Why are Cryptocurrencies ‘Burned’?
Cryptocurrency is growing. With an estimated 320 million users worldwide – which is an average rate of 4.2% – the concept of digital currency is steadily taking over the public’s consciousness, leading to a market cap that is just over $8 billion compared to what it was five years ago – $100.1 billion in 2017 to $934.85 billion in 2022.
With this being said, cryptocurrency is still a bit of an enigma. For those who are not investors, the word alone seems to be a door to a world that is far too complicated, and even for investors, it feels almost impossible to understand all the ways in which blockchain works.
One of the areas that are easy to gloss over as “just a part of the process” is undoubtedly crypto burning. This is a phrase which is thrown around a lot on forums and network communities, but what does it actually mean? What is crypto burning? Why are cryptocurrencies burned, and what does it mean for your own investments? These are the questions that will be covered in this article, helping you to get a little closer to understanding an essential cog in cryptocurrency:
Crypto Burning Explained
Cryptocurrency is burned when a crypto community has decided they want – or need – to eradicate a number of tokens in order to reduce the total supply. To put this in traditional terms, the process is similar to a stock buyback, which involves a company buying back shares of a stock that it has issued simply to reduce the number of shares that exist in the market.
In terms of the process, it is not exactly as dramatic as the name suggests. All cryptocurrencies are created, bought and sold using blockchain technology. Blockchain itself is a decentralised network which is run and maintained by the users. When users trade coins, they do so by sending the tokens to and from various crypto wallets using private keys.
With this in mind, burning crypto is essentially sending tokens to a wallet which is designed to destroy them. In the crypto community, this is acknowledged as a “burn wallet” or an “eater address”, a place within the blockchain’s ledger which can lock up sent tokens and take them out of circulation. But why is this done, and what does it mean for your own tokens when a crypto burn takes place?
Stock To Crypto Similarities
One of the infamous reasons for crypto burning – and stock buyback for that reason – is to increase the overall value of the coin itself. Back when Bitcoin was created in 2009, Satoshi Nakamoto decreed that those who trade Bitcoin would have supply halved every four years, reducing the block reward for miners but effectively increasing the price of Bitcoin overall.
This is the classic rule of “supply and demand”, which is most notably attributed to gold and silver: when the supply decreases, the price will rise according to the steady demand.
When it comes to crypto burning, there are moments in time when crypto communities democratically decide to burn coins in order to manage the supply and increase scarcity. In many ways, this lends from the rule of “supply and demand” and Bitcoin’s programme to slash supply every four years, keeping the supply of the specific coin low – or as low as it needs to be – in order to keep the price stable.
Proof Of Burning
Another common reason for burning coins is the consensus mechanism, which involves miners purchasing and burning their tokens in order to mine within the blockchain. While it may seem a little counter-intuitive, these miners will receive rewards when they verify the blocks, meaning they are not necessarily losing out on their investment.
The reason this is done is to make the mining process cost-deficient, which avoids around 51% of attacks. If users buy crypto and then burn it just to become a user, service attacks are essentially raising the price of the coin – in tandem with “supply and demand” – as they are spending their money, buying coins on blockchain and then burning them to raise the value.
Proof of Burn (POB) is carried out quite regularly as it does not require too much computing power – which has been a thorn in Proof of Work (POW)’s side since the very beginning – and it guarantees the security of the blockchain network itself. Trustworthy users are essential for a healthy network and smooth transactions, which is why POB has become so popular.
Assisting The Networks
While there are a number of reasons why crypto burning is carried out, one of the other main factors is to assist the network that the cryptocurrency belongs to. For example, when Ethereum transitioned from POW to POS, it looked to burn just over $5 billion in tokens, according to the EIP-1559.
The reason it did this was that – before the merge – the total issuance of Ethereum was due to decrease by 90%, which would essentially make ETH a deflationary asset and ensure the issuance of the coin dropped below the burn rate. With the issuance low and the growth of adoption high, investors who trade Ethereum earn higher returns as the price would drive upwards due to the burn.
Another way in which burning has assisted networks is through keeping altcoins such as Tether and USD coin – which are known as stablecoins – pegged to their asset. Stablecoins are designed to be pegged to a fiat currency – for instance, one USDT is equivalent to one USD – and they do this by burning the supply when it is looking to move above or below the peg. When this happens, the protocol’s smart contract will automatically burn coins in order to drive the price back in tandem with the peg and ensure it remains constant. As mentioned previously, the sustainable nature of burning makes it an effective tool in this area, as it is crucial that stablecoins remain pegged to their chosen fiat coin.
If you have invested in a certain cryptocurrency, burning will almost always be a positive move for your investment. Whether it is to stabilise the mining process, drive the price up or assist in the maintenance of blockchain itself, burning is an effective method to achieve or maintain a goal for an entire network.