Understanding crypto token burns: A comprehensive guide

You’ll often see crypto projects talk about ‘burning’ coins, but what is the practice and why does it happen?

In short, cryptocurrency burning refers to the process of permanently removing a specific number of tokens from the supply in circulation. The act of burning tokens is permanent, meaning the assets are destroyed forever.

Token burning is intended to have a deflationary impact on the value of an asset, boosting its value by reducing the supply available. In essence, token burning applies the theory that an asset will hold a higher value if scarcity of that asset is maintained. But there’s much more to it than that.

Here, we’ll explore the rationale and technical mechanics behind token burning, look at the advantages and disadvantages of the activity, and reflect on some noteworthy token burns of the past.

What are crypto token burns?

As the name suggests, a crypto token burn is the deliberate act of permanently 'destroying' a set number of tokens to remove them from the total circulating supply. More specifically, this happens by establishing a ‘burn’ or ‘eater’ address for tokens to be sent to. This address is unique and deliberately engineered to only retrieve cryptocurrencies. The wallet cannot return a private key — also known as a seed phrase — making it impossible for its assets to be accessed and spent or sent to other addresses. This action, in effect, destroys the coins sent to the wallet by locking them up in a place where no person or entity has ownership — effectively removing them from the supply.

Crypto burns are considered noteworthy events because the act of destroying tokens is irreversible. To many, token burning demonstrates a project owner’s long-term commitment to their roadmap.

What’s the point of a token burn?

There are many reasons for a token burn to take place – some planned, some reactive. Fundamentally, a token burn alters the balance of supply and demand, and as assets are being taken out of supply, which creates more scarcity, the value of that asset should in theory rise. Project owners may take this approach to increase the value of the tokens they hold. In traditional finance, this motivation is similar to a publicly traded company buying back stock to reduce the number of shares in circulation.

There are various other reasons why a token burn may take place.

Boost market sentiment

Some projects may use a token burn as an opportunity to market their offering by capitalizing on potential price action for their token once the burn occurs. The anticipation of a token burn and resulting interest could attract engagement to the community, boosting sentiment among traders, developers, and other industry players.

Promote mining balance

Early adopters of a token can have an unfair advantage over newcomers because the speed at which coins are created through proof-of-work (POW) reduces each time a new block is mined. Token burning helps to promote a fair balance for new users by encouraging regular mining activity. Here, miners must burn early coins and mine new ones. This process makes it harder for early adopters with large mining infrastructure to hold the majority of coins in circulation.

Reward token holders

Token burns are also a way to reward those who’ve been long term supporters of a project and hold native tokens. When the supply of tokens is reduced, a holder's proportional ownership increases — just as the value of the total assets they own does.

Elevate token utility

By reducing the supply of tokens through burning, project owners can also enhance the utility of the tokens that remain. This is because, as scarcity increases, the tokens that remain have a more valuable role to play in enabling transactions, staking, or other platform features.

Benefits of token burning

A token burn is often used strategically to bring benefits to the project itself, and to holders of its native token. Meanwhile, what’s known as the proof-of-burn (POB) consensus mechanism is used to allow users to participate in a network by burning a certain amount of coins.

Blockchains powered by the PoB mechanism use it to validate transactions. What’s more, by participating in PoB, users demonstrate their commitment to the network by sacrificing some of the tokens they hold. By burning tokens, users are essentially investing in the consensus process, which brings stability and security to the blockchain. PoB is considered by many to be more environmentally friendly than other consensus mechanisms, such as proof-of-stake, because it consumes less energy.

The wider benefits of token burning include the following:

Price recovery

In situations where a token’s price has fallen and the project owners want to reverse the move, a token burn can be used to help the asset price recover. As explained above, this is a simple case of burning coins to reduce supply which should (in theory) cause prices to rise. For this to happen, however, a large quantity of tokens will need to be burned. However, if the circulating supply is approaching its maximum total, developers may be hesitant to complete a token burn.

Stability

Similar to price recovery, a token burn can help bring stability during a period of volatility for a token. First, if a token burn does cause the asset's price to rise, the positive sentiment gained from the increase could halt a period of downward selling pressure for the token. Second, often, a token burn is seen as a positive sign of a developer’s commitment to the project. This could provide another boost to the positive sentiment surrounding the project, further reducing volatility.

User incentives

Token burns can also incentivize existing users to stay involved while attracting newcomers to the project. Existing users might see the value of their token holdings rise as a token burn causes prices to increase, nudging them to continue holding for the long term. Because a token burn is considered by many to signal a developer’s long-term commitment to the project, more people may be attracted to own tokens in anticipation of a future rise in asset value.

Disadvantages of token burning

One of the major disadvantages of token burning is the potential for perceived price manipulation. Because token burns can positively impact price action, a burn event could be considered manipulative if the reasons for it and the expected outcomes are not communicated clearly. In an industry where transparency and accountability are vital, any perceived deception from a project owner could be harmful.

For project owners, it’s wise to consider the various other disadvantages before committing to a token burn.

Regulatory scrutiny

Because token burning impacts an asset’s price action, it could draw the attention of regulatory bodies eager to address manipulation and fraud. The degree of scrutiny depends on the jurisdiction, and project owners should consider the regulatory environment before going ahead with a token burn.

Limited benefits

Many consider the advantages of token burning to be limited and seen in the short-term only. Although sometimes effective in bringing stability during a period of price volatility, building a sustainable crypto project requires a carefully defined and implemented strategy, with token burns potentially playing one part of.

It’s irreversible

A token burn is permanent — once the assets are gone, they’re gone for good. This brings the risk that a burn event turns out to be harmful to the project, and the action can't simply be reversed. That’s why strategic planning and transparent communication with the project network are crucial before committing.

High-profile token burns in crypto history

Given their permanence and the potential long-term impact on a project, it’s easy to why certain token burns in crypto history have grabbed the headlines.

Vitalik Buterin destroys $6B in SHIB

Ethereum co-founder Vitalik Buterin drew attention in 2021 for burning more than 410 trillion Shiba Inu coins (SHIB), worth a total of $6.7 billion. The coins had been gifted to Buterin by the project’s creators in a reported marketing stunt. Declining to be involved, Buterin sent 90% of the coins to a dead blockchain address to remove them from circulation. In a charitable move, the remaining 10% of the gifted coins were passed on to an Indian COVID-19 relief fund set up by Polygon founder Sandeep Nailwal.

Terra’s algorithmic experiment

The meteoric rise and equally monumental fall of the Terra protocol was fueled by what many thought was one of the most transformative algorithmic developments in crypto to date.

The company behind Terra, TerraformLabs, launched TerraUSD (UST) in September 2020. UST differed from other stablecoins because its peg was maintained by algorithms, rather than massive reserves of cash or debt. The algorithm relied on a sister coin, LUNA, to work.

Here, users (supported by the algorithm) would essentially be buying UST and burning LUNA, or buying LUNA and burning UST. This token burning process helped to keep UST pegged at $1, which theoretically brought stability to the coin.

The uniqueness of LUNA’s algorithmic experiment helped see the price of LUNA and UST skyrocket up until April 2022. May 2022 brought things to an abrupt end. A large liquidity withdrawal of UST set off a chain reaction of panic selling, leading to the eventual de-pegging of UST and the project’s collapse.

Ethereum’s EIP-1559 burn strategy

August 2021 saw the implementation of Ethereum Improvement Proposal 1559 (EIP-1559) — the latest of Ethereum’s standards updates that outline new features or processes for the blockchain.

EIP-1559 introduced a major update to the fee market of Ethereum with the arrival of fee burning. Through fee burning, ETH is burned each time the Ethereum network is used, causing the asset to be deflationary. The development was significant. In the year after EIP-1559 was implemented, ETH’s inflation rate stood at 2.2%. Had EIP-1559 not been implemented, that rate would have been nearly double. Deflation is considered positive for a cryptocurrency because it incentivizes the long-term holding of an asset, increasing adoption of the currency as a store of value.

The final word

Token burning has become an influential activity in cryptocurrency, with many projects adopting it as a tactic to stabilize the value of their native token, incentivize long-term holding, reward loyal users, and much more.

Challenges and risks do remain, however, as the act of burning tokens can bring volatility to a project and its underlying token. That’s why OKX believes it's wise for users to do their own research and understand an asset and project — including its burn strategy — before jumping in.

Disclaimer:

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