Alex Fatuliaj
January 16, 2024
Tokenomics Tuesday

What is burning?


Either destroying some of the launched tokens (the option for this needs to be coded into the smart contract) or sending them to an inaccessible wallet. It’s used primarily to increase the token price, which comes with drawbacks seldom talked about.

Why not just keep the tokens?


Simply not selling the tokens does the same thing as burning tokens (reduces real circulating supply), except for two key differences:

  1. Optics: saying “We’ll hold these tokens forever,” seems much less commendable than “We’ll burn these tokens,” and implies a significantly greater lack of dedication to whatever strategy the project is contemplating.
  2. Trustlessness: burning the tokens waives the team’s ability to go back on their decision; the community doesn’t need to trust them.

However, it seems most of the space has forgotten about the notions of unwanted consequences and opportunity costs. Let’s explore.

Benefits of burning


There are 4 main, interlinked benefits of burning tokens which stem from the underlying desire to increase the token price, and the subsequent effects that brings. Pretty straightforward.

  1. Increases token price: burning tokens increases the token price as long as the demand doesn’t decrease. A price chart going up is seen as a sign of success (which it often is), so this is great for sentiment around the project.
  2. Rewards: token holders are rewarded given their bag increases in value. Early investors are rewarded for their support and are simultaneously disincentivised to sell the token.
  3. New speculative token buyers: burning tokens is a popular utility and often is seen as a huge green flag for any investors looking for a return. Burning tokens incentivises them to buy in and hold, which boosts the market cap of the project, TVL, UAW, and other metrics.
  4. Reduced velocity: by disincentivising token selling and trading within the ecosystem, the token velocity is slowed down - i.e. the amount of tokens available for new buyers decreases. Thus, buy pressure has a greater impact on the token price.

Who benefits from burning


We can divide the benefits into two camps: the token holders and the project itself.

Token holders


This includes the community members, investors, and the team. With an overall decrease in circulating supply, the token price appreciates without anyone needing to do more than simply hold the tokens, assuming demand remains the same. This rewards early supporters and builds rapport between them and the project, inherently aligning incentives due to the second reason below. This is particularly important with investors and early supporters, as, if incentivised, these entities will protect their bag from FUD and will constantly boost sentiment.

Project


Burning tokens doesn’t happen unannounced. Whether it’s inherently written in the whitepaper or an ad hoc change to the protocol, everyone knows if the project will be burning the tokens. This attracts more demand for the token, increasing the popularity of the project, which creates a positive flywheel of growth. Thus, as per the former point, people are disincentivised to sell the token not only because it is appreciating due to a decrease in supply, but also because the project is attracting greater demand, boosting the price further.

People often look into the future and state they would rather have deflation than inflation because of the above reasons as well as the lack of constant sell pressure. But, a capped max supply also prevents constant future sell pressure once the tokens are vested, so this argument is rather peculiar, to say the least. Let’s assess the drawbacks, and see whether deflation is a better choice than a capped max supply.

Drawbacks of burning


There are a few drawbacks of burning tokens that are seldom discussed, centred around drawbacks for ecosystem participants and token economics. But first, a key point.

There are many projects where the ‘token holders’ are the ‘users’, such as GMX. For these projects, points 1, 2, and 3, are merely minor elements to consider, but the other drawbacks of burning are still key. For all other projects, which is most projects, points 1, 2, and 3, along with the others, often cause big problems. Read this article for more info: <Token holders are not users>.

  1. Token holders are not users: there are usually a lot more people who just buy and hold the token in a wallet as an investment compared to those who actually use the project for its product/service. Beyond short-term sentiment and vanity metrics, these investors do not add any value to the actual project, so burning tokens rewards them for no real benefit.
  2. Free rider problem: by appreciating the overall token price and rewarding everyone, projects lose the ability to direct rewards more efficiently at those who actively use the protocol and bring value. Moreover, it also rewards greater bag holders in terms of absolute value - this includes commonly the investors, team, and whales, which is fine, but not particularly “user-focused”.

  3. Source: where are the burned tokens coming from? If they’re bought back and burned, then it’s capital that faces great opportunity cost - it could’ve been spent on improving the product, marketing, or rewarding actual users. If they’re collected from fees, then it’s essentially a tax on real users for the benefit of all token holders - is that worth it?
  4. Borrowing becomes expensive: specifically for DeFi projects, borrowing capital becomes more expensive because the repayments are normally in the token.
  5. Disincentivised activity: if everyone is incentivised to hold the token, nobody will spend it, causing less activity in the ecosystem which paints a worse picture than the positive one of the token price going up. Moreover, if the burn is a percentage of transaction fees, this disincentivisation leads to less burning which doesn't let projects benefit from the burn as effectively.

  6. Lower revenue: lower activity subsequently causes lower protocol revenues (which are normally amassed via transaction fees).

  7. Optics: relying on burning tokens to increase the token price implies that the product/service is subpar since the token price should go up naturally as the tokens are vested as demand grows. Supplementing that with burning can help boost the price, but why not boost the price by building a better product?
  8. Security laws: as I mentioned above, everyone knows about burning, and most people invest into tokens due to burning because they think the price will go up. Depending on the implementation and jurisdiction, this may overlap with security laws.

  9. Compliance: extending point 8, CEXs often also view burning as unfavourable in the face of compliance, which can make it difficult to list.

Who pays the costs of burning


We can divide the entities that pay the costs into two camps also. This time its users and the project.

Users


Real users of the protocols, those who actually bring value and usage to the project, are the ones who pay the majority of the costs of burning tokens by dealing with higher slippage, paying back more expensive loans, and bearing unfair reward mechanisms. Fundamentally, token holders are investors who rotate capital wherever sentiment and monetary yield are greatest; they are not here for the long term. Real users, however, who use the product/service the protocol is offering, are. Focus on rewarding them appropriately.

Project


The token price may go up, but the market cap, a somewhat reasonable representation of value within the protocol, remains the same (since the supply decreases). Although the price chart looks nicer, anyone who looks at the market cap will see no improvement in the ecosystem. This is compounded by lower volumes and transaction revenues. Moreover, the increase in token price is caused by a reduction in liquidity rather than increased demand, which will bring the price back down when people start selling.

Is burning worth it?


Fundamentally, it depends on the strategy. Burning tokens can boost token price and sentiment, which will yield short-term demand and traction. However, these benefits are plagued with long-term drawbacks, namely a potentially ever-growing misallocation of efforts.

The question you have to ask yourself is “Why?”

If the answer is to boost the token price, do it. But you’re putting a plaster over a core issue, a plaster that protects you for a short while but also lets bacteria reproduce and worsen the underlying condition. Most projects implement burns by burning a % of a transaction fee. But will there even be people transacting? Are you going to have a significant number of users to make the burning actually increase price?

If the answer is to reward people, then a better option would be redistributing rewards to those who actively use the protocol. You’re not rewarding those who bring no value to you, you’re not inflating the supply more than it already was, and you won’t be concerned with security laws.

If the answer is to attract speculative buy pressure, do it. But be warned, that speculative buy pressure will leave even quicker.

And finally, if the answer is to create an overall deflationary economy, ask yourself, “Why is that so much better than a token economy with a 0% inflation rate?” Value is subjective, but you cannot artificially create scarcity and pretend the underlying value of something has increased. Natural scarcity caused by the reality of the complex world is valuable. Manually burning the supply isn’t. But, ironically, maybe I’m being subjective.


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