Token Burning Mechanism Explained

By MeinCrypto | DeFi Cafe | 21 Nov 2019

$6.48 tipped


You have probably asked yourself, why would anyone on earth burn or destroy their precious crypto tokens? What’s the reason behind it, what are the mechanics and most importantly, how can you make money off it? 

Well, I've got good news, you’ll find all the answers you’re looking for in the article below. 

There is a chance you’ve landed here because of the recent Stellar 50% token supply burn that amounted to $4.7B. 

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Let’s dig deeper into the topic of burning...

What is token burning?

to·ken burn·ing

/ˈtōkən bərniNG/ 

adjective

  • A token burn is the destruction of a certain amount of tokens (or coins) in order to reduce their number in circulation.

To put it simply, token burning is when you take cryptocurrency, coins, tokens, or whatever you wanna call them, and destroy them. A token burn removes said tokens or coins from circulation forever, thus reducing their total supply. 

According to the law of supply and demand, if the total supply of coins is lowered, their value should theoretically increase as long as there is sufficient demand for the coin. And by sufficient demand, this includes ‘future demand’, as the cryptocurrency market is still widely speculative. 

Therefore, the practice of token burning is quite common in the crypto industry as it more often than not impacts the price positively. 

And the price is arguably the most important aspect of a cryptocurrency because if we’re going to be real, the majority of people aren't in this industry for the technology, they're in it for the massive gains. 

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Now getting back to token burning… 

How does token burning work?

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While the concept of token burning is rather straightforward – the removal of a specific number of coins from circulation forever – accomplishing this task can be done in different ways.

First of all, token burning doesn’t actually disintegrate the tokens involved in the burn, but rather these tokens are simply rendered unusable in the future. This is because blockchains are designed to be immutable, meaning a blockchain’s data or history cannot be altered. 

Therefore, the coins cannot simply be deleted from circulation, but rather they can be physically or algorithmically taken out of circulation by sending their token signatures to an irretrievable public wallet known as an “eater address”.

In this wallet, the status of these coins can be publicly viewed on the blockchain and all of its funds are frozen for eternity. 

Now, as for the different ways tokens can be burned, the process can be done via three primary ways. 

  1.  The project’s team/developers can repurchase tokens and take them out of circulation by sending them to the “eater address”.
  2. The project’s team/developers can simply take available tokens out of circulation by sending them to the “eater address”. 
  3. The project’s team/developers can program supply-reducing burning functions directly into smart contracts. This way tokens can be burned on a periodic basis based on the token’s utility. 

Regardless of the method used to burn tokens, the result is the same – burned tokens are rendered unusable and effectively erased from circulation.

Reasons for token burning

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There are multiple reasons why cryptocurrency projects choose to burn tokens, but no matter the reason, they all have the same underlying purpose – to support the token’s stability and price growth. 

By reducing a token’s supply, the value of each remaining coin should theoretically go up in value. Just think about it, with fewer coins in circulation there are fewer coins to sell. Also, supply and demand play a major role in price appreciation too, which is why many cryptocurrencies have a finite amount either in circulation or in future supply. 

Another reason, which is often overlooked, is that token burning is an alternative to paying out dividends and thus being labeled a security. It has the same underlying effect as to incentivize investors to buy and hodl, but it does it in such a way that goes under the SEC’s radar. 

In fact, token burning is actually really similar to what’s called a ‘stock buyback’ in traditional finance. Sometimes companies will repurchase shares of their own stock, which in turn pushes the value of everybody’s shares up. 

Investors can then sell their shares at a higher price if they choose, which is the same concept as in token burning. However, the key difference is that once a token is burned it’s never coming back. But in traditional finance, a company can sell its purchased shares when it needs cash flow and thus push its own stock down. 

Yet another reason why some projects do token burns is to correct the supply of tokens. For instance, say a project does an initial coin offering (ICO) but doesn’t sell all of its tokens. Instead of holding on to an excess supply of tokens, which further centralizes the project, a moral project would burn unsold tokens after their ICOs end.

Lastly, the final reason I could come up with is to prevent spam attacks on the network. Some cryptocurrency projects may burn fees from every transaction to prevent spam transactions and protect itself against Distributed Denial of Service (DDOS) attacks. 

While this last reason for token burning (spam protection) isn’t intended for price growth, it does support the token’s price stability. 

3 Mechanisms of Token Burning

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While developers have similar motivations for burning their coins or tokens, different projects implement different burning mechanisms to suit their project’s needs and token’s utility. 

In the following section, I delve into 3 different burning mechanisms utilized by 3 different projects:

Binance Coin (BNB) - Quarterly buyback coin burn

Binance, the world’s largest cryptocurrency exchange by trading volume implements a repurchasing program and quarterly burning mechanism for their native cryptocurrency, Binance Coin (BNB)

The exchange uses 20% of their quarterly profits to repurchase and then burn BNB tokens. 

Binance has vowed to continuously execute this quarterly token burn until 50% of BNB’s total supply (100 million BNB tokens) are repurchased and burned. 

Thus far, the exchange has conducted 9 quarterly BNB token burns resulting in 14,525,153 BNB burned, equating to $170,000,000 USD in value.

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- Source: www.binance.vision

Ripple (XRP) - Burning fees on each transaction

Ripple’s XRP token implements a burning mechanism in which tokens are burned gradually with each transaction. When transacting through XRP, there is a small fee for sending XRP, just like there’s a fee for sending Bitcoin (BTC) or other cryptocurrencies. 

However, when transacting XRP, the fee doesn’t get paid to miners for validating the transaction, instead, it gets automatically burned. This burning mechanism acts to safeguard against DDOS attacks and prevent spam transactions from bloating the network.

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- Source: www.turfpool.com

Kyber Network (KNC) - Burning fees on each performed action

Kyber Network is an on-chain liquidity protocol that allows users to swap ERC-20 tokens in a decentralized manner through its liquidity providers. When a user swaps tokens on the Kyber Network, they pay transaction fees in KNC, the protocol’s native cryptocurrency.

Every time a token is swapped on the Kyber Network, a portion of the fees paid in KNC is burned and removed from the token's total supply. Therefore, KNC’s burning mechanism reduces the token’s total and circulating supply.

More than 4 million KNC tokens have been collected in fees and nearly 3 million KNC tokens have already been burned – removed from the total supply and circulation forever. 

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- Source: www.tracker.kyber.network

Summary

Cryptocurrency projects that implement token burning mechanisms are very interesting. It’s a relatively novel approach to a cryptocurrency’s tokenomics and there are various implementations and features that can be adopted.

All in all, token burning offers a wide range of benefits that enhances the long-term value for coin holders as it can preserve the wealth for all participants in the network.

What do you think about token burning mechanisms? Which cryptocurrencies do you think implement token burning best?

Let me know in the comment section below.


MeinCrypto
MeinCrypto

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