Contrary to popular belief, an off-chain burn tax will end up detrimental for most parties involved. This brief piece outlines why I think off-chain taxes will likely not be adopted by major exchanges (and rightfully so).
Let’s open with two key thoughts about burn taxes in general:
- Burning does not create utility or price increases
Beyond speculatory purposes, a cryptocurrency gains value if it is in demand, ie. it can be used for something. There is a common misconception that reducing the supply of a cryptocurrency increases its price by default. This is only true if the cryptocurrency retains a steady or increasing quantity demanded, which cannot be assumed given a low-utility product such as LUNC. Burns only lead to price gains if they are combined with an increase in demand & utility, leading to the next point.
2. Burn taxes diminish utility
It is well-documented that economic taxes reduce the velocity of money. An economic transaction with a 0% tax will be more popular than one with a 1% tax. As such, if there are two competing L1s that offer the same product but have a differing fee, users will use the product with the lower fee. A chain that charges you 2.4% to interact with it will not be utilized by customers who aren’t chain loyalists. For a product to be successful, it must appeal to a mass consumer base and must be competitive.
Now, let’s think about why an off-chain tax could prove to be detrimental for both users and exchanges:
- Diminishing volume & interest
A tax on internal trades will reduce volume on the taxed pairs. Most market makers pay a maximum of 0.1% per transaction, so increasing this fee by 1,100% would heavily cut into their margins. Trading these pairs would be far less profitable for market makers. As a coin drops in volume, it loses ranks across several metrics and there is likely to be less interest in the coin overall. If market makers lose interest in a coin, there will be liquidity issues and normal customers will have a hard time filling size trades without slippage problems.
2. Competitor risks
If one large exchange implements an internal burn tax, they potentially stand to gain a few thousand low-value customers, but they would lose almost all of their high-volume traders. For market makers and whale traders, trading fees are price elastic, which means customers respond strongly to small changes. For example, if Binance implemented this tax, they would likely lose at least 15 out of their top 20 LUNC market makers to KuCoin, and vice versa. Put simply, any major exchange that implements this tax will be donating millions of dollars to their closest competitor.
3. Security risks
Assuming a hypothetical scenario where two or three major exchanges implement the off-chain burn tax at once, they open up their users to security risks from smaller exchanges. For example, if a group of popular exchanges such as Binance, FTX, KuCoin & Coinbase implemented the tax together, they would be incentivizing market makers to use smaller exchanges that still do not have the burn tax. Usually, smaller exchanges have a slightly elevated insolvency risk and have much worse liquidity. In general, it is safer to incentivize market makers to remain on safer platforms. This is done by keeping trading fees competitive.
4. Precedent risks
As proven by the aforementioned points, an internal burn tax is a loss-making economic transaction for large exchanges. There is currently a social media push for this tax to be implemented. If a major exchange implements a loss-making policy based on a social media push, even if all parties involved have good intentions, it would set a strong precedent for other groups — it suggests that if you spam an exchange enough on social media, they will provide donations or implement loss-making policies, which is not the correct precedent to set & will cause future problems by malicious groups looking to take advantage of the exchange’s goodwill.
Conclusion
While burning is good to reduce supply overhang, it should not be done at the expense of the coin itself. Adding an off-chain burn tax is likely to reduce volume, liquidity, and in the long run, prices, across the board. Major exchanges are unlikely to implement such a policy as it is both loss-making for them and unsafe for users. Even major exchanges with altruistic intentions cannot implement this tax for the safety of their users. The Terra Classic community should focus on the on-chain tax for burns & making on-chain systems more efficient instead of seeking to control external measures that will do more harm than good.
As a better solution, I would highly recommend a reverse stock split (by five zeroes) to undo the unit bias issue.
Thank you for reading my thoughts on the off-chain burn tax.
