Cryptocurrency: What is coin burning and why it should be a part of every investor’s calculus?
Spokesperson: Prof Krishna Prasad
Date: 3rd September 2021
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If you are new to cryptocurrencies, you must have been amused hearing about coin burn; wondering why someone needs to burn the coins? Well, let us explain.
Coin burn is a process where the miners and developers remove the coins from circulation. In other words, coin burn is a process of destroying the coin so that it is not available for further use (trading or otherwise). The developers and miners will send the coins to the specialised addresses whose private keys are not accessible. Further, they should provide the proof-of-burn algorithm to the market to facilitate cross verification.
Krishna Prasad, Associate Professor of Finance, T A Pai Management Institute, explained this with an example: Imagine a person having 10 notes of Rs. 2,000 and he/she decides to burn (literally) 5 notes. Once 5 notes are burnt, these notes cannot be used/accessed by anyone including the issuer. As cryptocurrencies are virtual and cannot be literally burnt, the miners/developers use digital means to make the coin unusable.
Coin burn is basically done to create a supply crunch, thereby creating an artificial upward pull for the token price.
Abhay Chebbi, Pro-Chancellor, Alliance University, said that in the real world, coin burn would amount to making a pile of currency coins or notes, and lighting a pyre to the pile. Coin burn in the cryptocurrency world is exactly the same albeit it is the burning of the cryptocurrency virtually. Each cryptocurrency network defines a protocol for accomplishing the burn but it amounts to associating the coins in circulation with unobtainable private keys so nobody can claim them to be theirs. Additionally, the event of a Coin burn itself is recorded in the ledger books so the burn is foolproof.
New Fad?
According to Edul Patel, CEO & Co-founder of Mudrex, coin burning is not a new concept. However, this has gained a lot of attention lately following the recent London Hard Fork upgrade to the Ethereum network. With this upgrade, around 3.17 ETH is being burned every minute. To put this into perspective, the average price of ETH over the past seven days was $3200. It means that more than half a million dollars worth of ETH is being burned every hour! Such news manages to grab eyeballs faster.
Why crypto creators burn their coin
Prof. Chebbi said crypto creators burn the coins in an attempt to increase the value of the coins that remain in circulation. It is not very dissimilar to what happens in the realm of Oil. “If the price of a barrel of crude oil drops because there is a glut in the supply and the demand is not commensurately high, then the oil-producing nations reduce the supply so the prices go back up again. The same dynamic of supply and demand is at play behind the process of coin burning,” he told FE Online.
Explaining further, Prof. Prasad said the regular currency (INR, USD, GBP etc.) is issued and controlled by the respective governments through the central banks. If the country issues excess currency it will lead to inflation (hyperinflation) as the supply of money is greater than the demand. On the other hand, if the country issues less currency it might lead to depression or contraction of the economy. Similarly, the excess supply of coins might result in inflation. As these coins are not issued or controlled by any single authority, the developers/miners burn the coins.
Almost all cryptocurrency networks have defined the protocols and mechanisms for coin burn. “Proof-of-burn” has become as integral a part of crypto talk as “proof-of-work” (which gives rise to coins being mined).
It is not necessary that all cryptocurrencies need to be burned. Only those with excess supply undergo this process.
Main Objective
“The primary objective of coin burn is to regulate the supply and thereby stabilize the price. The process is similar to demonetisation of currency or buy-back of shares. On June 25th Infosys Ltd. announced the buy-back 1.084 million shares. The objective here was to reduce the supply of Infosys shares traded in the stock markets. The earnings per share (EPS) of Infosys after the buy-back will increase which will in turn increase the share price. Similarly, when the inflation in country rises due to excess money supply, the central bank increases the interest rates. The person with excess cash will then deposit the money in bank, thereby, reducing the liquidity. This example is not exactly same as the burn process, however, achieves the same objective,” said Prof. Prasad.
When the developers/miners burn the coins, the number of coins available in the digital currency market reduces. As a result, the price of the coin will increase (at least theoretically it should).
Prof. Chebbi said a fundamental difference between the fiat currency and cryptocurrency is, fiat currency is inflationary in nature while cryptocurrency is deflationary. The reason for this is, the total amount of fiat money in circulation keeps increasing with time (through the instrument of debt, and printing of money by the Central banks). But, the total amount of cryptocurrency (for most currencies) in circulation has an upper limit — for example, in the case of Bitcoin, the target is 21 million coins. Therefore, the value of a unit of fiat money loses value over time (because of inflation), and in the case of crypto money when mining can no longer unearth new coins, a unit of crypto money will keep accumulating value (deflation). Even so, till such a saturation point is reached, the crypto promoters reckon the Coin burn is a good way to boost the value of cryptocurrencies.
Coin burn impact on market
Prof. Prasad said the outcome of coin burn is not yet been proved (as it is a recent phenomenon). However, theoretically the burn process should stabilise the prices/markets.
Prof. Chebbi also said that the jury is still out there on the impact of the burn process on the cryptocurrency market. In the immediate aftermath of Bitcoin’s last Coin burn, it did gain value. On the other hand, burning of BNB tokens didn’t fetch any appreciable dividends for that currency. “We think that the long-term stability and viability of a cryptocurrency market is driven more by the strength of that currency itself (such as the confidence of the investors in it and eventually its acceptance by the world as a medium of exchange). However, Coin burn does have a place in propping up the currency and for demonstrating the promoters’ commitment to the currency,” he said.
“The same way that different fiat currencies — the U.S. Dollar, Indian Rupee, the U.K. pound etc have their innate strengths, different cryptocurrencies be it Bitcoin, BNB tokens, or Ethereum have their own strengths. The impact of the Central banks’ policies (quantitative easing or tightening of money supply et al) on the stability of different currencies is not uniform. Extrapolating that to cryptocurrencies, we find that different currencies respond to Coin burn in their own distinct ways,” Prof Chebbi added.
Coin burn impact on investors
According to Prof Prasad, the coin burn process is very important for two reasons.
– First, the investors get the tangible benefit through improved valuation.
Second, the coin burn process signals the investors that the prices will be stabilized through self-regulation in the absence of regulators.
For example, when an individual stock hits the upper or lower circuit, the stock exchange (NSE or BSE) suspends the trade to allow the prices to stabilize. But this is not possible in the case of digital currency. Hence, the coin burn instils the confidence among the investors as it serves as a mechanism to stabilise the digital currency prices.
Study coin burn before investing
Prof. Chebbi said, “Unless you are hoarding Coins of any denomination (be it Bitcoin, BNE or others), you don’t want to burn the coins you own. Currently, only the promoters (for example Binance’s BNB tokens) burn some of their holdings so the people investing in their currency realize a higher value for their investments. If you are an investor looking to invest in crypto, you should study if Coin burns have happened for that currency and if there is a defined burn schedule.”
“It should be a part of your calculus while making investment decisions. In general, if Coin burns have happened and/or scheduled, it should give you more confidence that there are people invested in seeing that currency grow, and that would be a factor in its favor,” he added.