The coin burn (also called token burn) mechanism in tokenomics, reduces the total supply of tokens or coins by removing them from circulation. It forms a part of the deflationary policies in the protocol of a cryptocurrency.
In a coin burn, the tokens or coins are burned or permanently destroyed. Cryptocurrency like Ethereum (ETH), Binance Coin (BNB) and Shiba Inu (SHIB) include this mechanism in their protocols. (Read this article on the basics of how the Ethereum network burn tokens).
Tron (TRX) has issued their coin burn on what they called Independence Day. The project burned 1 billion TRX after switching over from the Ethereum mainnet to their own mainnet. This also burned the ERC20 tokens that were issued during Tron’s ICO.
This is a reasonable means to prevent the supply from inflating. It is much more common among coins or tokens that have a high circulating supply or no fixed supply.
The burn creates scarcity, which in theory helps to increase the value of a digital currency based on the demand for it.
There are 4 main reasons for a coin burn.
The traditional non crypto-economic model allows centralized monetary authorities to regulate and control the supply of money. They can increase the money supply during times of low liquidity in order to boost the market.
However, more money in circulation leads to inflation and that can affect the cost of goods and services as prices increase. More money supply leads to more spending power, and thus that increases demand for public consumption.
In reality the effect of inflation is that it diminishes spending power over time. While it increases the price value of assets, the increase in money supply debases the currency since prices of commodities also increase.
Interest rates tend to rise with inflation. It is a way the central bank encourages people to kill demand, slow down the economy and increase savings. Now this is a truly centralized approach that becomes a balancing act for the regulators of the economy.
Cryptocurrency will try not to have an inflationary model which is the primary purpose of the coin burn. With this model it gives more value for the holder and supply never drastically increases due to a central authority. Instead it follows a decentralized and market driven approach to keep money supply in check.
Fair Token Distribution
The fairness in token distribution is that the platform does not keep more supply than what should be acceptable for a decentralized network. The community is given the right to vote for a coin burn when it is announced on a network during the process of digital governance.
This allows token holders to decide whether it is in their community’s best interest. This uses a form of governance token that allow holders to cast their vote. Majority consensus will always win in the ecosystem.
When the token developers hold the majority of tokens it is not deemed a fair distribution. Therefore, the core team could decide on burning tokens by putting more money back to the network for all holders to have a form of equity.
The system can be effective in maintaining the price and rewarding loyal token holders. Thus the distribution of tokens is not manipulated by a single authority that decides over the rest of the token holders. When the decision goes to a vote, it benefits the greater community.
Maintains Peg For Stablecoins
Coin burning can also be used in algorithmic stablecoins, as a form of burn-and-mint mechanism to keep the value pegged to another currency or basket of assets. As the name implies, it uses a protocol designed to hedge against price volatility in the cryptocurrency market.
However, the effective use of a burn-and-mint mechanism for stablecoins has become questionable and risky since the collapse of Terra UST. Unfortunately protocols developed using this are still prone to bank runs, or when users start withdrawing at the same time and devaluing the currency.
Incentive To Holders
The coin burn incentivizes token holders by increasing its value. Let’s say we have the following example of a digital currency Y:
Price of Y = Marketcap (MC) / Circulating Supply (CS)
CS = 1,000,000
MC = 1,000,000
Price of Y = $1.00
Assuming a user has 10,000 coins, they are valued at 10,000(1) = $10,000.00.
A coin burn takes place to reduce the supply by -100,000, but increases market cap by +100,000.00.
CS = 900,000
MC = 1,100,000
Price of Y = $1.22
It cuts the circulating supply by 10%. This then changes the price of Y. Assuming a user has 10,000 coins, they are now valued at 10,000(1.22) = $12,222.22. Value increases without increasing the currency supply.
The above is just one example of a coin burn, so they can produce different results. Destroying the coins or tokens alone just removes it permanently from circulation, but you need to return value back to the holders.
The money that is given back in a coin burn can be taken from fee collection (e.g. transactions) or other sources like liquidity pools. The value this creates rewards the community and encourages longer term holding of the tokens.
In traditional finance this would be similar to buybacks in a stock to reduce the number of shares in the open market. This returns money back to the shareholders of that stock and also makes it deemed more valuable due to less supply if there is a high demand.
Although it does increase the price value, this is not always true. If there is no money to replace the burned tokens, then it does not reflect an accurate picture of the real price value.
The important requirement to sustain coin burning in a cryptocurrency is liquidity. If the token or coin is liquid, that means it can be sustainable because of the value it has created (it has utility and purpose). If there is little to no liquidity, there is really no need for a coin burn because there is no value to return back to the network.
While coin burning makes a currency more scarce and deemed more valuable, there has to be sustainable demand to maintain its value. Without it then there is nothing to back up the currency's value and it would be considered a dump.