February 20, 2023 - 9 min read
Tokenomics is essential to consider before investing in a crypto project. Ideally, a project should have a thoughtful design to incentivize buying and HODLing their native assets long-term, as failure to do so increases the likelihood that users will abandon the protocol after the token price pumps, dump the assets onto the market, and then leave the ecosystem to become stale. That is, poor tokenomics are unsustainable over the long term.
Building a proper ecosystem and incentive structure around its token distribution with users in mind means that the token value will not be inflated away through aggressive marketing tactics and other promotional schemes to draw in new users. A well-built platform will strike a perfect balance between driving demand higher over time while managing their inflation rates, sometimes even turning the circulating supply of the relevant asset deflationary.
Among many revolutionary features, perhaps the most appealing aspect here is the restoration of power to retail users. That is, that users of a given Web3 protocol become stakeholders in the project itself. By using the platform and exchanging value using the token, they collectively make the platform what it is, and therefore have a self-interest in its success. This is reflected in a method of managing a project’s tokenomics called token burning.
Below is a brief explanation of token burning, some pros and cons of its implementation, a few examples of how it has been applied, and some thoughts on the importance of tokenomics.
Essentially, token burning is a catch-all term which refers to the destruction or removal of a token’s circulating supply. There are different ways of achieving this, but the effects of token burning are basically that when there are fewer tokens available in circulation, the price for each token should go up, if demand remains constant. Hypothetically, if demand were to increase and tokens were also burned, this would cause the asset’s price to increase dramatically as the tokens are withdrawn from existence.
Of course, token burning usually takes place alongside token minting, so there are normally more tokens being created than there are being destroyed at any given moment. However, it is common for projects to create maximum token supply limitations, meaning that token burns have significant and lasting effects on projects: in the long term by decreasing the overall token limit, and by reducing the circulating supply in the short to medium-term.
As for short-term demand, an exciting new project can draw lots of attention and, consequently, demand for the project’s tokens. On the other hand, demand can fall quickly, and no amount of token burning can save the price from demand destruction. The demand aspect of the equation can create all sorts of price swings in the short to medium term, and so predictions are difficult to make despite the ability to influence token supply via burning.
Perhaps the most common way to carry out a token burn is for a protocol’s foundation to purchase a set amount of tokens on the open market and effectively remove the tokens from circulation. This is achieved by sending the tokens to a private burn address which cannot be recovered as the private keys to the burn address were never known and thus the tokens cannot be recovered. The term token burning was likely coined in order to easily illustrate the end result without much nuance.
Another method is to include a ‘burning mechanism’ into the protocol’s code as it pertains to token issuance. There is a transparency advantage to using a codified burning mechanism since the effects on circulating supply and thus inflation rates are more easily communicated through scheduled burn events.
The predictability derived from an in-built burning mechanism is favorable over longer time horizons in terms of price appreciation and usefulness as a means of conducting transactions. It has also become increasingly common, and often called for by token holders, that tokens are regularly burned at varying frequencies and volumes. Binance, for instance, burns tokens quarterly, which helps prop up the spot price of its BNB token.
The four main burning methods are: ICO burns, circulation burns (VeChain, Tron), out-of-circulation burns (EOS, Stellar), and gas fee burns (XRP, ETH with EIP-1559). ICO burns are typically done for unsold ICO tokens. The difference between circulation and out-of-circulation burns essentially boils down to whether or not the tokens were burned before ever coming into existence. Gas fee burns are written into the code and burn a small amounts of crypto along with each transaction.
In November 2021, Terra (LUNA) burned 88.7 million LUNA, and projects like Ethereum (ETH) have been burning tokens in real time following the implementation of EIP 1559. PancakeSwap recently burned $72 million USD worth of their token, CAKE, with regular burns being recorded on-chain. The frequency and volume of the burn amounts determine the significance of any effects on token pricing, but the demand-side variable confounds any analysis of the effects of token burns. Therefore, it must always be considered when discussing burn events and supply-side tokenomics.
Back in 2019, the Stellar Development Foundation (SDF) conducted a 55 billion XLM token burn worth nearly $5 billion USD in order to “become more efficient.” The coin saw a sharp increase in price in the days following the news, rising nearly 25%. Of course, token burning does not guarantee higher market prices as it only affects the supply-side of the tokenomics equation, and does not directly change demand sustainably. That sort of demand is developed organically through establishing a healthy ecosystem and network effects derived from growing user bases.
This is different from a stock buyback in that when the SDF burned their 55 billion XLM tokens, the foundation did not retain the tokens, but simply disposed of the tokens altogether. Secondly, the tokens don’t give holders equity in a company the same way as stocks do, like utility tokens, and therefore token holders don’t enjoy an increased share of ownership in a company and that company’s future cash flows.
When companies perform stock buybacks, the shareholder equity liabilities decrease, and the company’s cash is deployed in order to purchase the stocks. However, when a crypto firm conducts a token burn, it represents a decrease in both the circulating and total supply, without a corresponding offset of equity liabilities for token holders, meaning the company doesn’t consolidate power by acquiring an excessive amount of shares.
After all, token burns are effective mechanisms for taming inflation and even creating deflationary forces as the supply is diminished. As mentioned above, the token-burning process is irreversible and the tokens cannot be recovered, since the burn address uses unobtainable private keys. Users can also monitor the address using blockchain explorers, ensuring that the burned tokens never move from their final resting places.
In some cases, token burns have been conducted to fix accounting errors, as was the case for Tether. Tether Operations accidentally minted $5 billion in USDT on Tron’s blockchain and subsequently burned 4.5 billion USDT after missing a decimal point. Other projects have used token burning as security measures to guard against spam transactions and disincentivize DDoS attacks as well.
If not inherently clear, it’s already been demonstrated that thoughtfully designed tokenomics schemes are more sustainable long term. Web3 protocols offer interesting new vectors for creativity with regards to tokenomics design, allowing users to vote with their wallets and exercise autonomy over their finances.
As mentioned, Binance has committed to removing half of the total circulating supply of its native cryptocurrency via regular burn events. The number of tokens removed from circulation is automatically calculated according to what it calls its Auto-Burn formula. The burn mechanism was introduced in Q4 of 2021 and attracted a lot of attention from investors intrigued by the supply-and-demand implications coming from such a policy.
Prior to the auto-burn design, BNB burn events were reflections of the tokens’ usage and revenues derived from Binance’s exchange. At popular request, the new mechanism offers a more transparent, objective, and decentralized process. This of course echoes a popular theme of Web3 culture: decentralization of the process and a trust, but verify attitude towards transparency. It’s notable to mention that in addition to Binance’s auto-burn mechanism, BNB tokens are also burned in real time via the design of Binance Smart Chain’s gas fees.
Control of a currency’s circulating supply has traditionally rested with regulated, central authorities. That has been increasingly changing, though history has demonstrated that innovations in finance happen when trust in banking institutions wanes and inflation rears its ugly head.
Fortunately, Web3 offers founders, early investors, employees, developers, node operators, enterprise businesses, entertainers, artists and retail users alike opportunities to leverage value from using and impacting an ecosystem in which they hold a token, and thus have a stake in perpetuating the token’s value and utility.
Tokenomics, and specifically token burning, uses circulating supply as a vector to impact the value of its users and token holders’ stake in the ecosystem. Token burning also directly rewards early and long-term adopters in that early users of a given platform were able to access a more liquid supply, hypothetically.
Token burning is not simply the destruction of tokens or a buyback of stocks as the corporate world commonly conducts, gobbling up all of the company’s stake from its shareholders with cheap debt. Rather, it is a movement in which users of a protocol will have a more harmonious relationship with founders and top stakeholders in that the benefits of the system are more transparently fair.
If this is allowed to perpetuate, we will witness a burst of useful and thought-provoking Web3 projects engage in a race to understand tokenomics design. The free market will have plenty of options to choose from, and it should be exciting as people vote with their wallets.
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