Cryptocurrency 'Burning': Can It Manage Inflation?

In the past year and a half, digital currencies have come to prominence in both the daily news as well as investor attention. There are still many prominent holdouts, but more and more investors are buying into the importance of digital currencies and blockchain technology. As a result, in just 12 months the aggregate value of all cryptocurrencies skyrocketed by more than 3,000%. The fact that some investors managed to get very wealthy very quickly off of the trendy new investment area has only fueled further interest in the space. Even in the short time in which digital currencies have grabbed our attention, there have nonetheless been trends which have come and gone. Bitcoin was one of the first major trends in the cryptocurrency space; shortly after that, privacy coins like dash and monero seemed to be all the rage. Now, it seems that another procedure has become one of the trendiest parts of the digital currency world: coin burning.

The term "coin burning" conjures up imagery of an investor taking a match to tangible currency. Of course, as digital currencies exist only in virtual form, that is not physically possible. Nonetheless, the idea is one that holds. Coin burning is the process by which digital currency miners and developers can remove tokens or coins from circulation, thereby slowing down inflation rates or reducing the total circulating supply of coins, according to the Motley Fool.

How is this accomplished? In the digital currency world, it is difficult if not impossible to control the flow of tokens once they have been mined. In order to remove tokens from circulation, miners and developers acquire those tokens and then send them to specialized addresses that have unobtainable private keys. Without access to a private key, no one can access these tokens for the purposes of using them for transactions. Thus, the coins become unusable and, for all intents and purposes, relegated to a space outside of the circulating supply.

Cryptocurrencies are not the first to discover coin burning as a concept. In fact, this process is highly similar to the idea of a publicly traded company buying back stock. Companies of this type use cash on hand to buy back shares of common stock, thereby reducing the total shares outstanding. This process helps to reinforce the value of those shares that remain in circulation and can also help to improve earnings per share; with fewer outstanding shares, the ratio of net income to shares becomes higher.

Coin burning hopes to accomplish a similar goal. By reducing the number of tokens in supply, developers and miners hope to make the tokens that  remain in circulation rarer and, therefore, more valuable.

There have been at least two cryptocurrencies that have already attempted coin burning. Bitcoin cash has gained consderably in value heading into the spring. On April 20, cryptocurrency mining firm Antpool announced that it has sent 12% of the bitcoin cash coins it receives as block rewards for validating transactions to unobtainable addresses. Considering that Antpool validates somewhere close to 10% of bitcoin cash transactions, this is not a small quantity of tokens. Antpool is thus slowing down the inflation rate for BCH, and this may be contributing to the massive growth bitcoin cash has experienced in recent weeks.

Before bitcoin cash got in on coin burning, though, Binance Coin (BNB) explored this strategy, as well. BNB is the official token of the Binance digital currency exchange; BNB is used to incentivize users, allowing them to pay for transaction fees in a staggered manner. According to reports, more than 1.8 million BNB tokens were burned in the first few weeks of the year. The process was repeated in April, with another $30 million or so of BNB burned at that time. So far, BNB has yet to see the same massive gains that bitcoin cash experienced, but it has nonetheless been a top performer among digital currencies so far this year.

Of course, there are massive risks associated with coin burning, too. First, burning coins is no guarantee that the remaining coins in circulation will gain in value. It does not necessarily even reduce the total number of tokens outstanding in circulation, as the supply of tokens in circulation seems to fluctuate considerably.

Bitcoin is an example as to why coin burning may not work. Bitcoin is capped at 21 million tokens; some analysts believe that this cap helps to contribute to the value of BTC. Still, bitcoin has also created new tokens in several instances thanks to hard forks; this is how bitcoin cash, bitcoin gold and other spinoffs came to be. If bitcoin were to fork again in the future, even more tokens would be generated. Thus, the idea that bitcoin is "scarce" is thus somewhat artificial.

Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns bitcoin and ripple.