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As new tokens are mined and enter circulation every day, cryptocurrencies need to ensure that the market is not oversaturated with supply. After all, prices in the digital currency market are almost entirely dictated by the economic principle of supply and demand.
To maintain a fine balance between token supply and market demand, stakeholders often volunteer to destroy or ‘burn’ a small number of tokens. This act of destroying tokens is what the cryptocurrency community commonly refers to as a ‘coin burn’ event.
Over the past few years, this mechanism has been used for a wide variety of reasons, with deflation being the most common one. In this article, let’s explore the process of token burning and understand how they became an effective tool to boost investor trust and crypto valuations.
Who Controls Cryptocurrencies — And, Thus, Coin Burns?
Before answering why coin burns are necessary though, we must first learn how cryptocurrencies are structured and managed. In other words, we need to figure out who the primary stakeholders in a cryptocurrency are before we can ascertain their motives.
Needless to say, cryptocurrencies come in a variety of shapes and sizes. Some of the most prominent differences, however, usually boil down to their founding principles, development strategies, and goals.
Take Bitcoin, for instance, which is the world’s first and largest cryptocurrency. Ever since it was first unveiled in 2009, Bitcoin’s development has been shaped by its community alone. Since the project is decentralized, anyone can make direct contributions to it as long as their proposed changes are agreed upon by a majority of the user base. This purely decentralized approach has allowed the Bitcoin community to integrate new features such as Segregated Witness (SegWit) in recent years.
Over time though, it became clear that efforts could be accelerated and streamlined if each project had a dedicated organization or foundation managing it. After all, a similar observation was also made in the software industry a few decades ago, resulting in the highly successful Linux Foundation and other development nonprofits.
As a result, newer cryptocurrency projects — which are often based on breakthroughs in blockchain technology — are now favoring this ‘managed’ approach. This paradigm shift has not only brought in significant talent to the industry, but also legitimized cryptocurrency on the global financial stage.
- Certain cryptocurrencies — such as Bitcoin — require the entire community to reach a consensus for development to proceed.
- More recent digital currencies — such as Litecoin and Ethereum — have set up organizations or foundations to head development. This helps ensure that projects stay on track and that they continue to deliver as per investor expectations.
- The latter functions similarly to democracy — in that a small and knowledgeable group of known experts are authorized by the public to make the right decisions.
- The Ethereum Foundation, for example, has conducted significant research in the blockchain and cryptocurrency spaces since its inception.
What Token Burning Does for the Crypto Market
As mentioned previously, coin burns directly affect the dynamics of supply and demand. By reducing the overall number of tokens in circulation, these events make tokens scarcer and boost the cryptocurrency’s valuation. This is why coin burns are known to directly incentivize and reward a project’s existing investor base.
As an example, projects will often burn a fixed number of coins or tokens each year to stay above a minimum price point. This motivates users to hold onto their existing token investments and not fear devaluation in the near future.
While the term ‘coin burn’ applies solely to the cryptocurrency market, the concept has actually existed in the broader financial system for decades. Share buybacks — a commonly used mechanism in equity markets — allow publicly traded companies to repurchase shares and improve their financial statement, at least on paper. Similarly, burning tokens can signal confidence in the project’s long term financial viability.
Recent Coin Burn Events
As long as a majority is in agreement, coin burns can be initiated by either the cryptocurrency’s maintainer or the core community.
In the case of digital currency EOS, for example, the community overwhelmingly voted in favor of two token burn events between 2019 and 2020. Notably, the project’s parent company Block.one was not involved in the coin burn event as the network participants (stakeholders) reached consensus by themselves.
In contrast to that on-the-fly approach, however, certain projects will intentionally burn tokens once every month, quarter, or year to keep the total supply within manageable levels. This is most commonly observed in cryptocurrencies issued by exchanges such as Binance and OKB.
Tether offers us yet another glimpse at controlled coin burn events in the cryptocurrency market. As a ‘stable’ coin valued at 1 USD, Tether issues one token for every US dollar it can guarantee in physical and liquid assets. At times, however, the valuation of these assets may drop below the number of Tether tokens circulating on the market. Coin burns offer a straightforward way to reduce this supply and ensure that Tether can account for each token.
How Cryptocurrencies Pull Off Token Burns
It’s worth noting that there’s no universally accepted procedure for a coin burn. The only requirement is that the tokens must be permanently inaccessible after the event.
Metaphorically speaking, a coin burn is equivalent to tossing out the keys to an otherwise unbreakable safe. In crypto, anyone that has permanently lost access to their wallets over the years has also inadvertently ‘burned’ tokens. This is why news reports often indicate that the ‘true’ supply of Bitcoin is much lower than the circulating supply number would have you believe.
In cases where coin burns are actually planned; however, a specific method is usually followed to ensure that the process is permanent and irreversible. Cryptocurrencies based on the Ethereum blockchain employ smart contracts for this purpose. Other cryptocurrencies may have their own burn procedures built into the code, as is the case with Binance’s BNB token.
Since most cryptocurrencies are committed to transparency, burned tokens are placed in an irretrievable public wallet known as an “eater address.” This wallet can be seen by all network participants but is practically frozen forever.
Why Deflation Is the Right Answer
Venezuela and Zimbabwe serve as important warning signs for the global economy. Over the past decade or so, both countries have had their respective fiat currencies wiped out due to hyperinflation. Today, the Bolivar and Zimbabwean Dollar are both worth more as decorative fixtures than actual currencies.
At a time when dollars, euros, and a number of other major currencies are being printed in their trillions, coin burns allow cryptocurrencies to move in the exact opposite direction.
Lykke is a Blockchain-based fintech company building a global marketplace for the fee-free exchange of any kind of digitized assets. Lykke offers trading of a wide range of cryptocurrencies, 21 fiat currencies, and unique services for managing your investment portfolios such as the LyCI crypto indexes and the corresponding investable utility tokens.