What is a Token Burn?

0
125
What is a Token Burn?
What is a Token Burn?

The governance of many industry projects chooses to burn some of their cryptocurrency. ETH, BNB and SHIB, some of the most valuable cryptocurrencies on the market, use this mechanism. But what exactly is a token burn? What are the reasons for such a choice? Presentation of a practice highly appreciated by investors.

What is a Token Burn?

A “burn” refers to the mechanism by which the units of a cryptocurrency are burned, that is to say, destroyed in an intentional and permanent manner.

Therefore, a burn reduces the circulating supply of the cryptocurrency since the total number of tokens available decreases.

It is a deflationary process, as opposed to the issuance of tokens (mint), which occurs as a reward for mining or validation of a block depending on the blockchain on which a cryptocurrency operates.

A burn does not literally involve the destruction of tokens; it is only figuratively. Indeed, concretely, the process by which the tokens are burned consists of sending them to a “dead wallet”. The peculiarity of such a wallet lies in the absence of a private key, which means that it is impossible to gain access to it and that it will therefore be forever inactive.

FQOJVPfaywZK18qGEsHBsCAfGWvCre0nXkiBm5OqyBXW4ad4Nyh9gmQgUjELyRNfKl03pXbLJHO4PW8JbvuFtWrVDqNCC8m9sVrmNTzJCF7yG3Zean8NHaReyApTyr1ESKFr4vWdIhnI2RhLRA

Figure 1: Overview of one of the dead wallets used on the Ethereum blockchain

Once the tokens have been sent to a dead wallet, it is impossible to recover them. In the screenshot above, we see that the equivalent of $265 million in ERC-20 tokens has been burned on this dead wallet, as well as the equivalent of $24.7 million in Ethers (May 2022).

If a comparison is needed, imagine locking cash in a safe that didn’t have an access code by design, making it impossible to unlock.

There is another way in which tokens can be lost forever, and this is not to be confused with a burn.

These are human errors; if we get the wrong address when we try to send funds or if we lose access to a wallet, these tokens will be lost forever, even if the number of tokens in circulation will not officially drop.

Why is it Interesting to Burn Tokens?

The most common reason behind a token burn is an increase in the scarcity of the asset in question. This has its origin in the law of supply and demand. The more the supply of an asset is reduced, the more it has value due to its rarity, and all the more so if combined with a consequent demand.

Thus, burning tokens makes it possible to reduce the supply in circulation and increase its rarity, which is likely to increase its value, and, therefore, its price (assuming that demand remains the same before and after the burn).

The Case of Ethereum (ETH) and the EIP-1559 Update

The Ethereum blockchain is one of the best examples of using a burn mechanism to increase the value of its cryptocurrency, ETH, over the long term.

From its launch in 2015 until 2021, the Ethereum blockchain had no way to burn ETH. This changed on August 5, 2021, with Ethereum Improvement Proposals 1559 (EIP-1559). This blockchain update changed the way transaction fees were collected.

To put it simply, part of the transaction fees paid during a transfer on the Ethereum blockchain is, since EIP-1559, burned. Automatically sent to a dead wallet, these ETH are taken out of circulation.

This change comes to slow the growth of the circulating supply of ETH, which has an average annual inflation of 4.5% and is mostly unlimited.

djPTkWWEGz20gXUY5NoHqvTltcSaGDSBN 6Jo7TddCrGkJavrMmT1QDt JnndwDA96 2AwkKLLZIKy 3mtrr9vShVjMIZHFK4i7Ba7OmXZDA1uy8Nh3oIGrUmDcvWXdvr2lZFOMYHPlzSPT0WA

Figure 2: Overview of ETH statistics since the implementation of EIP-1559

Thus, at the time of writing these lines (May 2022), approximately 8 months after the implementation of EIP-1559, the Ethereum blockchain has burned 2,345 million ETH, equivalent to $4.6 billion at the current price, while it has issued a mining reward of 3,848 million ETH according to Watch the Burn.

This is a net issuance of 1,502 million new ETH. The EIP-1559 has therefore made it possible in 8 months to reduce the issuance of ETH by 60.95% via this new burn mechanism.

However, it is difficult to say that these burns contributed significantly to the increase in the price of ETH. But it is likely that in the long term, this mechanism will support the growth of the cryptocurrency price.

The Shiba Inu (SHIB) and Vitalik Buterin

A very famous case of token burn in the cryptocurrency industry is that of the Shiba Inu (SHIB) and Vitalik Buterin, the famous co-founder of the Ethereum blockchain.

Indeed, Shiba Inu founder Ryoshi sent 50% of the total SHIB token supply to Vitalik Buterin when the project launched in August 2020.

Vitalik Buterin, almost a year later, decided to burn almost all of the SHIB tokens he held by sending them to a dead wallet. This decision has, therefore, considerably contributed to reducing the maximum number of SHIB tokens in circulation: from 1 quadrillion to 590 trillion. Shortly after this destruction, the price of SHIB soared to new records before stabilizing.

epaWr83R7C BS3AvXajEujjpGE5qlrWHQ0CmcsKO7decwxEAp44NOT4zHeswxiFTLQlQczZ5WWc5OdQ

Figure 3: Vitalik Buterin transaction burning 41% of total SHIB token supply

Burn-related Manipulations

There may be manipulations related to the burn mechanism, and we draw attention to this. Let’s take the concrete example of a team holding 20 million tokens out of 100 million in circulation; it logically owns 20% of the supply in circulation.

Now imagine that many tokens are burned, but only tokens that the team does not own. The share of tokens held by the team will therefore increase.

Say 10 million tokens are burned, so the team will hold 20 million out of 90 million tokens, i.e. 22.22% of the supply in circulation. This can be worrying in terms of the governance of a project and its centralization.

In the case of lesser-known projects, it is possible that a team claims to burn tokens on a dead wallet, while in reality, the wallet on which the tokens are sent is not a dead wallet (they can therefore retrieve the contents). Diligent research should be carried out when a team plans to destroy part of the tokens.

The Different Types of Burns

There are many ways to burn tokens. Ethereum and the EIP-1559, as we have seen, automatically burn part of the network transaction fees.

Another example is Binance’s BNB. It is one of the best-known cryptocurrencies in the industry when it comes to the burn mechanism.

Indeed, since October 2017 and until the end of 2021, each quarter,  the Binance platform used 20% of its profits to buy back BNB at market price and burn them.

Figure 4: BNB token burns performed by Binance each quarter

The particularity of BNB lies in the commitment made by Binance from the start of the project to burn BNB in this way until 50% of the initial circulating supply, i.e. 100 million BNB tokens, is burned.

This involves reducing the circulating supply of the BNB token to increase its scarcity and value at the same time. The way Binance burns BNB via a buy-at-market may be reminiscent of a company buying back its own shares from investors.

This redemption at a market price, therefore, acts as a way of rewarding the holders of BNB tokens.

However, since January 2022 (the 18th burn), the BNB token burning mechanism has evolved, and Binance has introduced auto-burn. This new mechanism uses a mathematical formula taking into account the total number of blocks generated and the average price of BNB over the quarter.

This worked out pretty well for the project since BNB is one of the most highly valued cryptocurrencies on the market. At the time of writing these lines, 37.2 million BNB tokens have been burned, i.e. nearly 2.2 billion dollars, by accumulating the amounts burned that this represented in dollars at each iteration.

Another type of burn takes place in the context of algorithmic stablecoins. These have a two-cryptocurrency system, in which one absorbs the volatility of the other, the stablecoin.

To do this, the circulating supply of the two cryptocurrencies is elastic: this involves a burn mechanism on one of the two cryptocurrencies in opposition to the issuance of new tokens of the other cryptocurrency in order to stabilize the price of the stablecoin.

So, let’s say an algorithmic stablecoin deviates from its parity with the dollar on the way down. In this case, an arbitration mechanism exists, which consists of sending a stablecoin token to the protocol to burn it in order to receive in exchange the equivalent of a dollar in the other newly issued token.

This mechanism restores the price of the stablecoin to 1 dollar. The Terra USD (UST) and the infamous LUNA, the Decentralized USD (USDD) and the TRX, or the USN  and the NEAR use this type of burn as part of an elastic monetary policy.

It should be noted that even in this type of burn, the main objective is to increase the value of the volatility-absorbing cryptocurrency.

Finally, anyone can actually burn tokens, for any reason whatsoever, by sending them to a dead wallet themselves.

Conclusion on the Practice of Token Burning

Burning tokens is a common practice in the cryptocurrency industry. Having the effect of reducing the supply in circulation, it is important to understand the ins and outs of this, and we hope that this article has helped you to see more clearly.

The main objective behind a token burn is to influence its value by making it rare. However, this does not mean that this mechanism is necessarily a good thing since it is far from being the only factor influencing the valuation of a cryptocurrency.

In general, investors appreciate this practice and push developers or the governance of projects that do not do so to implement a burn mechanism. However, value capture is not guaranteed, and no project should rely solely on this.

The governance of many industry projects chooses to burn some of their cryptocurrency. ETH, BNB and SHIB, some of the most valuable cryptocurrencies on the market, use this mechanism. But what exactly is a token burn? What are the reasons for such a choice? Presentation of a practice highly appreciated by investors.

What is a Token Burn?

A “burn” refers to the mechanism by which the units of a cryptocurrency are burned, that is to say, destroyed in an intentional and permanent manner.

Therefore, a burn reduces the circulating supply of the cryptocurrency since the total number of tokens available decreases.

It is a deflationary process, as opposed to the issuance of tokens (mint), which occurs as a reward for mining or validation of a block depending on the blockchain on which a cryptocurrency operates.

A burn does not literally involve the destruction of tokens; it is only figuratively. Indeed, concretely, the process by which the tokens are burned consists of sending them to a “dead wallet”. The peculiarity of such a wallet lies in the absence of a private key, which means that it is impossible to gain access to it and that it will therefore be forever inactive.

FQOJVPfaywZK18qGEsHBsCAfGWvCre0nXkiBm5OqyBXW4ad4Nyh9gmQgUjELyRNfKl03pXbLJHO4PW8JbvuFtWrVDqNCC8m9sVrmNTzJCF7yG3Zean8NHaReyApTyr1ESKFr4vWdIhnI2RhLRA

Figure 1: Overview of one of the dead wallets used on the Ethereum blockchain

Once the tokens have been sent to a dead wallet, it is impossible to recover them. In the screenshot above, we see that the equivalent of $265 million in ERC-20 tokens has been burned on this dead wallet, as well as the equivalent of $24.7 million in Ethers (May 2022).

If a comparison is needed, imagine locking cash in a safe that didn’t have an access code by design, making it impossible to unlock.

There is another way in which tokens can be lost forever, and this is not to be confused with a burn.

These are human errors; if we get the wrong address when we try to send funds or if we lose access to a wallet, these tokens will be lost forever, even if the number of tokens in circulation will not officially drop.

Why is it Interesting to Burn Tokens?

The most common reason behind a token burn is an increase in the scarcity of the asset in question. This has its origin in the law of supply and demand. The more the supply of an asset is reduced, the more it has value due to its rarity, and all the more so if combined with a consequent demand.

Thus, burning tokens makes it possible to reduce the supply in circulation and increase its rarity, which is likely to increase its value, and, therefore, its price (assuming that demand remains the same before and after the burn).

The Case of Ethereum (ETH) and the EIP-1559 Update

The Ethereum blockchain is one of the best examples of using a burn mechanism to increase the value of its cryptocurrency, ETH, over the long term.

From its launch in 2015 until 2021, the Ethereum blockchain had no way to burn ETH. This changed on August 5, 2021, with Ethereum Improvement Proposals 1559 (EIP-1559). This blockchain update changed the way transaction fees were collected.

To put it simply, part of the transaction fees paid during a transfer on the Ethereum blockchain is, since EIP-1559, burned. Automatically sent to a dead wallet, these ETH are taken out of circulation.

This change comes to slow the growth of the circulating supply of ETH, which has an average annual inflation of 4.5% and is mostly unlimited.

djPTkWWEGz20gXUY5NoHqvTltcSaGDSBN 6Jo7TddCrGkJavrMmT1QDt JnndwDA96 2AwkKLLZIKy 3mtrr9vShVjMIZHFK4i7Ba7OmXZDA1uy8Nh3oIGrUmDcvWXdvr2lZFOMYHPlzSPT0WA

Figure 2: Overview of ETH statistics since the implementation of EIP-1559

Thus, at the time of writing these lines (May 2022), approximately 8 months after the implementation of EIP-1559, the Ethereum blockchain has burned 2,345 million ETH, equivalent to $4.6 billion at the current price, while it has issued a mining reward of 3,848 million ETH according to Watch the Burn.

This is a net issuance of 1,502 million new ETH. The EIP-1559 has therefore made it possible in 8 months to reduce the issuance of ETH by 60.95% via this new burn mechanism.

However, it is difficult to say that these burns contributed significantly to the increase in the price of ETH. But it is likely that in the long term, this mechanism will support the growth of the cryptocurrency price.

The Shiba Inu (SHIB) and Vitalik Buterin

A very famous case of token burn in the cryptocurrency industry is that of the Shiba Inu (SHIB) and Vitalik Buterin, the famous co-founder of the Ethereum blockchain.

Indeed, Shiba Inu founder Ryoshi sent 50% of the total SHIB token supply to Vitalik Buterin when the project launched in August 2020.

Vitalik Buterin, almost a year later, decided to burn almost all of the SHIB tokens he held by sending them to a dead wallet. This decision has, therefore, considerably contributed to reducing the maximum number of SHIB tokens in circulation: from 1 quadrillion to 590 trillion. Shortly after this destruction, the price of SHIB soared to new records before stabilizing.

epaWr83R7C BS3AvXajEujjpGE5qlrWHQ0CmcsKO7decwxEAp44NOT4zHeswxiFTLQlQczZ5WWc5OdQ

Figure 3: Vitalik Buterin transaction burning 41% of total SHIB token supply

Burn-related Manipulations

There may be manipulations related to the burn mechanism, and we draw attention to this. Let’s take the concrete example of a team holding 20 million tokens out of 100 million in circulation; it logically owns 20% of the supply in circulation.

Now imagine that many tokens are burned, but only tokens that the team does not own. The share of tokens held by the team will therefore increase.

Say 10 million tokens are burned, so the team will hold 20 million out of 90 million tokens, i.e. 22.22% of the supply in circulation. This can be worrying in terms of the governance of a project and its centralization.

In the case of lesser-known projects, it is possible that a team claims to burn tokens on a dead wallet, while in reality, the wallet on which the tokens are sent is not a dead wallet (they can therefore retrieve the contents). Diligent research should be carried out when a team plans to destroy part of the tokens.

The Different Types of Burns

There are many ways to burn tokens. Ethereum and the EIP-1559, as we have seen, automatically burn part of the network transaction fees.

Another example is Binance’s BNB. It is one of the best-known cryptocurrencies in the industry when it comes to the burn mechanism.

Indeed, since October 2017 and until the end of 2021, each quarter,  the Binance platform used 20% of its profits to buy back BNB at market price and burn them.

Figure 4: BNB token burns performed by Binance each quarter

The particularity of BNB lies in the commitment made by Binance from the start of the project to burn BNB in this way until 50% of the initial circulating supply, i.e. 100 million BNB tokens, is burned.

This involves reducing the circulating supply of the BNB token to increase its scarcity and value at the same time. The way Binance burns BNB via a buy-at-market may be reminiscent of a company buying back its own shares from investors.

This redemption at a market price, therefore, acts as a way of rewarding the holders of BNB tokens.

However, since January 2022 (the 18th burn), the BNB token burning mechanism has evolved, and Binance has introduced auto-burn. This new mechanism uses a mathematical formula taking into account the total number of blocks generated and the average price of BNB over the quarter.

This worked out pretty well for the project since BNB is one of the most highly valued cryptocurrencies on the market. At the time of writing these lines, 37.2 million BNB tokens have been burned, i.e. nearly 2.2 billion dollars, by accumulating the amounts burned that this represented in dollars at each iteration.

Another type of burn takes place in the context of algorithmic stablecoins. These have a two-cryptocurrency system, in which one absorbs the volatility of the other, the stablecoin.

To do this, the circulating supply of the two cryptocurrencies is elastic: this involves a burn mechanism on one of the two cryptocurrencies in opposition to the issuance of new tokens of the other cryptocurrency in order to stabilize the price of the stablecoin.

So, let’s say an algorithmic stablecoin deviates from its parity with the dollar on the way down. In this case, an arbitration mechanism exists, which consists of sending a stablecoin token to the protocol to burn it in order to receive in exchange the equivalent of a dollar in the other newly issued token.

This mechanism restores the price of the stablecoin to 1 dollar. The Terra USD (UST) and the infamous LUNA, the Decentralized USD (USDD) and the TRX, or the USN  and the NEAR use this type of burn as part of an elastic monetary policy.

It should be noted that even in this type of burn, the main objective is to increase the value of the volatility-absorbing cryptocurrency.

Finally, anyone can actually burn tokens, for any reason whatsoever, by sending them to a dead wallet themselves.

Conclusion on the Practice of Token Burning

Burning tokens is a common practice in the cryptocurrency industry. Having the effect of reducing the supply in circulation, it is important to understand the ins and outs of this, and we hope that this article has helped you to see more clearly.

The main objective behind a token burn is to influence its value by making it rare. However, this does not mean that this mechanism is necessarily a good thing since it is far from being the only factor influencing the valuation of a cryptocurrency.

In general, investors appreciate this practice and push developers or the governance of projects that do not do so to implement a burn mechanism. However, value capture is not guaranteed, and no project should rely solely on this.