Coin Burn as a Business Strategy and Consensus Algorithm
Coin Burn represents an unconventional mechanism for creating and transferring value, distributing digital wealth, forward-thinking investment, and offering an alternative consensus algorithm, Proof-of-Burn.
What Exactly is Coin Burn?
Simply put, burning coins means sending these coins to a verifiable UN-spendable address. The coins will be permanently locked-up and can never be retrieved, or traded.
This address is termed as an “eater address” or as some like to call it a “black hole”, due to the fact that the keys of this address are not obtainable by anyone.
The coins don’t vanish, yet they are not usable by anyone including their previous owner.
The process of burning coins works in the same way as sending any transaction over the blockchain.
This is to ensure that the coin holder is really holding these coins and that they have the amount they want to burn.
Once the coins are sent the transaction gets verified and propagated across the blockchain.
This guarantees that the transaction is recorded and is viewable to everyone.
Once the transaction is added to the blockchain the coin’s total supply will be updated accordingly.
It is important to differentiate between two levels within the concept of Coin Burn.
The first level is part of a “business strategy” and known as Coin Burn.
Business strategy takes place at a higher level of the enterprise’s governance whether it be an ICO, an exchange, or a firm. It encompasses the enterprise’s vison, goals, values, and processes.
Therefore, it is located outside the blockchain, yet it is executed in it. In this regard, Coin Burn is a mechanism to achieve a competitive advantage.
The second level is the “infrastructure”, which is further divided into two sub-levels. The first sub-level is where Coin Burn is used as a consensus algorithm called Proof-of-Burn (PoB).
The second sub-level is where PoB is used as part of network security architecture to prevent a Distributed Denial-of-Service (DDoS).
The infrastructure level is embedded in the governance of the blockchain as its genesis resides at the protocol layer.
Level 1: Business Strategy
This level relates to the coin holder’s or the business’s higher goals and how it aims, through burning coins, to achieve growth, offer competitive advantage, create value, and gain investors’ commitment in the coin.
Business strategy, in this specific scope, will be discussed through the lens of:
The cryptocurrency market has four key metrics which are used to indicate the value of a crypto asset. These are: maximum supply, total supply, market capitalization and circulating supply.
Coin Burn affects these metrics by varying degrees. In the following paragraphs we’ll demonstrate the interplay between Coin Burn and these metrics.
Market capitalization, known as market cap, is considered to be the most important metric, which indicates the relative size of a crypto asset in the market.
It is calculated by multiplying the current price of a crypto asset by its circulating supply. Therefore, the second important metric is the circulating supply, which refers to the approximate number of crypto assets circulating in the market.
Burning coins will affect the number of circulated coins as the more coins get burnt the less will be circulated in the market.
This metric can be a guide if a crypto asset would appreciate, especially when coupled with an increased demand and proved utility of a coin.
Consequently, it is hoped that burning coins will increase a crypto asset’s market cap.
Maximum supply, as its name indicates is the maximum number of coins that will ever exist for a specific crypto asset.
Certain blockchains burn Bitcoin as a Proof-of-Burn consensus algorithm, increasing the scarcity of the coin in the market, and thus making it more attractive to investors.
This process has contributed to the rapid increase of Bitcoin’s value at the peak of the hype.
Total supply, according to marketcap, is the total numbers of coins that are in existence minus coins that have been verifiably burnt.
Total supply includes these coins which are HODLed, locked, reserved or can’t be sold. Based on this, total supply shouldn’t affect neither the price of a coin nor its market cap. With this in mind, coin burning doesn’t affect total supply.
The interplay between Coin Burn strategy and these three metrics above brings the issue of demand and supply and scarcity to the forefront. Burning coins is used to lower supply in order to create scarcity and increase demand. This strategy creates value by increasing the price of a coin.
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Coin Burn Vis-à-Vis Supply, Demand and Scarcity
Coin burn is grounded in the economic theories of supply and demand and scarcity.
Supply refers to the greatest amount of an item that is accessible in the present market.
While demand refers to the willingness of customers to buy an item at the set price.
As it has been argued above, when a coin is burnt it is taken permanently out of the circulation, which effectively means that there are less coins in the market.
Taking into consideration that there is a fixed maximum supply of a coin, investors should show more interest in the coin, resulting in more demand and consequently pushing the prices to higher levels.
However, this willingness to pay a higher price in a scarce coin is tightly connected with the utility of this coin.
Investors would be encouraged to HODL a crypto asset if they believe that the project behind this asset can deliver long-term value.
Another factor comes to play here is the psychological influence these theories have on investors’ behavior.
Coin Burn sends a strong message that there is a diminishing circulating supply of a coin. Investors place a higher value on coins that are scarce than on coins that are abundant.
Therefore, when a coin is perceived to be scarce it is demanded and valued more. Marketeers use the scarcity principle as a sales tactic to drive up demand.
For example, each quarter of 2018 Binance buys back and burns 20% of its BNB coin which has a maximum supply of 200 million coins till they reach 100 million BNB. Basically, Binance considers this as part of its business strategy.
The underlying reasons are to create more value for BNB by reducing the number of circulated coins, and thus increasing their price; creating the sense of scarcity; and sending a message to investors that Binance is rewarding coin-holders by sacrificing its own coin, hence increasing investors’ commitment to the coin and the project in general.
ICOs may resort to burning all coins that haven’t been sold by the end of the ICO. Employing such a tactic may result in increasing the price of the coin once listed.
However, this tactic has to do more with the ICO’s efforts to be transparent and keep good reputation by adhering to the declared percentage of the coin distribution in the whitepaper.
Level 2: Infrastructure
Blockchain infrastructure is the very base layer known as the protocol layer.
It is where the blockchain’s governance with regard to consensus algorithm and security, among other design elements, are laid down.
As discussed above, this level is divided into two sub-levels:
1. Proof-of-Burn (PoB) consensus algorithm
As explained above, PoB consensus is reached by burning coins through sending them to an inaccessible address where they are kept permanently.
This consensus algorithm is mainly used as an alternative to Proof-of-Work (PoW).
In PoW, the more is invested in mining equipment, the higher the chances to mine a block.
However, this comes with a high cost to the environment, energy, and financial resources.
Miners have to invest heavily and form mining rigs or pools to overcome mounting financial cost and algorithmic difficulty.
PoB consumes only the coins that are burnt in a process called minting as no real work is done.
Contrary to PoW, PoB doesn’t consume real world resources, overcoming the problems associated with PoW.
In PoB the miner needs to burn a certain amount of their own coins in order to mine the next block.
Sometimes these coins are natives to the blockchain such as with Slimcoin consensus algorithm.
Other blockchains require burning bitcoins in order to be able to mine a block or receive coins.
XCP is a good example where miners burnt bitcoins in exchange of the same amount of XCP.
Burning coins is compared to buying a virtual mining rig which entitles you to mine blocks.
Although PoB diverges from PoW in saving real world resources, they converge in their need for investing in the rigs.
Miners in a PoB blockchain need to invest heavily in burning more coins periodically in order to grow the size of their rigs, increase their chances in mining new blocks, and prevent their rig’s power from fading away.
PoB is thought to be a decentralized mechanism contrary to PoW which has become centralized as miners are creating mining pools.
However, this is controversial as miners in PoB can also form virtual “furnace” by investing collectively in the cost of burnt coins.
1. Network Security
A Distributed Denial-of-Service (DDoS) attack overloads the target’s system with requests generated by multiple computers or machines, creating a high-volume traffic beyond the handling capacity of the system.
For example, in 2015 bitcoin suffered a flood attack of transactions, leaving 80,000 bogus transactions in the mempool.
Experts claim that it took 2 years to clear out all these bogus transactions, during that period the confirmation time for block generation had dramatically deteriorated.
In order to overcome this security concern, blockchains such as Ripple uses PoB in its XRP ledger, whereby each transaction must destroy a small amount of XRP an equivalent of 0.00001 XRP or 10 drops.
This transaction cost increases along with the load on the network, making it very expensive to deliberately overload the network. The average daily coin burn in the network is 4 XRPs.
While the coins are completely destroyed, their benefit is extended to the entire ecosystem. This mechanism ensures that the network remains secure, agile and stable.
Further, this makes XRP scarcer and benefits all holders by making XRP more valuable.
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The mechanism of burning coins ensures that coins are taken out of circulation permanently by sending them to a verifiable UN-spendable address. This mechanism takes place at two levels.
A higher level as part of a business strategy – known as Coin Burn, which is designed outside the blockchain but is still executed in it. This strategy is followed by the crypto asset holder in order to achieve competitive advantage and create value to investors by burning their own coins.
The interplay between Coin Burn and crypto assets’ market metrics such as market cap, maximum supply and circulating supply, results in the coin’s scarcity due to the deficiency created between demand and supply provided that the coin has a strong use case.
The second level is the infrastructure. This is found at the base of the blockchain in the protocol layer.
This level relates directly to PoB consensus mechanism. This level is divided into two sub-levels.
First, PoB as a consensus algorithm which doesn’t consume real world resources unlike PoW.
The more the miners burn coins in virtual rigs, the higher their chances in mining a new block.
PoB can suffer from the same ills PoW has. It requires investing heavily in burning coins in order to be able to win mining privileges.
Further, miners can form “furnace”, as opposed to pools or rigs in PoW, so that they can pool financial resources to keep burning more coins and receiving bigger rewards.
The second sub-level is the security level. PoB is used to prevent DDoS by imposing a cost for each transaction request.
The cost of transactions increases as the load on the network increase. This ensures that it will be costly to a malicious party to use the network adversely.
Employing PoB in this context ensures that although coins are burnt during the process, the benefits are distributed on the entire ecosystem by keeping the network agile and secure, and increasing the value of the burnt coin due to scarcity.
DisclaimerThe writer’s views are expressed as a personal opinion and are for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
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