Coin Burning: What it is and How Does it Work?
What is Coin Burning?
Coin burning — as the name suggest — is a process of intentionally ‘burning’ or eliminating the coins by rendering it unusable. This is done by sending a portion of the coins to an ‘eater address’, which is often referred to as a ‘black hole’ since the private keys to that address are not obtainable by anyone. Therefore, any coins sent to an eater address are unrecoverable and cannot be used again, ever! These coins are effectively taken out of circulation and is publicly recorded and verifiable on the blockchain.
Reasons for Coin Burn
Why would anyone be willing to burn coins? Well, there are many interesting reasons why coin burning is a good idea.
1) More Effective Consensus Mechanism
This applies to coins that adopt Proof-of-Burn (POB) as their consensus mechanism. POB is a unique way of achieving consensus in a distributed network, requiring participants — miners and users — to burn a portion of coins. There are many variations of POB which will be discussed in the next section.
2) Increase Value of Coins
In order to understand this, we need to understand the basic economic laws of demand and supply.
Scarcity is a central economic concept that gives value to a particular asset and in this case, cryptocurrency. Unlike fiat currencies, cryptocurrencies are deflationary in nature. This means that the coin supply for most cryptocurrencies are fixed, with no additional coins created once it has reached its total supply count. The best example is Bitcoin, which has a fixed supply of only 21 million; if demand increases, prices would increase since there is a limited number of Bitcoin in circulation. Likewise, if the supply of Bitcoin further decreases — due to burning, lost private keys or forgotten Bitcoins — then prices would similarly increase since there is now a lesser amount of Bitcoins to satisfy people’s demands.
Coin burning reduces the total supply in circulation since the coin is intentionally destroyed. It is an effective method of increasing and stabilizing the valuation of coins and tokens. Economic principles dictate that reducing the quantity of something makes it much more valuable!
3) Protection Against Spam
Coin burning acts as natural mechanism to safeguard against Distributed Denial of Service Attack (DDOS) and prevent spam transactions from clogging the network. The same way how users pay a small fee for sending Bitcoin (BTC) or pay gas for smart contract computations in the Ethereum blockchain, coin burning creates a cost for executing a transaction. Instead of paying fees to miners to validate transactions, some projects have integrated a burning mechanism where a portion of the amount sent is automatically burnt. Ripple (XRP) is a project that utilizes this burning model.
Categories of Coin Burning
Coin burning can generally be classified into 2 distinct categories, integrated at the protocol level or implemented as an economic policy.
Category 1: Protocol-Level Mechanism
This category relates to coin burning models that have been integrated into the core protocol layer of the blockchain. In simplified words, any coin burning mechanism that have been hardwired into the coin’s DNA (code base) belongs in this category.
- Proof-of-Burn Consensus Algorithm
There are coins that employ a Proof-of-Burn (POB) consensus mechanism, which requires miners to show verifiable proof on the blockchain that they have burnt (destroyed) a portion of their coins. Now, this might seem crazy at first but POB actually tries to solve key issues facing the Proof-of-Work (POW) consensus algorithm used by Bitcoin. No real-world resources are consumed other than the destruction of the underlying coins, thereby overcoming the issues of heavy financial costs related to mining hardware, massive energy consumption and environmental damage caused by POW.
There are many variations of the POB model, each with different features:
- Burning Native Coins for Mining Rights: This POB model requires miners to burn a portion of their coins in order to acquire the rights to mine blocks. The ‘cost’ to mine in this case is the destruction of miners’ coins instead of paying for expensive mining equipment or electrical resources which is required in a POW model. Slimcoin implements such a system. Miners who successfully mine a block in this POB model will still get mining rewards for their efforts.
- Burning Bitcoins to Create New Native Coins: Some coins like Counterparty (XCP) implement a POB algorithm that requires burning the currency of Bitcoin in exchange for the same amount of coins in the native currency, XCP. During Counterparty’s ICO, interested investors had to send their Bitcoins into an eater address for destruction, in exchange for XCP coins. This way, the newly created XCP tokens had value because the same number of Bitcoin was destroyed to create it.
- Burn-And-Mint Equilibrium: Factom (FCT) on the other hand, uses a more complex version of POB that burns native tokens in return for credits (formally known as ‘Entry Credits’). Credits are used to store data into Factom’s blockchain. The reason it is called Burn-and-Mint is because Factom’s coin supply is not fixed and has an in-built inflation rate, meaning that new coins will be constantly created and ‘minted’. However, if the demand for Factom’s services outweighs the coin inflation rate, then technically it will be deflationary since FCT must be burnt to use access Factom’s services.
Spam Protection Mechanism
Requiring a cost to send transactions is a vital aspect for any blockchain to prevent spam transactions and DDOS attacks from compromising the network. Projects such as Ripple (XRP) and Request Network (REQ) have hardwired a burning mechanism for every transaction on the network. This means that for every single transaction, a small amount of coins is burnt in the process. Users indirectly ‘pay’ for the cost of sending a transaction on the network. This way, the entire network benefits from greater value since the supply of native coins reduce over time, which will eventually increase prices in the long-term.
Directly paying fees to miners for them to validate transaction — in the case of BTC and ETH — may be a value-reducing proposition since only the miners get the reward and the overall network can even lose out when the miner sells away his reward for cash. In a coin burn structure, the ‘cost’ that a user indirectly ‘pays’ from destroying the coin is a value-enhancing proposition for every user in the network since supply is reduced. Therefore, it can be argued that a coin burning mechanism is a more equitable and fairer way of distributing value to all participants in the network.
Category 2: Economic Policies
This category of mechanism is usually implemented as an economic policy or program undertaken by the project. It is not integrated into the protocol layer or code base of the project. It can be a one-off event or follow a periodic schedule.
- Destruction of Unsold ICO Tokens
Some ICO projects that did not meet their hardcap and are therefore left with unsold tokens could choose to destroy them. Instead of keeping the tokens for future use, the project chooses to voluntarily burn the excess coins so as to distribute value back to their token holders. Projects that engage in this usually receive a positively favourable image in the community as it highlights the commitment of the team in ensuring long-term success for the project.
- Dividend to Coin Holders
Projects that have generated profits from their operations — like Binance collecting trading fees from users — could also use their profits to buyback their native tokens from the public and destroy those coins as a form of ‘dividend payment’, which essentially increases value to coin holders.
A dividend is a payment from a company to its shareholder. The company would seek to share the wealth by distributing the profits it generated for the year to shareholders, in a bid to reaffirm the solid growth and prospects of the company.
It must be mentioned that coin burning is a method for cryptocurrency projects to evade securities regulations. This is because direct dividend payments — both in the form of pure cash or native tokens — would classify the tokens as an investment security (since they are similar to stocks), thereby requiring regulatory oversight by the authorities. Other examples of coins that employ a periodic burn schedule include Tron (TRX) and Hacken (HKN).