As inflation is hitting record levels across major economies worldwide, controlling the supply of assets is becoming a more critical issue than ever.
If the supply exceeds the demand for an instrument, it will decrease in value. On the contrary, the asset will grow in price when the demand surges and the supply falls or stays at the same level.
Central banks leverage a variety of policies and tools, such as the Fed funding rate (or central bank interest rates outside the US) and yield curve control, to increase or contract the money supply and ensure their economy’s stability.
In the crypto space, digital asset projects have access to coin burning, a mechanism that offers an easier and more direct way to control the supply of their tokens.
But what is coin burning, and how does it work? Let’s find out together in this article!
What Is Coin Burning?
Coin burning refers to a deflationary mechanism in which a part of the token supply is removed from circulation. As a result, the circulating supply of the cryptocurrency decreases, which can facilitate an increase in value in case it is combined with favorable dynamics in terms of demand.
Like fiat currencies and even scarce assets like gold, most cryptocurrencies feature yearly inflation rates to maintain their ecosystems’ growth and provide economic incentives – for example, rewards for yield farming, playing Play-to-Earn (P2E) games, or staking native tokens as validators.
This means that projects mint new coins every year, which increases its new flow of supply and also the total supply (in most cases).
However, for holders, high inflation is definitely not a favorable scenario. If the supply of a coin increases at a rate that is higher than the growth of demand, it will lead to a significant fall in the asset’s price. Axie Infinity serves as an excellent example here, where the massive inflation of the Smooth Love Potion (SLP) in-game currency – along with other factors – destabilized the Play-to-Earn solution’s economy and disincentivized players with diminishing rewards.
To keep inflation under control, crypto projects incorporate a deflationary component into their ecosystems that either limits or reduces the coin supply. This can be regular token burning or a mechanism like Bitcoin’s halving event that decreases the amount of BTC that can be mined with each block by half every four years.
In rarer cases, projects leverage coin burning for purposes other than economic incentives for holders. For example, DeFi lending protocols mint tokens (such as Aave‘s aTokens) representing the cryptocurrencies lenders supplied to the platform along with their earned interest. After redeeming them for the original deposit and the generated yield, the protocol burns the token it minted for the user.
In other scenarios, coin burning can be utilized to:
- Redeem crypto collateral by burning the decentralized stablecoins (e.g., DAI) minted by the user
- Redeem deposits and earned revenue by burning liquidity provider (LP) tokens
- Ensure the security and validate records in blockchain networks utilizing the Proof-of-Burn (PoB) consensus mechanism
- Stabilize the price of algorithmic stablecoins via native cryptocurrency burning and minting
- Avoid spam and protect against DDoS attacks by burning transaction fees or a specific amount of tokens with each transfer
How Does Coin Burning Work?
Coin burning can occur in several forms across different cryptocurrency ecosystems. What’s common in all is that, in the end, a portion of a digital asset’s supply is moved out of circulation.
In its most basic form, a project simply decides to burn a specific amount of tokens from its reserves. In this case, developers allocate the coins meant to be burned in the reserve wallet and send a transaction to an eater or burner address, an irretrievable public wallet that can be audited by all network nodes but remains perma-frozen. This is also the method Ethereum co-founder Vitalik Buterin used to burn $6.7 billion of Shiba Inu (SHIB) tokens last year.
To automate (and potentially decentralize) the burning mechanism, smart contracts can be leveraged with the following steps:
- The cryptocurrency protocol initiates the burn function, which indicates that it seeks to burn a specific amount of coins.
- The smart contract verifies whether the protocol’s wallet has enough coins to execute the burning process.
- In case there are enough tokens in the wallet, the contract will execute the function call and move the assets to a burner address to remove them from circulation.
- The contract will include proof of burn in the transaction, so it can be easily verifiable on the blockchain.
Similar to how publicly-traded companies repurchase their stocks, a project’s coin-burning mechanism can also incorporate buybacks prior to moving tokens out of circulation.
In such a case, instead of using its own reserves, treasury, or other ecosystem funds, the project buys back a specific amount of tokens from the open market (e.g., cryptocurrency exchanges) from sellers to burn them via any of the processes mentioned above.
Most importantly, the coins that have been moved to eater addresses are impossible to recover, which means that they stay out of circulation forever.
Coin burns (or buyback-and-burns) can happen either on an ad-hoc or regular basis. Regarding the latter, many projects set a specific condition (e.g., burn 50% of the platform fees earned in the native token) for regular crypto burning.
The Ultimate Tool to Control the Token Supply
Coin burning is an essential tool for crypto projects to keep their native tokens’ inflation under control, incentivize holders and stakers, as well as maintain the stability of their ecosystems by moving a portion of the supply out of circulation.
In other cases, this mechanism can also be utilized for block validation via the PoB consensus algorithm, achieving price stability for stablecoins, and redeeming underlying assets via DeFi protocols.
While coins are not literally burned but instead moved to a perma-frozen and unaccessible eater address, burning can be implemented in several ways. AAX, for example, used the fees collected on its future markets to do regular buyback-and-burns for its native AAB token.