Is Token Burning a Value Driver?
Do the destruction of Bitcoin and all other cryptocurrencies sound like the worst idea ever? Well, it’s not as terrible as it sounds and the burning or destruction of cryptocurrencies is actually quite common.
Since almost all cryptocurrencies have a limited total number, burning cryptocurrencies actually causes an increase in the value of the coins that have been left behind. Taking the example of the Bitcoin, only a total of 21 million Bitcoin can be mined, and so far, we have 16.7 million in circulation. Now, if 1 million Bitcoins will be burned and demand remains the same, there will be a decrease in supply and an increase in price.
The flipside, of course, is that by burning my cryptocurrency I obliterate my own value. Suppose I own 1,000 Bitcoins and I choose to burn all of them, there will be a marginal increase in the value of Bitcoin, but I will have lost my Bitcoin.
So what’s the motivation for burning cryptocurrencies?
The New Dividend
As a way of investing in their own company, Iconomi platform issued its own cryptocurrency known as ICN. Anyone who owns ICN automatically becomes a shareholder or part owner of Iconomi platform which entitles you to share in the profits of the organization based of course on your percentage of ownership.
Sharing in profits is traditionally paid via dividends; however, major legal concerns surround the crypto space so Iconomi found a creative and unique way of paying out dividends. Depending on how much profit the Iconomi platform makes, the company buys ICN on a continuous basis from the market and burns them. Once burned, the value of ICN crypto increases because scarcity has been created. ICN holders, on the other hand, visibly see an increase in the value of their coins. So, in place of dividends, ICN rewards its shareholders by increasing the value of their holdings.
New Coin Creation
Cryptocurrency burning can also be justified by the fact that newly created tokens get their values following the burning of existing cryptocurrencies.
During the creation of a new cryptocurrency, the developers generate its value from literally nowhere. During the creation of a new currency, any interested party will invest in it by sending Bitcoin or Ethereum usually to the developer of the currency. These cryptos can be stored or sold by the developer. On the other hand, the investor, by investing in the new crypto creates demand for it, and value is attached to the new cryptocurrency. A similar value is also passed on to the developer which in turn doubles the total value of the crypto in the market.
When the developers burn the received investment, they essentially transfer value rather than create it because burning cryptocurrency creates scarcity, and should the Bitcoin demand remain unchanged, the value of a Bitcoin will rise. So, the increase in the value of Bitcoin is the basis of the value for the new cryptocurrency.
Counterparty implemented this principle during their ICO. A Bitcoin address that was unusable and unspendable was created by Counterparty developers where ICO investors could send their Bitcoin. This meant that the developers could not claim the Bitcoin received and these Bitcoins could never be used again. The process of address creation and Bitcoin burning was completely transparent and could be viewed online. Counterparty used the proof-of-burn method to burn the Bitcoins. By doing this, they were able to foster trust since they couldn’t gain from the ICO and there would be no temptation to sell the Bitcoins received and retired happily in Fiji.
Transaction Fees
Paying for transactions is yet another way of burning cryptocurrencies. Ripple cryptocurrency is using this tactic. Ripple burns a small amount out of every transaction carried out. In this way, there are fewer Ripple cryptos in circulation, which will naturally drive up the price and the Ripple network benefits from the use of Ripples since you will be using them to carry out the transaction. The transaction fees paid to end up benefiting the entire Ripple network and not just one party or miner.
Getting Rid of Unsold ICO Coins
During an ICO (Initial Coin Offering), there will be a set number of coins to be sold placed by most ICOs. There are times when ICO coins are not completely sold at the end of the ICO, and these coins find themselves in the company’s wallet. Since the ICO leads to an increase in the value of the coin, the company is then deemed to have received free money, and it can easily sell off the outstanding cryptos on the market making a good profit from them.
There are ICOs that enact the policy of burning unsold coins following an ICO. Neblio is one of these companies. Neblio kept their promise and burned all the coins that hadn’t been sold at the end of their ICO. By doing so, Neblio only used the value obtained from the genuine sale of their crypto in the development of their blockchain application. As a result, the income of Neblio’s ICO was rooted in the real demand for their crypto.
Burning Cryptocurrency and Proof of Burn
The burning process usually involves sending crypto coins to an invalid address. This invalidity makes the address inaccessible and unusable. The same thing can happen should you send Bitcoin to a non-existent address on the blockchain. Your Bitcoin would be forever lost in cyberspace.
Proof of burn method was developed as a way to prove to investors that cryptocurrencies have genuinely been burned. This method uses the same reasoning that blockchain technology uses, i.e. that trust can be ascertained by the system without having third parties verify actions. Proof of burn offers practical and untampered evidence to anyone interested that the cryptocurrency has actually been burned.
Cryptocurrencies are continuously rising in value, and it’s not advisable to burn by yourself. This is something that should ideally be left to crypto-issuing companies since it gives them a way to justify value creation in addition to paying for transactions and dividends to their investors.
Whenever a crypto company declares that they will burn cryptocurrencies, it’s important for you to ensure that they are using proof of burn method and then follow through with the process.
Why Should You Care?
Now, let’s look at how cryptocurrencies are valued. What are the reasons behind the fluctuation of cryptocurrency value? Cryptocurrency is driven by demand and supply. When a lot of people want the token (they create high demand), they will compete against each other to purchase it, and this drives up the price.
But what happens when tokens are plenty, and there’s enough for everyone? High supply means there’s almost no competition for the tokens which will lead to low pricing and a possible decrease in value. Burning half the tokens will lead to a decrease in total supply which will lead to high demand-low supply dynamic which will push up the price.
Token Valuation
The terms used in the understanding and valuation of tokens are largely copied from stock market/equity valuation regardless of the fundamental differences between equities and tokens. Often, we will refer to both equity and token’s “market cap” as the number of tokens or shares in distribution multiplied by the token or share price, however, this similarity only serves to confuse the essential differences between the two assets which lead to misunderstanding, confusion, and mistakes when it comes to crypto valuation.
Equities stand for the legal ownership in a company while tokens denote the currency used for the payment of a specific utility in an underlying platform, protocol or ecosystem. What this means is that the valuation of equity only requires an analysis of the company and its capacity to generate cash flow since we possess legal claim on the company’s cashflow by ownership. Valuing a token, on the other hand, requires looking at the demand and supply for the underlying protocol as well as the token’s economic model to ensure that the pricing of the token is connected to the demand for the core protocol.
The Difference Between Equities and Tokens
- What is Equity?
When a person owns equity, also referred to as a share or stock, it means that they own a percentage of the company that’s represented by that stock. This ownership is legally recognized and affords equity holders certain rights that are enforceable in a court of law. Possession of equity grants its owner the legal claim to a part of the company’s cash flow which can take the form of frozen cash flows, i.e. assets or actual cash flows like dividends.
Valuing an Equity
Legally, equity stands for ownership in a company and allows the owner to lay claim to the company’s cash flow. That is why the valuation of equity is solely based on the company’s capacity to produce cash flow. When a company has positive earnings or is making a profit, an investor will look at the price to earnings ratio of the company, which in other words is the price paid for the company’s cash flows. In the event of negative earnings, an investor may choose to either consider the magnitude and probability of future cash flows or look at the assets of the company particularly “frozen” cash flow which can be unlocked — willingly or forcefully. In each case, the primary valuation metric used by the investor will be the company’s ability to produce cash flows. A quick note here is that venture capitalists usually look at the probability of future cash flows while value investors look at frozen cash flows.
Revenues can capture the attention of an investor as long as they show the company’s ongoing cost composition in such a way that the investor can determine the ability of the company to make a profit on those revenues in the future and generate cash flow for shareholders. Revenues are seen as value created by the company while profits/earnings are values captured by a company
- What is a Token?
Tokens don’t represent any form of ownership in a company. Actually, a token may not even have an underlying company. Broadly speaking, tokens represent the currency used to make payments for specific utilities in an underlying platform, protocol or ecosystem powered by them. More specifically, some may have certain uses as in the case of a protocol — such as Ethereum’s gas fees which are used to pay for transaction processing or in a project’s ecosystem where tokens can work as a medium of exchange, i.e. PowerLedger’s POWR tokens. POWR can be used to purchase and sell energy on the platform. Ideally, tokens can be used for both purposes.
Valuing a Token
Having established that a token represents currency or utility in the protocol, it’s very important that its valuation is based on the demand and supply for that particular protocol. However, this is not enough. The value of the token shouldn’t be dependent only on demand for the protocol, but rather on the degree of association between the demand for the token and demand for the protocol. This is because; unlike equity, tokens don’t entitle their owners to any legally recognized ownership of the core protocol.
Conclusion
Depending on the scenario, coin burning or proof-of-burn has many applications. Several cryptocurrencies out there have executed the proof-of-burn directly to avoid token sales or ICOs.
We cannot forget the likes of Binance (and other crypto-issuing companies) who purposely burn coins every so often to reward token holders.
We’re all for coin burning, and we hold on to some coins/tokens that execute some form of burning every now and then since we’re almost assured of a decent return.
