How does token burning work and what are the advantages?

Many cryptocurrency projects have adopted an approach called token burning to restrict the supply of their tokens. This may conjure up images of smoke and matches, but no tokens are actually burnt in the process. They are, however, rendered unusable in the future. So, what’s the point of token burning and who does it benefit?

Token burning explained 

When a company decides to burn tokens, it has two options. It can either purchase existing tokens from the market (known as buy-back) or it can choose to take existing currency out of circulation. 

This could be tokens stored elsewhere such as in a Treasury or team wallet, or it could be unallocated tokens. For example, when OKEx launched OKChain in February of this year, the exchange decided to burn the 700 million unissued OKB tokens to make it a completely deflationary currency and the first fully circulating platform token.

To ‘burn’ these tokens, their signatures are sent to a black hole (or “eater”) address. This is an irretrievable public wallet that can be viewed by anyone and the coins’ status is broadcast to the blockchain.

Some companies may burn tokens as a one-off event while others, such as Binance, and OKEx hold quarterly burns. How and why companies burn tokens ultimately depends on what they’re aiming to achieve. One-off burns often occur after a fundraise is completed and tokens are leftover. They could also happen to correct a mistake.

Tether, for example, accidentally created $5 billion in USDT! They had to swiftly burn these tokens so as not to destabilise the 1:1 peg with the US dollar. Regardless of the mechanism, the result is the same: the tokens are removed from circulation and can never be used again.

What are the advantages of burning tokens?

If asset burning is a common practice, what, apart from correcting an error or removing tokens from circulation, are the benefits of this? To start with, token burning is a deflationary mechanism usually meant to affect the token price. Just as with the Bitcoin Halving, it comes down to the laws of supply and demand.

Burning tokens ,like the halving, is restricting the supply. If the demand stays the same or increases, the price will naturally go up. If the demand dwindles, the burning won’t have had much effect. 

Exchanges like Binance, Huobi, KuCoin, and OKEx periodically burn tokens to incentivise their holder to keep them as they become more valuable. However, while it often affects the price, most trading platforms are actively building up use cases for their tokens and additional benefits for their holders, such as the ability to pay for goods and services online in their exchange token and early access to promising IEOs.

OKB holders, for example, can access discounted trading fees, just like HT and BNB holders, but they can also participate in offers outside the OKEx platform, such as loans and tourism packages, paid for with OKB. Binance, too, allows BNB holders to use its native token to buy goods and services online and pay travel expenses, among other options.

Incentives for traders may not be the only reason for token burning. Some projects, such as Ripple, carry out token burns to add a layer of security and avoid spammed transactions. 

What about Proof of Burn?

Proof of Burn (PoB) is another use that some projects have found for token burning. They have created a consensus mechanism to verify transactions to the blockchain, based on users burning their tokens to gain mining rights. It works by restricting the number of blocks miners that can verify to match with the number of tokens they’ve burnt. This creates virtual mining fields that continue to grow as more tokens are burnt.

Just as reducing the token supply, PoB will also reduce the number of miners as there is a need for fewer resources and lower competition. This leads to the obvious problem of centralisation, as too much capacity is given to large miners who can burn vast quantities of tokens at once, greatly affecting the price and supply.

To avoid this dilemma, a decay rate is often used which effectively reduces the total capacity of individual miners to verify transactions. In many ways, PoB is similar to ç (PoS) as both mechanisms require miners to lock up their assets to mine. Unlike PoB though, with PoS, stakers can retrieve their coins when they stop mining.

The takeaway

Token burning can be extremely beneficial for holders and projects alike to reduce inflation and incentivise users to hold. The Proof of Burn mechanism continues to be problematic though, which is probably why this consensus mechanism has gained little traction so far.

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