Token Burning: A mechanism for controlling circulation

27 September, 2019

Did you know that some cryptocurrency projects actually burn tokens? Not literally, but figuratively. Token burning is a practice common among projects for which tokens do not exist primarily as an economic tool for buying and selling. Big names like Ripple and Tether are known to burn tokens.

Rest assured that token burning is not as bad as it sounds. It is a questionable practice, but it isn't one that threatens the stability or future of cryptocurrency. Burning is just a mechanism for controlling circulation. And for whatever reason, those projects that employ the practice feel the need to control token supply.

Read this post all the way through and you will learn everything you need to know about token burning. It is one of the more fascinating aspects of cryptocurrency that few people know about. Like most other things crypto related, token burning is one of those little things with nuances that affect the overall price of certain tokens.

What it is

Token burning is the process of removing tokens from circulation by relegating them to what is known as an 'eater address'. An eater address is essentially a digital wallet from which tokens cannot be retrieved once they have been placed therein. The tokens exist and can still be identified on the blockchain, but they cannot be used by anyone.

Let's say you start your own cryptocurrency project and want to employ token burning as a way to maintain value. You would write into your code some sort of smart contract that would automatically burn tokens based on whatever parameter you set. Maybe you want to burn the tokens that are created when transaction fees are applied to buying and selling.

Your smart contract would be triggered whenever your tokens are bought or sold on an exchange. That contract would take the fees created by those transactions and immediately send them to the eater address rather than your exchange wallet. Those tokens would be instantly taken out of circulation. They would permanently reside at the eater address.

Why projects employ it

Token burning is pretty simple to understand in principle. But you might not understand why projects would use it. There are several reasons but let us start with a discussion of who does not use token burning. Bitcoin is one such project. Bitcoin doesn't utilize token burning because it already has a built-in mechanism for controlling circulation.

Bitcoin was developed with a limited number of available tokens. There are only 21 million of them in total. Once they are all in circulation, that will be it. So right from the ground up, controlling circulation was achieved by limiting tokens.

The final bitcoin is expected to be put into circulation sometime around 2040. In the meantime, circulation is also controlled through the mechanism by which coins are mined. To mine successfully, miners must collect transaction data and validate it through a complex mathematical equation before it can be added to the current block. Miners are rewarded for their work with bitcoins.

However, only the first miner to complete the current block gets rewarded. As such, only one coin is released into circulation with each validated block. Circulation control doesn't stop there, though. Circulation is further controlled by gradually devaluing the reward and making the work more difficult to complete. This inverse relationship prevents coin mining from speeding up so quickly that coins are released early.

Bitcoin and cryptocurrencies like it do not employ token burning because they don't have to. But what about other projects that do utilize it? Let us look at some of the reasons behind their strategies.

Preventing inflation

Many of the projects that employ token burning do not exist solely as moneymaking ventures. Most are blockchain ventures that utilize tokens as a funding method for project development. These kinds of projects cannot afford the kind of price inflation Bitcoin is subject to. Why? Because they don't have the cash on hand to cover all of their tokens should investors suddenly pullout.

Said projects employ token burning specifically to cover themselves financially. They are intentionally preventing inflation so that investors do not look at their projects as get rich quick schemes. This forces investors to seriously consider the value of a project on its own merits, thereby tempering expectations and weeding out all those who are not generally interested in helping the project succeed.

Increasing token value

Although token burning does prevent out-of-control inflation, that does not mean the practice devalues tokens. It doesn't. When used properly, token burning gradually increases the value of tokens at a safe and quantifiable pace. Why is this good? Because it allows projects to gradually increase their value so as to keep investors interested.

Serious investors want to see gradually increasing value. They also want to see the projects they are investing in create something tangible. As long as they see that value, they are more than happy to keep their money parked. Gradual price increases through controlled token burning accomplishes this quite nicely.

Token buyback

Some projects, especially those designed as security tokens, utilize coin burning as a mechanism for buying tokens back from investors. This practice is similar to public companies buying back shares or stock. Buybacks are utilized as a means of helping projects maintain control over their own direction.

In a typical stock scenario, companies that sell stock are public companies controlled by shareholders. This sort of situation opens the door to one or two wealthy investors taking control of a company by buying up the majority of stock. To avoid such problems, companies might buy back stock so as to maintain at least 51% ownership.

Cryptocurrency projects do the same thing with token burning. They maintain majority control by not allowing investors to own too many tokens. It is more or less a self-defense mechanism.

As a consensus algorithm

The final reason a project might employ token burning is to have a consensus mechanism that is resource light. If you are not familiar with consensus algorithms, these are the means by which computer nodes prove their authority to validate transactions and build blocks. Bitcoin uses a proof-of-work consensus algorithm.

As previously explained, computer nodes on the Bitcoin network validate transactions by completing complex mathematical equations. Because each equation only has one right answer, nodes prove their authority to validate transactions by coming up with the right answer. The 'consensus' part of the equation comes in when all of the nodes on the network produce the right answer. Once they all agree, transactions are added, and blocks are built.

Proof-of-work is one of the most reliable consensus algorithms out there. But it is also resource-hungry and constantly growing. Token burning can be used to accomplish the same thing while simultaneously keeping the amount of work necessary to achieve consensus at a minimum.

As a consensus algorithm, proof-of-burn requires miners to burn a certain number of tokens in order to be eligible to validate blocks. This might sound counterproductive to incentivizing miners, but it actually works quite well. Remember that gradually burning tokens gradually increases the value of those tokens.

Proof-of-burn essentially requires miners to burn tokens at the same rate they mine them. They are rewarded not with an increased volume of tokens, but rather a higher value on the tokens they already possess. This sort of consensus algorithm doesn't require nearly the same amount of work as proof-of-work. It also consumes but a fraction of the resources.

Benefits to both parties

At first glance it seems that token burning only benefits the projects that utilize it. But actually, it benefits both parties. Projects benefit by being able to control circulation and inflation. They benefit by maintaining control over their own projects. Such incentives are more than adequate justification for the practice.

Investors and the miners benefit from coin burning as well. First, they are protected by runaway inflation that would otherwise result when too many coins are in circulation. Second, they benefit from gradually increasing value that has a firm foundation behind it. And third, they benefit from the fact that coin burning weeds out those who only invest in cryptocurrencies as a way to make a quick buck before pulling out and running away.

Remember that token burning is pretty much a deflationary practice. At its heart, that is what it is. Token burning is a way to artificially deflate the value of tokens for the purposes of achieving some other goal. Those who utilize it well enjoy the many benefits from it.

The other thing to remember is that most projects that employ token burning do not have a hard token limit in place. As such, controlling circulation is absolutely necessary. Otherwise, projects could simply create new tokens at will, the same way national governments create printed bills and minted coins. This sort of token creation can lead to the very kind of runaway inflation coin burning is designed to prevent.

And now you know what token burning is. It might not matter to you, but at least you now know the basics - just in case the topic ever comes up in conversation.