In the past year and a half, digital currencies have come to prominence in both the daily news as well as investor attention. There are still many prominent holdouts, but more and more investors are buying into the importance of digital currencies and blockchain technology. As a result, in just 12 months the aggregate value of all cryptocurrencies skyrocketed by more than 3,000%. The fact that some investors managed to get very wealthy very quickly off of the trendy new investment area has only fueled further interest in the space.

Even in the short time in which digital currencies have grabbed our attention, there have nonetheless been certain trends that have come and gone. Bitcoin was one of the first major trends in the cryptocurrency space; shortly after that, privacy coins like Dash and Monero seemed to be all the rage. Now, it seems that another procedure has become one of the trendiest parts of the digital currency world: coin burning.

Key Takeaways

  • "Burning" a coin, in terms of cryptocurrency, refers to sending an otherwise usable token (or fraction thereof) to an unusable account
  • The act of burning effectively removes tokens from the available supply, increasing its relative scarcity.
  • Proof-of-burn (PoB) is one consensus mechanism used to secure and validate a blockchain system that relies on the concept of burning and is seen as a more cost-effective method than popular alternatives.

What Is Coin Burning?

The term "coin burning" conjures up imagery of an investor taking a match to tangible currency. Of course, as digital currencies exist only in virtual form, that is not physically possible. Nonetheless, the idea is one that holds. Coin burning is the process by which digital currency miners and developers can remove tokens or coins from circulation, thereby slowing down inflation rates or reducing the total circulating supply of coins, according to the Motley Fool.

How is this accomplished? In the digital currency world, it is difficult if not impossible to control the flow of tokens once they have been mined. In order to remove tokens from circulation, miners and developers acquire those tokens and then send them to specialized addresses that have unobtainable private keys. Without access to a private key, no one can access these tokens for the purposes of using them for transactions. Thus, the coins become unusable and, for all intents and purposes, relegated to a space outside of the circulating supply.

Background of Coin Burning

Cryptocurrencies are not the first to discover coin burning as a concept. In fact, this process is highly similar to the idea of a publicly traded company buying back stock. Companies of this type use cash on hand to buy back shares of common stock, thereby reducing the total shares outstanding. This process helps to reinforce the value of those shares that remain in circulation and can also help to improve earnings per share; with fewer outstanding shares, the ratio of net income to shares becomes higher.

Coin burning hopes to accomplish a similar goal. By reducing the number of tokens in supply, developers and miners hope to make the tokens that remain in circulation rarer, and thus more valuable.

Proof-of-Burn

Proof of burn (PoB) is one of the several consensus mechanism algorithms implemented by a blockchain network to ensure that all participating nodes come to an agreement about the true and valid state of the blockchain network. POB is often called a POW system without energy waste. It operates on the principle of allowing miners to “burn” virtual currency tokens. They are then granted the right to write blocks in proportion to the coins burnt.

Iain Stewart, the inventor of the POB algorithm, uses an analogy to describe the algorithm: burnt coins are like mining rigs. In this analogy, a miner burns their coins to buy a virtual mining rig that gives them the power to mine blocks. The more coins burned by the miner, the bigger their virtual mining "rig" will be.

To burn the coins, miners send them to a verifiably un-spendable address. This process does not consume many resources (other than the burned coins) and ensures that the network remains active and agile. Depending upon the implementation, miners are allowed to burn the native currency or the currency of an alternate chain, such as Bitcoin. In exchange, they receive a reward in the native currency token of the blockchain.

You can send out transactions to the network that will burn your own cryptocurrency coins. Other participants can mine/burn on top of your block, and you can also take the transactions of other participants to add them to your block. Essentially, all of this burning activity keeps the network agile, and participants are rewarded for their activities (both burning their own coins and burning other people’s coins).

To prevent the possibility of unfair advantages for early adopters, the POB system has implemented a mechanism that promotes the periodic burning of cryptocurrency coins to maintain mining power. The power of burnt coins “decays” or reduces partially each time a new block is mined. This promotes regular activity by the miners, instead of a one-time, early investment. To maintain a competitive edge, miners may also need to periodically invest in better equipment as technology advances.

Practical Applications of Coin Burning

There have been at least two cryptocurrencies that have already attempted coin burning. Bitcoin cash has gained considerably in value heading into the spring. On April 20, cryptocurrency mining pool Antpool announced that it has sent 12% of the bitcoin cash coins it receives as block rewards for validating transactions to unobtainable addresses. Considering that Antpool validates somewhere close to 10% of bitcoin cash transactions, this is no small quantity of tokens. Antpool is thus slowing down the inflation rate for BCH, and this may be contributing to the massive growth bitcoin cash has experienced in recent weeks.

Before bitcoin cash got in on coin burning, though, Binance Coin (BNB) explored this strategy, as well. BNB is the official token of the Binance digital currency exchange; BNB is used to incentivize users, allowing them to pay for transaction fees in a staggered manner. According to reports, more than 1.8 million BNB tokens were burned in the first few weeks of the year. The process was repeated in April, with another $30 million or so of BNB burned at that time. So far, BNB has yet to see the same massive gains that bitcoin cash experienced, but it has nonetheless been a top performer among digital currencies so far this year.

Of course, there are massive risks associated with coin burning, too. First, burning coins is no guarantee that the remaining coins in circulation will gain in value. It does not necessarily even reduce the total number of tokens outstanding in circulation, as the supply of tokens in circulation seems to fluctuate considerably.

Bitcoin is an example of why coin burning may not work. Bitcoin is capped at 21 million tokens; some analysts believe that this cap helps to contribute to the value of BTC. Still, bitcoin has also created new types of tokens in several instances thanks to so-called "hard forks." This is how, for example, bitcoin cash, bitcoin gold, and other altcoins came to be. If bitcoin were to fork again in the future, even more tokens would be generated.

Notably, however, that while holders of the original token are usually granted new tokens in the process of forking, the newly issued token maintains its own, distinct blockchain and the new tokens are not the same as the old. Thus, bitcoin and bitcoin cash are two entirely different projects with different protocols, markets, and user communities.

Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns bitcoin and ripple.