There is a strange phenomenon popular with cryptographic protocols. People have dedicated their lives to accumulating decentralized assets in the hopes of one day becoming immensely wealthy when the value of their tokens skyrockets. Why then do some protocols “burn” these tokens – permanently remove them from circulation – by the millions or billions, when their creators could just as easily hoard them and become rich themselves?
The explanation for this practice, known as buyback & burn, relates to a simple element of economic theory: supply and demand. The less there is of something, the more people want a piece of what's left.
Supply and demand explain why you'll jump for that slice of cake when it's the last one left on the deli counter, and why you might even pay more for it. This function of economic psychology is also precisely why cryptocurrency protocols collect their tokens from secondary markets and then burn them – to increase demand for what is left and drive up the price of the token.
What is burning?
Technically, burning involves sending a token to a wallet that can only receive tokens. This means that these wallets, which are one-way, cannot spend tokens; these tokens can be considered permanently withdrawn from circulation.
Of course, you need to check that the tokens are indeed one-sided. Shiba Inu considered that the tokens were burned because they were sent to the dusty wallet of Ethereum inventor Vitalik Buterin. Buterin then donated tokens worth billions of dollars. to charities which has alleviated the suffering endured by Indians during the coronavirus pandemic. The token crashed on the news.
How about redemption and burning?
Buyback & burn refers to a program that buys tokens on the open market and then sends them to these one-way wallets. The buy-and-burn principle is similar to a stock buyback – where a public company repurchases its shares on the open market; he believes that by reducing the circulating supply of this stock, he increases the demand for what remains in circulation.
It’s up to the project to figure out how to raise that money. But where do crypto networks get the money from? Most buyback and burn tokens burn profits.
FTX Token (FTT), the trading token of crypto exchange FTX, buys FTT from its own exchange with a third of all the money the exchange brings in via fees (with a few exceptions including promotional discounts) .
Then the exchange burns them. This ensures that the price of the token is artificially supported by trading fees and that the exchange always has money in the bank to purchase these tokens.
Binance has long burned its exchange token, BNB. As of April 2022, it has burned approximately 1.8 million tokens, the equivalent (at April prices) of approximately $742 million.
Binance used to self-determine how many tokens it burned – this reflected Binance's usage and revenue, but it was unclear exactly how.
In the last quarter of 2021, Binance moved to an automatic burning system. Called auto-burn, it aimed to make burns “objective and verifiable”. The burns would no longer depend on the success of Binance, but rather on the price of BNB, which Binance interprets as the supply and demand of the token.
Alpaca Finance adopted a different type of buyback and burn mechanism: using 4% of all liquidation fees to buy back ALPACA tokens and then burn them. About half of a borrower's interest charges from the reserve pool are also burned.
It may seem odd that a company would burn tokens while simultaneously trying to increase the value of that token (often indirectly, through a decentralized community).
But a 2019 academic paper titled “Tokenomics and Platform Finance” noted that the ideal situation is that the “entrepreneur” can simultaneously “mine tokens as dividends,” such as by donating transaction fees to a community treasury . Thus, artificially increasing the price of tokens while earning dividends from the protocol “is an incentive-compatible reward system for the founding designer.”
Other deflationary mechanisms
Burning tokens is a deflationary element of monetary policy. This reduces the number of tokens available. This may also be disinflationary: the number of new tokens produced by the network could still exceed those burned, but the protocol's tactics could have a considerable impact on this growth.
But purchasing tokens is not a prerequisite for conducting a token burn. Sometimes the protocol or founding team already owns the tokens. When the Nervos Network launched its coin, CKB, it immediately burned 25% of its initial supply of 33.6 billion, significantly reducing its supply. The network did not need to purchase these tokens in advance.
This was at launch – in October 2019, Thorchain announced plans to burn half of the initial maximum supply via “use or burn,” a mechanism that burned tokens that the community had not allocated elsewhere. These were community-owned tokens – “use or burn” incentivized them to put their money to work, increasing the value of the token by adding utility or choosing to let them burn tokens to artificially increase the price of the token by reducing its supply. and thus increasing the demand for the remaining tokens.
Ethereum took another route via EIP-1559, an Ethereum upgrade that burned tokens instead of giving them to miners. The idea was that by burning tokens, the network would make gas fees more predictable. It would also incentivize miners to terminate their services before the network transitioned to what was then known as Ethereum 2.0 – a suite of upgrades to Ethereum aimed at helping the network run faster.
EIP-1559, introduced in August 2021, did not make the network deflationary; the number of coins created by proof-of-work mining always exceeded the number of coins burned. But this has limited the growth of new coins. In its first year, EIP-1559 burned approximately 2.7 million ETH.
NFT projects may also burn tokens – occasionally, for artistic value or to prove a point. An NFT collection called WZRDS has decided to allow NFT holders to burn listed NFTs at low prices. The idea was to punish NFT holders for “flipping” NFTs – selling them for a quick profit at a price slightly higher than they were purchased for.
Those whose NFTs were burned following the introduction of the new mechanic received Half-Skull of Wizard NFTs. Since July 12, when the specialized publication The Defiant broke the storythese new NFTs sold for just 0.17 – the originals sold for 3.2 ETH.
And their corollary: inflationary mechanisms
The opposite of buyback and burning is token inflation, in which the number of tokens in public circulation increases over time. As the real world has pointed out, through the inflation of currencies like the US dollar and the euro, inflation reduces the purchasing power of an individual currency unit.
But in crypto, inflation is necessary to keep decentralized players, like miners, interested. This is why, for example, the Bitcoin protocol mints new coins every time miners produce the “blocks” that make up the Bitcoin blockchain.
This increases the supply of new Bitcoins but simultaneously motivates miners to process transactions. Of course, this hasn't hurt Bitcoin's price: the coin went from virtually $0 in early 2009 to a high of around $68,000 towards the end of 2021.
In other cases, a protocol's community may vote simply to increase the maximum supply. This is what happened with Yearn Finance, which voted in February 2021 to increase the supply of the decentralized finance protocol token, YFI, by 20%.
The expansion of the offering was designed to reward key contributors to the protocol; 33% was reserved for de facto employees and the rest was paid into a community treasury, according to report by CoinDesk.
Does buyback and burn work?
The argument for buyout and burn is pretty simple. Philipp Schulz, partner of the INVAO Group, described the countless theoretical advantages in a 2019 blog post.
It said the buyback and burn programs “support the growth and price stability of the token’s value once listed for secondary trading,” result in “increased liquidity,” “lower price volatility” and “are incentivizing long-term growth investors to HODL the token, further adding to the asset’s price stability. This sounds great, but INVAO's token, IVO, is literally worthless.
There aren't many studies or analyzes on the effectiveness of buy-and-burn. That said, BNB, one of the largest cryptocurrencies, used buyback and burning and became one of the top five largest cryptocurrencies in 2022. Of course, a correlation is not a correlation .
So what about stock buybacks, the closest analogue? It's hard to say for sure if they work, but it's clear they're big business.
A Harvard Business Review report found that S&P 500 companies spent more than half of their profits, or $2.4 trillion, on buybacks between 2003 and 2012. Supporters say they help shareholders by making raise prices, although those against the idea believe the money could be better spent on growth than on artificially raising prices.