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What does it mean to burn cryptocurrencies?
Burning cryptocurrencies is a common practice, practiced by cryptocurrency platforms, which permanently removes tokens from circulation. By reducing the total supply of a coin, the hope is that the value of a given digital asset will increase with market demand.
“The economic rationale behind cryptocurrency burn-in is to control the supply of digital assets,” said Russell Stanley Geronimo, a corporate lawyer specializing in blockchain, decentralized finance AND tokenomics.
What does “burning cryptocurrencies” mean?
Cryptocurrency burning refers to a deflationary process that permanently removes cryptocurrency tokens from circulation. This is done to reduce the total supply of a digital asset in an effort to stimulate demand and increase market value.
The strategic maneuver creates scarcity, he explained, thus increasing the perceived value of a currency. This increases demand simply because there would be fewer available units tied to a specific good or service.
A coin burn is a deliberate, deflationary event. It works similarly to a stock buyback, where companies buy back their own shares, effectively canceling them.
“This could increase the price of that asset,” said Geronimo, who currently serves as chief legal officer at Oz Finance, a DeFi project based in the Philippines where token holders can gain residency status in special zones by staking cryptocurrencies. “It’s similar to the way central banks withdraw physical notes or coins.”
For example, when a government prints and issues more fiat currency – government-issued currency that is not pegged to a commodity like gold – this reduces its purchasing power, contributing to inflation. Combustion has the opposite effect.
Cryptocurrency burning can be implemented in a project as a built-in automatic mechanism, routine maintenance performed on a periodic basis, or as a one-off event.
The decision to burn cryptocurrencies can be written into a project’s white paper before launch, outlining the full intent to eliminate fractions of its supply along the way. It can also be subjected to a community vote, leaving the decentralized autonomous organizationor DAO, decides whether to burn or not to burn.
A profitable result, however, is not exactly guaranteed. The value of a digital asset fluctuates and is highly subjective, Geronimo said, especially within a volatile cryptocurrency market.
How does cryptocurrency burning work?
Blockchain is the backbone of financial technology like cryptocurrency, which permanently tracks and records every transaction for public review. So, when a project announces that it will eliminate a portion of its token supply, where does it go?
“[Burning crypto] it is done by sending aa tokens [crypto wallet] address where those tokens will be forever unrecoverable and can be considered lost from circulation,” said Alex Cerba, lead contributor to Marinated financea liquid episode protocol built on the Solana blockchain. “The address – or public key – used for this purpose can only receive tokens but will never be able to access them.”
Functionally, this allows projects and individuals to have verifiable proof recorded on the blockchain that tokens sent to the address have disappeared from circulation.
“But burning is primarily used to reduce the supply of a given cryptocurrency… in order to give more value to the tokens in circulation.”
Public keys act as virtual vaults. Typically, they are associated with a private key, providing the means to open the vault. In the case of cryptocurrency burning, however, the coins are sent to a “burner” or “eater” address with no known private key. Burning a coin literally locks out your digital assets and throws away your private key.
Often, cryptocurrencies are burned by the owners or developers of crypto projects. Project owners can themselves purchase an amount of the project’s available currency on the market and send it directly to burner addresses. Another method of burning cryptocurrencies, used by some networks like XRP Ledgerinvolves imposing a fee on each crypto transaction and consuming the fees collected.
“Some blockchains even have a mechanism built into the protocol that burns tokens when necessary,” Cerba said.
Using Marinade Finance as an example, Cerba explained how its users acquire a liquid staking token, which allows the holder to unlock their assets for cryptocurrency-related activities without experiencing delays or penalties. They receive one for every Solana token, known as SOL, staked or locked through the Marinade platform. On the Solana blockchain, these liquid tokens managed via Marinade appear as mSOL. Therefore, when a user is ready to recover their Solana tokens, the mSOL must be burned to maintain an accurate circulation number of mSOL to SOL in the protocol.
“Burning cryptocurrencies is a necessary feature for some protocols as it is an integral part of how they are designed,” Cerba said. “But burning is primarily used to reduce the supply of a given cryptocurrency… in order to give more value to the tokens in circulation.”
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Reasons to burn cryptocurrencies
The primary motivation for a crypto burn is to amplify market value. In practice, the deflationary tactic has produced other favorable results.
Reasons to burn cryptocurrencies
- To increase demand and market value
- Respect a consensus mechanism
- To protect yourself from spam and malicious actors
- To control inflation
- To maintain liquidity
- Commit to long-term scarcity
- To increase investor confidence
Burning encryption can be implemented as a consensus mechanism, referring to the codified systems that keep a network in agreement. Bitcoin, for example, uses a proof-of-work protocol that incentivizes miners, or validators, to verify transactions with a sum of tokens known as a block reward. By solving complex and computational mathematical equations, they receive an assigned amount of Bitcoin, which halves every four years.
Stablecoinsa cryptocurrency that pegs its value to an external “stable” asset, such as the US dollar or gold, is regularly subjected to supply-balancing burns – as well as new token issues – in order to maintain their value and control inflation.
Or a burn of the coin may occur simply to conform to its code. Then there is the market ploy.
“Cryptocurrency burning can also be used to reward users for their participation in the network,” said Dmitry Machikhin, founder and CEO of the cryptocurrency monitoring tools platform, BitOK.
“This increases – or at least maintains – liquidity in the market and can lead to greater investor confidence.”
By burning a certain amount of coins, you can incentivize it minersor transaction validators and other parties interested in continuing to hold coins. This demonstrates a long-term commitment to scarcity, making token holders slightly richer than they would have otherwise been.
“This increases – or at least maintains – liquidity in the market and can lead to greater investor confidence,” Machikhin said.
Cryptocurrency burning has also developed as a low-energy method for blockchain projects to increase their security and stability. When a project removes redundant tokens from circulation, it reduces the risk of malicious actors having too much control over the market, Machikhin said. Payment Protocol Ripple has an automated burning mechanism that waives transaction fees and protects against distributed denial-of-service attacksor DDoS attacks, designed to overwhelm a network, rendering it unusable.
Going further, some platforms require miners to brand the tokens they validate, marking their public address on each batch of tokens they validate, a method known as proof-by-burn.
What is the burn test?
Proof burn is a consensus mechanism that requires miners to burn a certain amount of coins in their personal possession to gain access to mining a block. By paying a specific amount, a miner is then rewarded with a block reward for verifying the transaction. This unlocks new tokens and adds a block to the blockchain.
When crypto burning is incorporated as part of an algorithm’s verification system, transactions are automatically verified. These protocols save resources while maintaining a smooth and active network.
“This serves as an incentive to keep the network secure, as miners are rewarded with new coins for destroying old ones.” Machichin said.
Protocols that use proof burn include Ripple, BitShares, Slimcoin, Counterparty, and Factom.
Here are the pros and cons of a proof-of-burn protocol.
Advantages of a Proof-of-Burn protocol
- Proof-of-burn protocol systems save energy, since mining rigs are virtual.
- Built to make cryptocurrencies more sustainable over time.
- Low hardware requirements.
- Create an economic model dedicated to scarcity, increasing value and market demand.
- Scammers are overrated by design, making network corruption fiscally unattainable.
- Proof of Burn projects attract long-term users; incentivizes miners to recover burned cryptocurrencies.
Disadvantages of a Proof-of-Burn protocol
- Miners must already own a generous portion of the token supply to afford the burn amount.
- No guarantee that miners will see the burned amounts again.
- Permanent loss of assets.
- The burn test has only been tested by moderately sized accounts.
- Transactions take longer to verify due to large block sizes.