Is token burn a scam?
During the past two years there’s been a lot of talk around token burns on social media, YouTube, Reddit and other platforms. Token burning became such a hot topic because in the realm of altcoins, nearly all projects choose to use this mechanism and boast its benefits.
What is token burning?
Crypto coins and tokens are burned when they are sent to addresses with no owners also knows as “eater address”, such as 0x0..0000 on Ethereum Blockchain or 0x0..dead on Binance Smart Chain. When assets reach such an address they can no longer be transferred back to the circulation supply rendering them unusable, a state called “burnt” or “burned” in the crypto world.
The process of token burn is usually performed by the developers of the crypto asset and might have various reasons, the most common one being the so called “deflationary purpose”. In theory, a decrease in the circulation supply tends to drive the price of an asset upward due to its increasing scarcity.
Another important reason for developer teams to burn tokens is to maintain the price peg of stablecoins. This assets are a class of cryptocurrencies whose value corresponds to another asset, most often the U.S. dollar. When market makers want to acquire new stablecoins that aren’t yet introduced in the circulating supply, new tokens need to be minted. The vice versa applies when entities wish to sell out their tokens to its governing authority, not to the open market, this tokens need to be burned to maintain the ratio between the total value of the token and its underlying asset.
There are other legitimate reasons for burning tokens, some projects use token burns to avoid spammed transactions, other projects might use burning for fair governance. In Ripple’s case, the company burns fees from every transaction to remove the incentive to overload the system for a quick profit.
Why should I care?
Even if there are legitimate reasons for development teams to burn tokens, during the latest period, a lot of shady altcoins that many people bet on are starting to use token burns maliciously.
The story is always the same, it is a young project with few holders and exorbitant total supply, in excess of hundreds of billions of tokens that right after launch burn more than 50% of the total supply in one or multiple transactions, advertising the move as a pro deflationary process that will drive the price up and project get off the ground, promising immense returns for investors.
In theory, burning some of the circulating supply will increase the price because it is a product of supply and demand. But for a young project with few holders, and potential investors who are uncertain of its real potential of growth, a sudden decrease of supply in its early stages will most likely fail to drive the price up.
So why do developers do this? Most likely they want to hide the fact that they own a huge portion of the circulation supply. Most popular blockchain explorers present a list of holders ordered by their percentage of the total supply that they own, in descending order.
If you check the holders page and see that a huge percentage of tokens are burned, you will have to calculate for yourself how much the other addresses actually own in terms of percentage from the total supply.
For example, if a token has 90% of the total supply burned, and the creator wallet has 2%, you should consider that in reality, those 2% which might seem low account for 20% of the current circulating supply. If the developers are ill intended, those 20% can be sufficient for a so call “rug pull” that will most likely cause the value of the token to fall to almost 0.
Other scammers were even more creative, they’ve burned tokens to known people’s wallet addresses, most often Vitalik Buterin. This method brings two benefits, the first one is that the receiver of the tokens might bring attention to the matter and indirectly advertise the asset and start to increase its demand. The second benefit is a lot more important, the burn will increase the market capitalization and thus providing free advertising. Besides the psychological implications that a huge number will have over most unexperienced investors, most coin trackers order their assets by market capitalization, in descending order. Market capitalization is calculated as current price multiplied by circulating supply. Since the “burn” was performed to a normal wallet, not a well known eater address, the tracking websites will not account those tokens as burned and will use them in the calculation of the market capitalization. So if a project “burns” 90% of the tokens to a normal address the market capitalization will be 10 times greater than what it should have been if the tokens were transferred to an eater address, artificially bringing the asset to a higher position in the rank.
In conclusion, there are a lot of good reasons for tokens to be burned, but when you are willing to bet on a new altcoin that might seem to have a great upside potential, the burn methodology used by the development team and its reasoning are needed to be taken into consideration and if they don’t seem quite right, it might be the sign that you should search for another gem to invest in.