Burning a coin is the process by which developers and miners reduce the maximum Total Supply of a cryptocurrency by permanently removing a number of coins from circulation. The purpose of burning the coin reduces the total supply of cryptocurrencies, from which the price of the coin will increase due to the increased scarcity.
Similar to the stock market, Burning coins is like the issuer buying back their own stock thereby pushing the stock price higher due to the decrease in the number of outstanding shares.
Based on the law of supply and demand, the main purpose of burning coins is to balance the interests of the parties in the market.
How does burning coins happen?
Basically, burning a lot of coins on the blockchain platform is done by sending that coin to a dead address. At this wallet address, you can’t transfer or withdraw or use the coins or say how the number of coins has been disabled. The process of burning the coin takes place in the order:
- The owner of the digital currency will choose the burning feature, and confirm the amount of money they want to burn.
- After that, the Smart contract will automatically verify the validity of the request. To burn a coin, the user must have in the wallet a coin with more balance than or equal to the amount of coin he wants to burn. The number of coins indicated to be burned must be a positive number. If the above factors are not met, the money-burning order will not be executed.
- After the valid request is confirmed, the number of coins burned will immediately be deducted from the wallet and the total supply of the cryptocurrency will be updated later.
The money burned will be permanently destroyed and cannot be recovered. Traces of coin burnings are recorded and verified by blockchain explorer.
Is burning coins good for cryptocurrency projects?
The real answer depends largely on the nature of the project as well as the motives of the coin burner. However, overall, besides security concerns, the issue of inflation (falling in value) is a big problem for any cryptocurrency ecosystem, and burning coins will basically solve that. Especially when price fluctuations in the digital market are often much stronger than in traditional financial markets, this makes investors more hesitant when entering the Defi market. To clarify, let’s take a look at the common coin-burning mechanisms.
Buyback and Burn
As the name implies, Buyback and Burn is the company’s use of out-of-pocket money to buy back the tokens/coins it issued at a market price and then burn them. The outstanding benefit of this mechanism is to help the price of coins/tokens grow long-term and sustainably and increase confidence with investors.
By increasing trading volume and liquidity, Buyback and Burn to protect the price of coins/tokens from sharp fluctuations thereby increasing the stability of the asset value.
Typically, blockchains and protocols will set aside a cost of profit to buy coins/tokens and burn them. This process is planned from the outset or adopted by the community voting process.
This is a new Consensus algorithm that users (miners) rely on to destroy their coins/tokens to win mining rights. In the PoB mechanism, miners will invest in resources such as virtual mining machines (or virtual mining energy) instead of physical resources.
In essence, the burning of coins has helped users demonstrate their commitment to the network, thereby gaining the right to mine – authenticate transactions. Burning coins is representative of virtual mining energy. Therefore, the more coins burned, the greater the number of mining resources, and the greater the chances of authenticating the next block for mining will increase.
The difficulties of burning coins
The act of burning coins is spontaneous and not mandatory but is mainly carried out in projects that design and miscalculate tokenomics. In this case, the value of the coin/token decreased due to the effects of inflation, and the measure of burning the coin was taken to stimulate deflation, helping to balance the interests of the parties. However, the challenge is posed when implementing Tokenomics balance.
Basically, the burning of coins to balance prices is based on the principle of Supply and Demand in the market. When the supply decreases and the demand remains the same, the price will increase. A few scenarios may occur:
- Investors will limit buying when they see a constant price increase, which reduces the trading volume.
- Conversely, tokens created over a long period of time will also cause investors to limit buying to avoid taking on the additional risk of losses.
So, when burning coins, finding a balance between Inflation and deflation and redesigning tokenomics has never been easy for the project’s builders.
Challenges created for blockchain platform
Coins like Bitcoin, Cardano, Polygon,… The maximum total supply is fixed and limited, which means that when burning and permanently destroying those tokens, the supply will also be reduced.
In the long term, the price of coins/tokens is associated with the development of the whole ecosystem. As the total supply decreases, the transaction cost to be paid will be higher due to being calculated as tokens rather than fiat. High transaction fees will limit users from making transactions and this is completely unhelpful to the ecosystem.
Through the above analysis, it can be understood that burning coins is a reasonable option to combat the inflation of the coin/token. Especially when market sentiment is positive, the burning of coins will push up the price of coins/ tokens, creating a FOMO effect in the community.
Conversely, when the market is negative, burning coins reduces selling pressure through the buyback and burn mechanism. However, the permanent destruction of tokens in the long term can cause scarcity, and increase gas fees affecting the ecosystem
So, the burning of coins is spontaneous but also needs to apply a reasonable strategy (the number of coins burned, the nature of the coin, the market context) to optimize efficiency, Especially in the period when the crypto market is having a strong and diverse momentum as it is today.