On the Importance of Burning Mechanisms in Crypto Currencies

Does the protocol have a burning mechanism in the smart contract? This is one of the most important questions for any currency in which you might consider investing.

If the ecosystem does have a burning component to the design this is a great thing! It means that the currency could be net deflationary (less and less supply over time) and thus designed to increase in price over time even if demand is decreasing!

Burning is New

Consider we have nearly every market in the world for nearly every asset in the world with both supply and demand rising! Take real estate for instance — demand from greater population growth means more homes demanded. Builders build more homes increasing the supply. Both are increasing yet prices still rise (because the USD is so inflationary), but perhaps also because demand is greater than supply especially in certain real estate markets. What I’m trying to say is even in traditional markets that have increasing supply prices tend to increase DESPITE that increasing supply.

For the first time in our world we have many assets (in the asset class of crypto currency) that have increasing demand AND decreasing supply!

You must take burning seriously! These apps could continue to operate for hundreds of years and there is NO LIMIT to how high prices can go (users will just need less and less quantity of the coin to do the same purchase). You will see a future where prices are generally falling in certain markets with no bottom. The currency decimal places go out 16 decimals!

What if My Coin Doesn’t Have a Burning Mechanism?

Lack of a net burning (net decreasing supply function), doesn’t imply the token is a bad investment, but it does mean that the future demand must be greater than supply and greater than demand currently. If you know supply is shrinking over time the currency could be a good investment even if demand shrinks too, because demand could still outpace (shrink less) than supply and thus be greater than supply and cause prices to rise. Therefore, a burning component that does result in a trend of decreasing supply (# of tokens in circulation) is a wonderful aspect for a currency to have for an investor. Don’t overlook its importance, but don’t let other coins go by simply because they don’t have a burning. There have been many many cases where coins shot to the moon despite not having good tokenomics simply because burning could out slowly

BNB — A Classic Example of a Burn Mechanism

BNB token for Binance has a net burn supply function: as users make trades they are charged trading fees, and if users pay that fee in BNB coin they get a discount, so nearly all trading fees are paid in BNB and BNB has a real user use case. As users run out of the BNB in their wallets they will buy more BNB, which drives the price higher.

Next as Binance receives those fees in BNB coin, it has agreed to burn part of it which means it will never come back and the BNB supply is permanently reduced. That is HUGE. That is real profit they are burning up. Why? Because they own a lot of BNB, and they want to create a nice dynamic for the investors of BNB (including themselves).

BNB Demand Side

It is reasonable to expect BNB token demand could substantially increase over time as more and more investors and traders come into the crypto currency space or even if they don’t — the current users just keep doing more trades which will still cause ongoing demand for users to keep buying more and more BNB coin. This is unlike ETH or BTC or many other coins. Most crypto coins are NOT consumed by users in the way BNB coin is. In a way, BNB is the first really great model for the first really great large exchange / app in crypto. The only downside is that BNB coin is not decentralized it is owned and controlled by Binance and this protocol (burning, max supply, etc.) could be changed by them anytime.

Why Isn’t Every Coin Making a Burn Function?

However, having a decreasing supply over time may not be functional given the purpose of the crypto currency and the role of the token in that ecosystem. For instance, Arthur Hayes has written that Ethereum needs to be slightly inflationary in order to work as designed. This may not be how it actually works in the short run as we have seen it turn deflationary as of late with the advent of ETH 2.0 and EIP-1559, changing the design of gas fees and transitioning it to a Proof of Stake (POS) consensus protocol.

Why else?

I also believe many coins were NOT invented to make the investors (holders) rich, but rather the creators of the currency (devs) rich, and they want the ability to keep printing more of their currency (like the fiat central banks). Yes they are designed scams like the USD. If you don’t understand that yet about the USD it’s time you did some research on how the Federal Reserve Bank was formed and how it works.

Price Increasing as a Result of Supply and Demand

Why do prices go up? Overall, it is because demand is greater than supply that means $ chasing to buy it is greater than $ chasing to sell it. Why does that happen? If the coin has a trend of continued new user growth, utility from locking it up in a way that prevents selling, then it is safe to forecast rising demand over time.

Kusama — Case for Increasing Demand Over Time

Let’s take Kusama (KSM) for instance. KSM token doesn’t have a burn function AND it doesn’t have a max supply — it can continue to be printed by the protocol.

However, how the token works is that other protocols (apps, tokens) want to build on that blockchain (substrate) because it has the same awesome security of Polkadot and substrate is massively scalable — great for large business enterprise applications like inventory tracking and supply chain management.

So, in order to get a lease for a parachain (something that is required for a protocol to be run on Kusuma), all these protocols (businesses behind other coins) have to buy KSM (or obtain it through crowd loans from investors that already bought it). Once obtained, they bid with it for being one of the few protocols to be accepted to obtain the parachain lease. If selected they agree to lock it up (the KSM they bought or borrowed) with Kusama while they hold their parachain slot.

Kusama — Commercial Shopping Mall Analogy

Think of a commercial shopping mall (Kusama) that requires all stores renting a space (other protocols) in the building to pay prepaid rent and lock it up on deposit with the shopping mall (KSM locked up). The shopping mall is Kusama and the currency in which they charge their prepaid rent is KSM.

The more parachains demanded the more KSM is locked up (effectively removed from supply). The demand of KSM will continue to rise over time if more and more protocols like using the Kusama substrate. KSM is also priced much lower than DOT and users (other protocols) can obtain nearly the same product / service with Kusama as they would if their parachain were on the Polkadot substrate, so we see KSM doing very well over the long-term.

University of Michigan Bachelors in Economics, Level II CFA and CMT