Burning Cryptocurrency: Meaning, Benefits, Drawbacks & More

Cryptocurrencies feature many complex concepts and mechanisms that create a robust system of decentralized finance. To navigate and simplify this elaborate space, both developers and crypto investors came up with various everyday terms. One such term is “burning crypto,” which is used to explain an instrument for controlling token supply.

Naturally, the process doesn’t involve actual fire but rather an intelligent solution for permanently disposing of digital assets. While the phrase thoughtfully describes the process, there’s much more going on behind the scenes. Not only that, but knowing the upsides and drawbacks of burning crypto can help you stay ahead and make better investment choices.

In this article, we’ll expand on the inner workings of this system, analyze its pros and cons, and even determine whether burning crypto is good or bad. Let’s dive in!

What Is Burning Crypto?

Burning crypto refers to the act of permanently removing a certain number of tokens from circulation. Since these are digital assets, they aren’t physically destroyed but are instead sent to a burn address. This is the address of a wallet that can’t be accessed, which means any crypto sent to it is gone for good.

One of the core principles behind crypto burning is intent. Coins and tokens are deliberately burned by the owner for various purposes, mostly to combat inflation by reducing the total supply. That is not the same as someone losing access to their wallet or forgetting their private keys.

Assets stored in lost wallets with forgotten seed phrases can still technically be accessed, should the owner remember the phrase. Burn wallets don’t have a secret key that allows holders to manage their funds. They operate one way only; they can receive tokens but can’t use or send them.

DeFi coin burning can be compared to the traditional finance (TradFi) practice of companies buying their stocks back. Companies can perform buybacks for various reasons, including driving the price of the remaining stocks up or preventing hostile takeovers. Essentially, the goal is to endure potential short-term losses for long-term gains.

Another TradFi example would be governments and central banks reducing the money supply to stabilize prices and interest rates. In the realm of crypto, burning is often utilized by blockchain projects to control the value of their token and ensure ongoing investor interest.

Many cryptocurrencies feature some sort of burning mechanism. For instance, burning Ethereum facilitates transactions, and BNB comes with an auto-burning system that periodically reduces the total maximum supply.

How Does Burning Crypto Work?

Burning crypto works by moving assets to purpose-built, inaccessible wallets. To better understand the process, we need to know how cryptocurrency wallets work.

Essentially, every crypto wallet features two key components:

1. Public key, which is visible to anyone and is used to receive coins or tokens
2. Private key, which only the owner should know since it’s used to confirm asset ownership and authorize transactions

Wallets created to facilitate crypto burning feature a burn address and no private key. Oftentimes, their public addresses are created in such a way that private keys can’t be generated in the first place. For instance, an address with a string of zeros makes it impossible to create a private key.

All of this makes these wallets effectively inoperative, and any cryptocurrency sent to them is lost forever. Token burning is further reinforced by the very nature of blockchain and its underlying technology.

Since blockchain acts as a distributed, decentralized, and transparent ledger, all transactions (including token burning) are permanently and irrevocably recorded on it. Once the funds are sent to inaccessible wallets and the transactions are confirmed on the network, nobody can retrieve them—not even project owners or token burners.

The process of token burning is most commonly initiated by developers and project owners. However, anyone who holds the assets can burn them. Many projects have built-in burning mechanisms that are familiar to investors from the get-go.

On the other hand, cryptocurrencies governed by DAOs (decentralized autonomous organizations) can implement token burning at any given moment. This can happen if someone submits a proposal regarding burning and the community votes favorably.

5 Reasons for Burning Crypto

Here are some of the key reasons for burning crypto:

1. Controlling inflation. The main reason for crypto burning is to combat inflation by reducing the number of tokens in circulation. This effect is particularly prominent with cryptocurrencies that have an infinite supply, like Ethereum. Without burning, the number of ETH tokens would endlessly increase, potentially destabilizing the whole network.
2. Promoting scarcity and increasing value. Considering the basic laws of supply and demand, after decreasing the supply of a cryptocurrency, the value of the remaining tokens should go up. While that’s not always the case, the process generally promotes scarcity, akin to precious metals like gold.
3. Encouraging investors. Crypto burning improves token metrics since the market cap remains the same while the circulating supply is reduced. It is also a sign of the confidence of the project owners. That can make the asset more attractive to both current and new investors.
4. Improving liquidity and staking rewards. Improved token metrics also often lead to more network activity. That can result in improved liquidity in markets as more people start using the assets. Furthermore, by increasing the value of remaining tokens, burning increases staking rewards for current holders.
5. Enabling a consensus mechanism. A proof-of-burn (PoB) consensus mechanism is similar to a proof-of-work (PoW) system. It’s designed to make up for some of the POW’s mechanism shortcomings while utilizing token burning to ensure network stability and functionality.

What is Proof-of-Burn?

Proof of burn is a consensus mechanism that some blockchains use to operate. It’s designed as an alternative to the prevalent proof-of-work and proof-of-stake (PoS) mechanisms. As its name suggests, the key aspect of PoB is cryptocurrency burning, which allows participants to facilitate network operations.

Burning in a PoB network is akin to mining in PoW or staking in PoS blockchains. It’s used to secure the network, verify transactions, and control token supply. Burned tokens are sent to an unusable wallet and effectively removed from circulation, giving both holders and the project all the benefits of crypto burning.

The main idea behind a proof-of-burn consensus mechanism was to make up for some of the shortcomings of proof-of-work systems. Primarily, PoW blockchains, like Bitcoin, need a lot of computational power and electric energy to operate. PoB aims to minimize the use of these assets and only “waste” tokens that are being burned.

Essentially, validators need to burn some of their tokens to gain the ability to create new blocks. Many PoB networks also have a decay system put in place so that the validators’ power lessens over time, incentivizing continuous token burning. In return, they are granted block rewards and transaction fees.

This system is seen as an energy-efficient version of the PoW consensus mechanism that promotes the project’s longevity and the stability of the internal economy.

4 Benefits of the Proof-of-Burn Protocol

Here are some of the biggest advantages of the proof-of-work consensus mechanism:

1. Energy efficiency. The biggest benefit of the PoB mechanism over PoW is its energy efficiency. The Bitcoin network is estimated to use 127 terawatt-hours per year, which is more than entire countries. Proof of burn would almost completely eliminate energy use and any downsides associated with it.
2. Low barrier of entry. PoW mining usually requires powerful and expensive mining rigs that can cost several thousand dollars. Not only that, but these machines regularly get outdated, requiring the purchase of new ones. On the flip side, PoB has a lower barrier of entry, allowing anyone with the minimum required amount of crypto to join mining.
3. Network commitment. Users who want to join PoB networks are incentivized to do so for a long period of time. Once they burn their tokens to get mining rights, the only way to get the value back is to continue participating for extended periods of time. That approach facilitates long-term dedication.
4. Enhanced security. By requiring participants to burn tokens at the beginning, proof-of-burn blockchains prevent most bad actors from attempting any malicious activity.

4 Disadvantages of the Proof-of-Burn Protocol

The proof-of-work protocol isn’t without disadvantages, with the most prominent ones being:

1. Irreversible loss of coins or tokens. Burning permanently destroys crypto assets. This process is particularly risky for individuals with modest holdings, as they might be required to burn a considerable part of their portfolio to participate. Over time, it can also impact the network economy of blockchains with limited maximum supply.
2. Lack of a return guarantee. Token burning results in an immediate loss of funds in the hopes that future mining will recover that and yield additional rewards. However, that’s not a guarantee, especially with uncertain projects and altcoins, which are known to be extremely volatile and unpredictable.
3. Limited incentive. While a PoB system promotes long-term thinking, it doesn’t do so indefinitely. Mining powers gained from burning tokens only work for a certain period of time, after which they diminish. After that, not every user will burn a portion of their assets again. Instead, they might simply quit the network.
4. Centralization concerns. Users with considerable holdings can burn more tokens and gain more power than the rest of the network. That gives them more influence and can result in them getting the most rewards.

Examples of Burning Crypto

Let’s take a look at a coin burn list to see some examples of burning crypto:

• Ethereum (ETH). Ethereum started off as a proof-of-work blockchain with an infinite maximum supply of ETH. However, the 2021 London Hard Fork update changed the network to a proof-of-stake, introducing a burn mechanism. Today, validators stake and earn ETH, while users pay fees in ETH and burn it in the process.
• Binance Coin (BNB). BNB is the native token of the Binance Smart Chain, and it was issued by Binance, one of the world’s largest centralized exchanges. BNB was introduced with scheduled quarterly burning events implemented to control the currency’s supply and value. The BEP95 update introduced real-time burning as well.
• Shiba Inu (SHIB). SHIB was developed without a burning mechanism and with a maximum supply of 1 quadrillion. To control this supply, creators later added burning mechanics to transactions. Moreover, Vitalik Buterin, creator of ETH, willingly burned 90% of SHIB tokens (with an estimated value of $6.7 billion) donated to him in 2021.
• Ripple (XRP). Ripple developers added a burning feature to their network as a means of preventing small spam transactions. The amount of XRP burned with every transaction is minuscule, but the numbers add over time. At the moment, around 11.7 million XRP tokens have been burned out of a maximum supply of 99.98 billion.

The Future of Burning Crypto

In the future, we might see a broader implementation of crypto burning, meaning more projects and currencies are going to leverage this mechanism due to its perks. As DeFi continues to grow and evolve, so does the need for stability and control among blockchain projects.

Modifications to current algorithms might fix some of the drawbacks and lead to their easier implementation. We could see the automation of processes using smart contracts, ensuring that the burning triggers without anyone’s interference under certain conditions.

The process could also be combined with other concepts in cryptocurrency, such as governance. Blockchains might develop where users would be able to vote by burning a portion of their assets to further promote dedication and long-term thinking.

On the other hand, token burning could face regulatory scrutiny that might slow down its progress. However, in the long run, regulation could result in an overall safer environment that could draw in a broader pool of risk-averse investors.

Key Takeaways

As we conclude today’s lesson, we can deduce that burning crypto is more than a mere blockchain process. It’s a potent financial tool used to regulate the internal economy, facilitate project longevity, and ensure its stability.

While there’s no clear answer to whether burning crypto increases the value of the remaining coins, that’s one of the main appeals that keeps drawing investors to these projects.

That makes it even more important to familiarize yourself with the concept and increase your chances of making lucrative investments. Best of luck navigating the DeFi expanse!