When a cryptocurrency community decides that they want or need to destroy units of a specific cryptocurrency, they use a process called coin burning. The process effectively takes those units out of circulation, reducing the total supply of that coin.
How Does Coin Burning Work?
The process of coin burning permanently removes crypto coins from the network, reducing the total circulating supply of the cryptocurrency in question and increasing its relative scarcity. To accomplish this, users send their crypto to an “eater address,” or a burning wallet, which is a crypto wallet with unobtainable private keys. That permanent transaction, confirmed on the blockchain ledger, takes those coins out of circulation.
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Why Do People Burn Coins?
After answering the question “What is coin burning?” or “What is a token burn?” the natural next step is to ask: why?
There are a few reasons why burning coins might occur for a particular cryptocurrency, even on a regular basis. Factors that could prompt coin burning include:
• Spam protection
• Increasing the value of a coin
• Demonstrating a commitment to the future of the crypto
Some projects implement this process from the beginning, as part of the protocol itself, while others choose to take it on in some form later down the line. With the rise of decentralized finance (DeFi) protocols, coin burning has become more common.
As a Consensus Mechanism
Some coins use proof-of-burn (PoB) to achieve consensus on the network. This requires both miners and users to burn some of their coins on a regular basis. Proponents of this method consider it an efficient way of verifying transactions because it does not use any real-world resources.
There are several specific methods of using this consensus mechanism, such as:
• In a PoB network, miners have to burn some of their coins to mine new blocks. Miners still receive rewards with some new coins if they find a block in this model.
• Some coins require the burning of a different cryptocurrency in exchange for new tokens on the new network. Miners might have to burn bitcoin, for example, to earn another coin.
• Some blockchains use more complex forms of PoB, such as burning native tokens in exchange for credits. Holders can then use those credits to perform a function on the blockchain. Sometimes this involves constant minting of new coins and burning of a portion of the coins.
To Protect Against Spam
Coin burning can be used to protect a network from Distributed Denial of Service Attacks (DDoS) and stop spam transactions from slowing down the network. Just as bitcoin users pay a small fee for sending transactions, or Ethereum users pay a gas fee for smart contract computations, coin burning results in a cost for executing a transaction.
Rather than paying miners a fee for validating transactions, some blockchains have opted for the integration of a burning mechanism. This mechanism can automatically burn a part of each transaction that gets sent. Ripple (XRP), for example, uses this method.
To Increase the Coin’s Value
The basic economic law of supply and demand dictates that if the supply of something decreases, then the price will have to rise, assuming demand remains constant. This is part of the reason that Satoshi Nakamoto (the name used by the person or people who created Bitcoin) programmed the Bitcoin protocol to “halve” every four years, which reduces the block reward for miners by 50%, meaning fewer bitcoins enter circulation.
In the context of the question “what is coin burning,” the destruction of coins can serve a similar purpose. Burning coins reduces the supply.
While fiat currencies are inflationary in nature and central banks can print them in unlimited amounts, some cryptocurrencies are deflationary in nature and have fixed supply limits. Bitcoin has a supply limit of 21 million coins.
The more people who want to buy, hold, or use Bitcoin, the faster the price will tend to rise because there are only so many coins to go around. As long as the demand stays constant and the supply remains limited, the price of Bitcoin can keep rising compared to any fiat currency.
For other cryptocurrencies, engaging in coin burning can sometimes occur in an effort to manage supply in a way that increases scarcity and tries to mimic Bitcoin’s supply and demand dynamics.
As a Sign of Long-Term Commitment
The owners of a crypto project sometimes burn coins on their network as a show of commitment toward scarcity. Doing so makes everyone holding their tokens a little richer. Owners may accomplish this through a burn mechanism, providing periodic burn schedules, or as a one-off event.
Different Types of Coin Burning
Coin burning typically falls into one of three categories:
1. Coin Burning at the Protocol Level
The proof-of-burn consensus algorithm discussed earlier falls into the first category. Blockchains that use PoB have coin burning built into their protocols. This means burning is an intrinsic part of the network and takes place consistently so long as the coin continues to function.
Using coin burning as a spam-protection mechanism can also occur at the protocol level. As mentioned earlier, transactions must have a cost to prevent the network from being spammed with fake transactions. One way to accomplish this is to automatically burn a portion of each transaction. This can make transactions faster, cheaper, and more efficient as well.
2. Coin Burning as Economic Policy
The second category involves developers who might decide to burn coins in order to control the supply of coins in order to manage inflation.
One example might be the deliberate destruction of unsold ICO tokens. The creators of a new project might have created X number of coins hoping to sell them all, but failed to meet this objective. In such a scenario, the developers could choose to burn the excess coins to maintain a specific level of supply.
3. Coin Burning in Lieu of Dividends
Some projects might also use coin burning as a sort of dividend payment to coin holders. If the owners of a token have a business that generates cash flows, like a crypto exchange for example, token holders could receive rewards through coin burning.
In a boon to those who’ve chosen a HODL strategy, the owners could buy back tokens from holders and burn those coins, thereby increasing the value of everyone’s crypto. This might occur in lieu of traditional dividends which might trigger securities regulations. The burn process could occur as a one-time event or a regularly scheduled one.
Burning coins involves taking them out of circulation and destroying them forever, permanently reducing the available supply of that token. The exact reasons for doing this can vary, although the crypto community typically views them as positive. Different types of cryptocurrency use coin burning in different ways, and it’s important to understand the approach of any crypto in which you’re considering investing.
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