Central banks have a way to limit supply of the money in circulation, and this is also possible with cryptocurrencies. Some tokens have a limited supply — i.e. Bitcoin will top at 21 million coins — and there is also a way to burn cryptocurrency to control the supply.
Coin burn assumes sending some coins to a public address from which those particular coins can never be spent because the private keys of such an address is unobtainable. This effectively makes these coins “lost,” as no one can get to access them.
What is the purpose of coin burn?
No matter how crazy it sounds, coin burn does have its purpose. It could be used for things like:
- Making new coins (proof of burn)
- Rewarding coin holders
- Destroying unsold coins after an ICO or token sale
For all those purposes, the public address where coins are burned should be known to all parties who could review the coin burn transaction(s) on the blockchain. Before we delve into details let’s clarify what Proof of Burn is.
From Bitcoin Wiki:
Proof-of-burn is a method for distributed consensus and an alternative to proof-of-work and proof-of-stake. It can also be used to bootstrap one cryptocurrency off of another.
The idea is that miners/participants should show proof that they burnt some coins i.e., sent them to a verifiably unspendable address. This is expensive from an individual point of view, just like proof-of-work, but it consumes no resources other than the burnt underlying asset. To date, all proof-of-burn cryptocurrencies work by burning proof-of-work-mined cryptocurrencies, so the ultimate source of scarcity remains the proof-of-work-mined “fuel”.
Now let’s take a look at coin burn use cases:
Creating new tokens
Some cryptocurrencies, like Counterparty cryptocurrency (XCP), were neither mined nor sold in an ICO. Rather, they were created using a proof-of-burn method, in which a certain amount of other cryptocurrency (say bitcoins) were sent to an unspendable address, and in exchange new tokens were generated on the same blockchain.
This method is used to avoid pre-mining or ICOs and also to reuse the energy which is already spent in mining the original cryptocurrency.
Rewarding token holders
By burning tokens the overall token supply is controlled, thus users get to benefit from an increased value of the tokens they are HODLing.
Owning a cryptocurrency won’t get you any dividends, but you do get to be rewarded when your virtual assets appreciate in value. And so some cryptocurrencies include a system that creates scarcity to financially incentivize users by burning tokens on a regular basis.
For instance, the cryptocurrency exchange Binance burns BNB tokens every quarter.
Maintaining fair-play after a token sale
A somewhat similar scenario takes place after ICOs or other token sales if all tokens designated for the sale are not sold. Here, coin burn is employed to maintain fair-play.
Generally speaking, tokens appreciate in value after an ICO or token sale. And if not all coins are sold, the company offering those coins gains an unfair amount of free money which they can get by selling the remaining tokens in the free market at the appreciated price.
To keep things fair for all parties, the unsold tokens are sent to an unspendable address.
Coin burn makes perfect sense for some cryptocurrencies and some scenarios. If you are eyeing to invest and experiment with a new cryptocurrency, you may want to ask whether it employs coin burn and invest accordingly. Generally speaking, rare things cost more, and coin burn makes sure that some cryptocurrencies are worth more than the other. Do remember that next time you want to invest in some new token. 😉