In the volatile world of cryptocurrencies, adaptability and innovation are essential components of success. One intriguing strategy gaining popularity in the crypto sphere is “Token Burning.” This has been recognized as a powerful tool for shaping the future direction of a cryptocurrency’s growth. In this article, we will dive into the complexities of token burning, analyzing its motivations, mechanisms, impact on tokenomics, transparency, and auditability, as well as the risks and challenges associated with it. Also, we will look at real-world examples from cryptocurrencies to shed light on the practical implications of token burning.

What is Token Burning

Token burning is a process that removes cryptocurrency tokens from circulation supply permanently. This is achieved by sending the tokens to a wallet address that can only be used to receive coins. The wallet is outside the network, and the tokens are no longer usable. It is also known as “Dead Wallet.”

Token burning can be done for a variety of reasons, the most common of which is to increase the value of the remaining tokens. Token burning can create scarcity, which can lead to higher prices by reducing the supply of tokens.

Why Token Burning

The primary motivation for token burning is to address the issue of oversupply, which is a problem that many cryptocurrencies face. By intentionally reducing the circulating supply, demand for the remaining tokens may increase, setting up a foundation for increased value. This enhanced value proposition has the potential to attract a wide range of stakeholders, from individual investors to institutions, all of whom are looking to capitalize on the potential of their holdings.

There are a few major reasons why cryptocurrency projects choose to burn tokens:

• To increase token value: As previously mentioned, token burning can cause scarcity, which can lead to increased prices. A higher token price can make it easier to attract new investors and partners, which can benefit both investors and the project itself.
  
• To reduce inflation: When new tokens are created and added to the circulating supply, cryptocurrency inflation can occur. Since there are more tokens available to purchase, the value of existing tokens may be reduced. By removing tokens from circulation, token burning can help to reduce inflation.
• To reward users: Token burning is an approach used by some cryptocurrency projects to reward users for their network participation. For example, a project may decide to burn a portion of the transaction fees collected. This helps to encourage users to join the network and use its tokens.

Burning Mechanisms

Depending on the design and goals of each project, there are various mechanisms for implementing token burning. Some common examples are as follows:

• Fee burning: Instead of being distributed to miners or validators, a portion or all of the network’s transaction fees are burned. This establishes a direct connection between network activity and token supply reduction. Ethereum (EIP-1559) and Binance Coin (BNB) are two examples.

• Buyback and burn: The project uses its earnings or revenue to buy back tokens from the market and burn them, decreasing the circulating supply and increasing the demand. This results in a positive feedback loop that increases the token price and project valuation. Examples: Binance Coin (BNB), Huobi Token (HT).

• Proof-of-burn: A broad agreement mechanism that asks participants to burn tokens instead of stake or mine them if they want to join or maintain their status in the network. As more tokens are burned to secure the network, it creates a trade-off between security and scarcity. Examples: Counterparty (XCP), Slimcoin (SLM).

• Token sink: A mechanism that allows users to burn tokens in exchange for certain rewards or services offered by the network, such as governance rights, access to premium features, or discounts. This encourages users to use and consume tokens instead of holding them. Examples: MakerDAO (MKR), Decentraland (MANA).

Examples of Token Burning

It is possible to burn any cryptocurrency. An estimated 4 million bitcoins, for example, have been burned or lost. Other cryptocurrencies have implemented token burning as a regular part of their strategies.

Ethereum:

In 2021, the second-largest cryptocurrency by market capitalization introduced a major upgrade called EIP-1559, that changes its fee structure and introduces burning Ether with each transaction.

Under this new mechanism, a base fee is automatically modified according to network congestion, and is burned instead of going to miners. This makes Ethereum more predictable and transparent in terms of fees, and also sets up a deflationary impact on its supply. Since August 2021, over 3.6 million ETH have been burned by using this controlled, steady method, which evolves daily. As of November 10, 2023, the estimated ETH burn rate is around 3.91 ETH per minute (24h).

Binance Coin:

The native token of Binance, the world’s largest cryptocurrency exchange by trading volume, has a quarterly buyback and burn program that aims to reduce its total supply from 200 million to 100 million BNB. The amount of BNB to be burned is determined by the trading volume on Binance’s platforms, creating a link between its performance and its token value. Since 2017, Binance has burned more than 20% of its initial supply, worth over $10 billion at current prices.

BNB burns take place once every quarter, and they just completed their 24th quarterly BNB burn of 2023 in July, with a total number of around 2 million BNB burned , approx value of more than $400 million. You can check the transaction here.

Bitcoin:

Unlike any other cryptocurrency, Bitcoin doesn’t support token burning but instead it has a different feature known as “Halving”. Although the aim is also related to scarcity and supply, but it works on different mechanisms. Bitcoin halving is a process that reduces the amount of new Bitcoins that are created and rewarded to miners for validating transactions.

The reward that miners receive for validating and adding new blocks to the blockchain is cut in half during a Bitcoin halving. The original reward was actually 50 bitcoins per block in the beginning, which has  been reduced to 25, 12.5, and, most recently, 6.25 bitcoins respectively after every halving. The next halving will reduce the reward per block to 3.125 bitcoins. The reduced rate of the creation of new bitcoins has a deflationary effect, making each bitcoin limited over time. The halving helps to keep the supply of bitcoins under control and prevents inflation. This process occurs every 210,000 blocks, or roughly every 4 years. The next Bitcoin halving is expected to occur in April 2024.

Impact on Tokenomics

Tokenomics is the study of the economic factors that contribute to the value of a cryptocurrency. Token burning has the potential to have a significant impact on tokenomics by reducing token supply and increasing scarcity. One of the main benefits of token burning is that it can help build a more sustainable economy for the cryptocurrency project. By reducing the supply of tokens, token burning can help to prevent inflation and ensure that the value of the remaining tokens is maintained. 

Token burning can have a significant impact on the tokenomics of a project, affecting various aspects such as:

• Price: Token burning can boost the price of a token by creating a deflationary effect on supply and delivering a positive signal to demand. The price effect is determined by a number of factors, including the quantity, frequency, and predictability of the burns, as well as market conditions and expectations.

• Volatility: Token volatility can be reduced by token burning by stabilizing the supply and demand dynamics of a token. The volatility effect depends on  how well the burning mechanism is compatible with network activity and value creation, as well as the market’s responsiveness and rational thinking.

• Distribution: Token burning may influence a token’s distribution by modifying its ownership structure and concentration. The distribution effect varies to who is burning the tokens and how they are collected, as well as the initial distribution’s fairness and inclusiveness.

• Utility: Token burning can increase or decrease a token’s utility by changing its functionality and role in the network. The utility effect depends on how well the burning mechanism has been integrated with the network design and goals, as well as the token’s usefulness and value to its users.

This change can attract long-term investors, established by the potential of sustained value growth and a more flexible cryptocurrency ecosystem. A cryptocurrency project is more likely to be considered as a wise investment if it has a strong tokenomics model and a well-defined plan for token burning.

Risks and Challenges

While token burning can have a number of benefits, there are also some risks and challenges to consider:

• Reduced liquidity: Token burning may decrease cryptocurrency liquidity by reducing the supply of tokens. This can make it more difficult to buy and sell tokens, which could turn investors away.
• Centralization: If the project team controls token burning, it may result in power concentration. This could give the project team excessive control over the cryptocurrency, making it more vulnerable to manipulation.
• Negative sentiment: If token burning is not done carefully, it could lead to negative sentiment from the community. For example, if the community suspects that the project team is burning excessive tokens, the value of the cryptocurrency may decrease.
• Lost opportunities: To be able to burn tokens, you need to own them. Once the token burn has finished, the tokens are permanently removed from your wallet and you will no longer be able to access them. Considering that the price might go up in the future. 
• Large Amount Needed: Burning a small amount of token won’t impact the price. For example, there are over 589 trillion Shiba Inu (SHIB) coins currently in circulation. Burning a few thousand SHIB wouldn’t affect the overall supply. 

Conclusion

To summarize, token burning is a powerful tool for shaping and optimizing the token economics of a cryptocurrency project. It can have a variety of advantages and disadvantages depending on how it is designed and implemented, as well as how it interacts with the network and the market. Token burning is not a solution that fits all, but rather a goal-oriented  strategy that needs careful analysis and planning. Before implementing token burning, it is essential to be aware of the risks and challenges involved.