What is Coin Burn?
Coin burn is a concept that is unique to the crypto markets and a wide range of coins and tokens have adopted it. In Coin Burn, native cryptocurrency is sent to a public address and from here, these particular coins can never be spent as the private keys of these addresses are not obtainable. In this process, coins are intentionally burnt or eliminated by sending a set portion of coins to an ‘eater address’, which is also known as a ‘blackhole’ and these are the unattainable addresses because of which these coins are rendered useless. Anyone can review the transactions as they are publicly recorded and verified by peers on the blockchain.
How does Coin Burn work?
Coin burn or Token burn happens as follows:
· A burn function is called by a coin holder, who states the nominated amount of coins they want to burn
· The number of coins a person has in their wallet is then verified and validated by the Smart Contract. Only positive numbers work.
· If the number of coins stated is invalid (eg., 0 or -3) or if the person doesn’t have enough coins, the burn function does not get executed.
· The coins will get subtracted from the person’s wallet if they do not have enough coins and the total supply of coins will get updated after which the coins will be burnt.
You might be wondering if this is even legal. Coin Burning is completely legal, and it has been practiced by many well-known developers like BINANCE (BNB) and TRON (TRX), which are famous for burning their coins to reward their coin holders. Binance does this a few times per year: its 7th coin burn destroyed 830,000 BNB ($16 million) in this way. VeChain and TRON use a similar model as well. This strategy has one advantage: the size of the burn is largely determined by market forces and price action.
The downside is that these burns do not always attract a lot of attention, and the results can be minimal. After two years, Binance has burned about 6% of its BNB supply. TRON, meanwhile, intends to burn $20 million worth of TRX over one year, adding up to 1.7% of its total supply.
Reasons for Coin Burn
Now the question lies, why would anyone be willing to burn their coins? Well, coin burning is a good idea for many interesting reasons.
1) Effective Consensus Mechanism.
Coins that adopt Proof of Burn (“PoB”) as their consensus mechanism fall under this category. PoB is a substitute consensus algorithm that was created to address the problem of energy consumption of Proof of Work consensus mechanism. The basic concept of PoB is that people are expected to burn their coins, to be able to mine in proof of burn consensus mechanism. By burning a portion of coins, it creates a unique way of achieving consensus in a distributed network.
2) Increase in Value of Coins
Coin burning is used to increase and stabilize the price of coins and tokens by reducing the total supply in circulation intentionally. To understand this, one must first understand the economic concept of demand and supply. Value can be added to a particular asset by creating scarcity. Cryptocurrencies are deflationary in nature, unlike Fiat currency; which means that with some cryptocurrency, the coin supply is fixed and no additional coins are created once the supply has reached its total count. For example, the fixed supply of Bitcoin is 21 million and if the demand increases, the prices would increase as there is a limited supply of BTC. But if the supply of bitcoin decreases, due to lost private keys, forgotten BTC or burning, the prices would still increase as the supply of BTC has lessened and the demands of people still need to be satisfied.
3) Protection Against Spam
Coin burning is used as a natural mechanism to prevent spam transactions and to safeguard against a Distributed Denial of Service Attack (DDOS). Coin burning generated a cost for executing transactions like how individuals pay a small fee for BTC transactions. Some projects have incorporated a burning mechanism where a portion of the amount sent is automatically burnt. A project that utilizes this model is Ripple (XRP)
4) Long Term Commitment.
A cryptocurrency project can use Coin Burning to signal a firm and long term commitment. A project’s growth aspect is reinforced by employing a coin burning mechanism, as this mechanism is used to burn excess ICO tokens or to provide periodic burning schedules. Greater price stability is enabled by coin burning which is essential for long term investors who are unlikely to sell or spend their coins.
Categories of Coin Burning
Coin burning is divided into two categories: Integrated at the protocol level or Implemented as an economic policy.
Category 1: Protocol Level Mechanism
In this category, the coin burning models are integrated into the core layer of the protocol of the blockchain. Basically what it means is that the coin burning mechanisms that are hardwired into the coin’s base code or DNA belong to this category.
Proof of Burn Consensus Mechanism
Many coins engage a Proof of Burn consensus mechanism and this requires miners to verify and prove on the blockchain that they have destroyed of burnt a portion of their coins. It does sound insane but POB tried to address and solve the problems faced by the POW consensus mechanism. It helps conserve energy as no real-world resources are used other than the destruction of these nominated coins and thus it overcomes the issue of financial costs related to the mining hardware, energy consumption, and environmental damage generated by POW.
There are many variations of the POB model, each with different features:
1. Burning Native Coins for Mining Rights: In this model, the miner has to burn his personal coins in order to get the right to mine blocks. Thus, here the cost of mining is not some expensive equipment as required in proof of work mechanisms but rather the coins that the miner has to burn.
2. Burning Bitcoins to Create New Native Coins: An alternative to burning the native currency is to burn other cryptos like Bitcoin in order to implement a POB algorithm. One example is Counterparty (XCP), during which’s ICO, interested investors had to burn their Bitcoin in exchange for XCP coins.
3. Burn-And-Mint Equilibrium: A more complex POB mechanism is the Burn and Mint Equilibrium wherein you get credits (formally known as ‘Entry Credits’) in exchange for burning the native token. These entry credits are then stored in the currency’s blockchain. This POB mechanism has a unique mechanism to keep inflation in check wherein though the coins are constantly minted, if the demand of the issuing company’s services outweighs the inflation rate of its coin, then technically it will be deflationary since coin must be burnt to use access issuing company’s services. One example of this model is Factom (FCT).
Spam Protection Mechanism
Projects such as Ripple (XRP) have hardwired a coin burning mechanism in their network for every transaction. It basically requires you to pay a cost to send transactions to prevent DDOS attacks and spam transactions that compromise and clog the network. A small amount of coins is burnt in the process to ensure that the security of the network is not compromised for every single transaction and this is an indirect way for users to ‘pay’ for the cost of sending a transaction of the network. As the supply is reduced, the value of the native coins is greater and more stable and this benefits the entire network.
Category 2 – Economic Policies
This mechanism is an economic policy implemented by the company, not usually integrated into the code base but run as a one-off event or periodically as per its needs.
Destruction of Unsold ICO Tokens
Every ICO has two limits a SoftCap or the lower limit and the Hardcap or the upper limit. An ICO can be successful even if it doesn’t hit the upper limit, however, when that happens, the company is left with unsold tokens. Instead of keeping these tokens for future use, some projects burn these tokens. What this does is, with a reduced number of tokens, the value of each existing token goes up and gives an increased value to the token holder. This is a welcome move in the community as it shows the project’s commitment towards its token holders.
Dividend to Coin Holders
Another use of the POB mechanism is to issue dividends to the coin holders. This is done by successful profit-making projects like Binance, which buyback and burn their native tokens in order to increase the value of existing tokens, and this appreciation in value is the dividend that is offered.
This form of dividend payment is essentially a method of avoiding securities regulation, as, if the dividend was paid in cash or native tokens, it would have led to the classification of the tokens as investment security (since they are similar to stocks), thereby requiring regulatory oversight by the authorities.
Many major exchanges like Binance, with their own native token, have adopted a periodic token burning mechanism and many ICOs have also incorporated a coin burning mechanism for the unsold token at the end of the token sale.
Coin burning has various different implementations and features that present a novel approach on a protocol and policy level for cryptocurrency projects. They have the potential to be used to sidestep securities law that governs the dividend-paying securities and is a viable tool in preserving wealth for all peers in the network.