null address, it cannot be reversed.
Origin of Token Burning
It is important to note that the foundation of token burning was laid by the first blockchain named Bitcoin. Bitcoin blockchain does not burn existing tokens but it has an automated program that reduced the total amount of mining rewards every four years.
This process is called the halving and it serves the same purpose as burning tokens i.e. controlling the total supply of a given cryptocurrency. The first formal token burning address is attributed to the Shiba Inu token which is a meme currency. Shiba Inu project introduced its token-burning address in April 2022.
The token burning addresses for Shiba Inu tokens emerged only once after its conception. To this end, the co-founder of the Ethereum blockchain Vitalik Buterin received 50% of the total Shiba Inu supply from the core developers.
Buterin sent around 400 trillion SHIB tokens to a null address and sent the remaining tokens to a charity cause. On account of the introduction of burn addresses, cryptocurrencies were able to reduce their circulatory supply and control prices.
For fiat currencies, most governments are unable to cut down the total circulatory supply or it can take a lot of time and it is a lengthy and complicated process.
Impact of Token Burning on Cryptocurrencies
Now that it has been established what token burning is and how it works. It is time to understand why token burning is needed and what impact it can have on a cryptocurrency project.
Investors who are holding a particular cryptocurrency should learn about the impact of token burning to make educated decisions about trading. Here are some of the most important utilities and applications of token burning;
Proof of Burn
Proof-of-Burn or PoB is a consensus mechanism that works to validate and maintain an updated record of the total cryptocurrencies that have been burned.
The miners and validators need to be able to view the record of all the cryptocurrencies that have been sent to burn tokens to avoid fraud. The PoB also assists the miners to perform token burning without requiring massive energy input.
The crypto stakeholders can verify burned tokens amount and history using a blockchain explorer. Additionally, PoB serves several other purposes. Its main function is to perform pre and post-verification of every burning transaction.
On the other hand, miners also turn to PoB to mint new coins. It happens in the blockchains, where miners are required to burn existing tokens first to mint new tokens or add new blocks to the genesis network.
Whenever the supply of an asset is decreased, it automatically results in increasing its price. In the same manner, one of the most obvious and direct consequences of token burning is price appreciation.
When a considerable amount of cryptocurrencies have been burned, it awards the cryptocurrency holders with a per unit increase of value. Since token burning decreases the total supply of a given cryptocurrency, it also complements its demand.
However, there is another reason that leads to price appreciation post-token burning. Whenever a token-burning event takes place it is covered by the crypto media. In this manner, cryptocurrency is exposed to public attention. There are many cryptocurrencies where token burning is a community affair.
In such cases, the token-burning participants interact and communicate using social media platforms. When a burning event is coordinated on social media, online interaction increase which result in greater traction.
Cryptocurrencies are affected by the macro and micro tenets of economics just like their fiat counterparts. Therefore, blockchain developers have to pay close attention to attain network efficiency.
With each new token creation, the mining speed automatically slows down. It means that the early miners have an advantage over those who joined the network later. However, burning fixes this issue by allowing the new miners more room for burning tokens.
It means that instead of burning unit token at the beginning of the mining process, the requirement is dispersed proportionately. There are also some blockchains where burning tokens is not mandatory to qualify for minting new tokens as miners.
It happens on account of a customizable PoB. The same PoB can grant different types of rewards to the miners and streamline equitable network activity.
Advantages of Token Burning
After learning about the need and inner workings related to token burning, it is now time to understand its advantages. Here are some of the most important benefits of burning tokens:
Supply and Price Management
Token burning serves the function of controlling the overall supply of a given cryptocurrency. It means that in case of a bear market or unprecedented market crash, the community can come together and stabilize prices. The structure of token burning is designed in a manner that brings more attention to the underlying token.
In this manner, the traction for the burned token increases and it can lead to positive price movement. Therefore, token burning can be seen as an innovative and effective way of managing the overall price and supply of a given cryptocurrency.
As mentioned before, token-burning events are often set up as community activities. Therefore, it becomes necessary for many cryptocurrency stakeholders to come forward and participate in the process. To make the event successful, all stakeholders need to coordinate and play their part. To achieve desired results from token burning, the cryptocurrency community members need to spread the word and maintain healthy online interaction.
There are many dedicated forums, where the participants remain active to learn about the latest developments on account of token burning. In this manner, token burning can be dubbed as a process that strengthens the community.
Human life has ingrained with the digital world in every aspect. Everything a person does is recorded online in one way or the other. To this end, a direct correlation between price appreciation and the number of online mentions has been noticed for cryptocurrencies.
Historically speaking whenever the total searches for a particular cryptocurrency increase on social media platforms or search engines, it is bound to gain more traction and gain demand.
Since token burning requires community interaction, it also paves the way for increasing online mentions. Therefore, the new users have a greater chance to benefit from token awareness on account of token burning.
Token burning can warrant the long-term stability of a given cryptocurrency. Blockchain and cryptocurrencies are new technologies and they are subject to unwarranted changes at every step.
For example, Ripple Labs the issuers of XRP currency faced a lawsuit from SEC for issuing unregistered securities. However, XRP introduced a token-burning mechanism that brought long-term price appreciation and stability to the cryptocurrency.
By adding a token burning option, the developers of a crypto project can show the investors that they are working on long-term stability for the token and it can also reinforce the trust of stakeholders.
The term deflationary is another term that is often thrown around in the cryptocurrency markets. A deflationary currency is a token that can maintain demand and reduce supply in the future.
In most cases, a currency can increase in value and consequently decrease in demand. This phenomenon is visible in all fiat currencies that are inflationary and responsible for detrimental effects such as loss of value and CPI rise. Cryptocurrency supply also increases consistently on account of minting over time. However, crypto can become deflationary by adopting a token burning process.
There are many instances where blockchains and other DeFi blockchains were attacked using the DDoS method. DDoS or distributed denial of service is a type of hack attack that involves overwhelming the network with inflated traffic using spamming.
Therefore, cryptocurrency projects can be vulnerable to such attacks and require proper security protocols to prevent them. Token burning is a method that not only decreases the total supply of a given token but also results in reducing the transaction count.
Therefore, in some instances, token burning can work as a protective measure against the possibility of a spamming exploit.
Limitations of Token Burning
There are considerable advantages to burning tokens. However, investors should not overlook its disadvantages at the same time. Here are some of the most common limitations that are associated with token burning:
It is important to note that once a token has been sent to a burn address, it cannot be reversed. To participate in a burn event, the investors need to purchase or acquire a token first. They may purchase a given token for a specified price.
When token owners participate in the burning process, they ought to lose their property in exchange for nothing in return. They may benefit from the percentage increase in price later.
However, the same price increase without losing a proportional part of their portfolio could have granted them better profits. On this account, there is always a sense of loss attached to profits created using token burning.
Token burning is considered an effective method to ensure price appreciation by decreasing the supply of a given cryptocurrency. However, to make this happen the investors need to burn a considerable portion of the cryptocurrency supply.
If a singular cryptocurrency owner decides to burn some of their tokens, it is not going to make any difference in the overall prices. In case a token burn event is poorly coordinated, it can lead to the empty losses of the tokens without achieving the desired price appreciation for the said cryptocurrency.
Measuring Price Changes
Token burning is ideal for price appreciation and supply management of a cryptocurrency. However, it is often not possible to predict the precise change or rate of change in unit price on account of token burning. The best analysts and developers can do is to project an estimate regarding the effect of the token burning.
However, in most cases, it is impossible to precisely measure the impact of token burning because there are several factors at work for the price determination of a cryptocurrency. If the token-burning event coincides with another major economic factor, it can reverse its impact or affect its application to a variable degree.
The cryptocurrency market is a world of programming and coding. Therefore, a majority of its participants are unaware of its inner workings. Therefore, there are several instances where threat actors may take advantage of the lack of technical knowledge among the stakeholders.
Rather than burning tokens, the malicious actors may send the designated tokens for burning to their digital wallets. In this manner, they can take advantage of increased prices and sell the siphoned tokens later to generate profits.
Therefore, the investors must invest in technical education regarding cryptocurrencies. Furthermore, the usage of consensus mechanisms like Proof of Burn can prevent such incidents by keeping a public and verified record of burned tokens and null addresses.
Loss of Confidence
Done right and within control, a token burn can increase investors’ trust and complement bullish movement. However, if a cryptocurrency project has no control over its token burning it can lead to a loss of faith among investors.
The small-scale investors may feel exploited and manipulated by having no control over frequent token burning and price pumps by whale investors. It is necessary to have standardized protocols to streamline token burning limits, time, and quantity to disarm exploitative practices.
Token burning is one of the advantages that cryptocurrencies have over fiat currencies. However, every investor should know about the pros and cons of token burning to make sure that they have an educated voice in their native crypto communities.
At the same time, it is necessary to spread awareness regarding proper token burning protocol to make sure that the stakeholders are not at risk of suffering from losses stemming from financial fraud. Token burning can be an effective tool for streamlining blockchains and it can bring long-term stability to the network if performed correctly.