What Does Burning Tokens Mean?
Burning tokens in crypto is a process in which a certain amount of tokens is removed from circulation permanently by sending them to a special smart contract that doesn’t allow their removal. In other words, once the tokens are stored within, they can never again be released into circulation.
The idea evolved with the crypto industry, with one of the first examples of its implementation coming from Ripple (XRP). The project introduced a coin-burning mechanism known as the destruction fee, where a small portion of XRP would be permanently removed with every transaction. Initially, the mechanism was introduced to combat spam on the network, but it quickly became apparent that it could have economic purposes.
These days, token burning is used for value appreciation, inflation control, supply manipulation, as an incentive for HODLing — since the remaining cryptocurrency value is expected to grow after a burn — and as a cost for specific features or services.
The Process of Burning Tokens
When it comes to how to burn crypto tokens, there are several ways to do it. The simplest one consists of these few steps:
1) Select the amount — Start by accessing your wallet and selecting the amount to be burned. Naturally, that means you must have the appropriate amount of crypto, plus a little extra for the transfer fee.
2) Obtain a burn address — Next, you need to have the address of the burn wallet/smart contract.
3) Perform the transaction — Initiate the transfer and confirm the blockchain transaction. After that, the transaction will be verified by the algorithm, and recorded on the blockchain ledger once it is completed. The project’s circulating supply will then be updated to reflect the change.
It is also worth noting that there is a consensus mechanism called Proof-of-Burn (PoB), which requires the participants to burn tokens to gain mining, crypto governance, or transaction validation privileges which can also be used to remove a portion of circulating tokens.
Why Burn Crypto Tokens?
The main reasons behind token burning, as far as most projects are concerned, involve reducing supply and creating token scarcity. Both reasons lead to the same outcomes — price influence through a supply shock, and token circulation control.
As the projects reduce the circulating supply, the assets should become more valuable simply because there is more of them available. If the demand for them remains the same or, ideally, goes up, the price should follow as well. This is also a good way to control inflation, so there are quite a few use cases behind the process.
How to Burn Tokens
There are two main ways to burn tokens, and it is the developers who decide which one (if any) will be implemented: Manual burning and automated smart contract bruns. Here is how they differ, and why developers might choose one over the other.
Manual Burning by Developers
Manual token burning happens when developers decide to remove a certain amount of tokens from circulation. This might not be a regular occurrence, and if it happens, it typically only happens when they or the community decide that there is need to do it.
It can also be done for promotional purposes or special events, or simply removing unused tokens. Sometimes, it may be done due to specific market conditions, or if the community votes that it should be done to help the project.
Automated Smart Contract Burns
Automated smart contract burns, on the other hand, take place regularly, as these events are programmed into the smart contract, or come as part of the protocol such as Proof of Burn, as mentioned earlier. This is usually done for several reasons, such as removing the need for manual intervention, or increasing the efficiency, transparency, and/or trustworthiness of the project.
One example of this is Binance’s native BNB. Initially, the developers used to burn the tokens manually, but have since switched to automated burns. Shiba Inu (SHIB), the second-largest meme coin by market cap, and PancakeSwap (CAKE), the native crypto of Binance Smart Chain’s largest DEX, also apply automated burns.
The Impact of Burning Tokens on Price
As mentioned earlier, one of the main effects of token burning is the token value impact. Here is why this is expected:
Economic Principles Behind Token Burning
Crypto prices are not backed by any kind of real-world assets that would give them value, aside from stablecoins. Instead, their value is determined by the supply-demand dynamics. Essentially, there is a specific number of coins or tokens in circulation and traders and investors who might be willing to buy them.
If they start selling the crypto, the available supply increases, which reduces its value. If, on the other hand, they decide to start buying massively, the price goes up, as the demand has increased while the available supply is getting smaller.
However, burning tokens has a similar effect because they are being removed from circulation, thus decreasing the available supply. In theory, this is the same as seeing an increase in demand, so unless the demand drops and traders start selling, the supply should shrink, and so the price should go up.
Does Burning Tokens Increase Value?
If the project burns some of its tokens and the demand remains unchanged, its price is expected to see a minor increase. If the demand goes up, the increase could be quite significant. However, as mentioned previously, if token holders start selling their cryptos, then the demand is dropping, and the circulating supply could increase despite the fact that the tokens were burned.
In that situation, the price could still go down. However, this only happens if the token holders lose interest or faith in the project, and decide to dump their cryptos. Usually, this doesn’t happen, unless there is a major controversy surrounding the project or the token.
Example of Token Burning in Action
To understand the burning process better, here are two examples of how it might work:
Binance Coin (BNB) Burn Events
Binance, the world’s largest crypto exchange, has its native token, BNB. The exchange introduced quarterly token burn events, which have become a crucial part of BNB’s tokenomics. As mentioned, the exchange originally burned the tokens manually, but has since switched to automated burns, as this brings greater predictability and transparency.
The goal is to reduce the BNB supply from the original 200 million BNB to 100 million BNB. In doing so, it will reduce its supply, and slowly ensure its price growth.
As of October 2024, the exchange conducted 25 burn events, destroying 49 million BNB — about 25% of the original supply, and around half of the tokens meant to be burnt before it achieves its goal. The burns are considered bullish events, which often encourage users to purchase around the time when the coins get removed from circulation.
Ethereum’s EIP-1559
Another example is Ethereum’s EIP-1559 proposal, which was implemented in August 2021. The upgrade introduced a change to the project’s fee structure and overall tokenomics by adding a fee burn mechanism, similar to what XRP introduced.
Ethereum has two types of fees — a base fee that must be paid for the transaction to be processed, and a priority fee, which is optional, but it incentivizes miners to prioritize the transactions that paid this fee. With the introduction of EIP-1559, the project started burning the base fee, which started reducing Ethereum’s total supply over time. This introduced deflationary pressure and will help the project control inflation.
Advantages and Disadvantages of Token Burning
Finally, let’s discuss the advantages and disadvantages of the burning process. There are a few important things to keep in mind in both categories, such as:
Advantages
One of the main advantages of token burning is the fact that it increases the scarcity of the tokens, which could lead to a potential value boost. In practice, this rarely happens immediately after the burn, as there are many more factors that impact the token’s price, so burning a portion of a supply, which is typically quite small compared to the entire supply, doesn’t have a major effect at once.
Over time, however, the prices are expected to grow, and usually they do. Projects that employ token-burning mechanisms often see great performance, especially during bullish times, so on some level, it is likely that this contributes to their overall price.
Another big benefit is that token burning increases the community’s trust in the project. This is because the burns show that the project is taking steps to stay in control, keep inflation from spiraling out of control, and, of course, it could help improve its price in the long term.
Disadvantages
However, there are certain disadvantages, with the main one being the risk of manipulation. There is a real risk of developers attempting to manipulate token prices by reducing supply, only for them to then dump their own tokens and reduce their value once more after community members have already purchased them. A similar method can also be used by the whales, only they don’t burn tokens, but can instead afford to buy massive quantities of them — enough to spark a bull run, only to then dump their cryptos.
This can lead to a loss of trust in the project and its developers, and if investors decide that the risks are too great, they could decide to abandon the project altogether, causing it to fail.
