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Why Proof-of-Burn

One of the most striking things about Counterparty is that its native cryptocurrency, XCP, was created and distributed by destroying bitcoins in a process known as “proof-of-burn”. All XCP that will ever exist were given out proportionally to those who recognized Counterparty’s value and were ready to “burn” their bitcoins to participate in Counterparty.

At first glance, destroying bitcoins sounds quite drastic. The most common objection to proof-of-burn is that those bitcoins could have been used to pay developers, raise bounties or fund marketing efforts for Counterparty. That is indeed a valid consideration, so what was everybody thinking as they destroyed their perfectly good and valuable bitcoins?

Counterparty’s developers built a distributed financial system on top of the Bitcoin blockchain. Like Bitcoin, the Counterparty community operates in a decentralized manner where everyone has an equal say in the project. The developers do not benefit from ongoing transaction fees as is the case with Mastercoin.

In order to give the Counterparty project maximum legitimacy right from the start, it was considered fundamentally important that:

  1. All new XCP cryptocurrency coins are distributed fairly and proportionally

  2. Counterparty developers do not enjoy any special privileges

  3. No lump sum of investor capital that allows developers to “make a killing”

Bitcoin achieves these three criteria through its proof-of-work mining system. All bitcoins created are awarded to Bitcoin miners in proportion to the computing power they provide to secure and sustain the Bitcoin network.

Counterparty is a second-level protocol that runs on top of the existing Bitcoin network and pays Bitcoin miners small fees to register Counterparty transactions in the Bitcoin blockchain. This means that Counterparty instantly benefits from having a trusted and secure mining network without the need to re-create its own or use additional resources for day-to-day operation.

It also means that the Counterparty developers had to find another way to distribute XCP fairly, eliminate the need to trust anyone with large sums of money while building Counterparty and its community in the same decentralized spirit that made Bitcoin so successful.

Establishing Counterparty’s legitimacy through proof-of-burn

Selling off a pile of pre-mined XCP coins would have obvious benefits, it would also have created Counterparty as a centralized project (one of many) and set up whoever holds the money from the sale as a potential point of failure. This is against the fundamental goals of both Bitcoin and Counterparty: to do away with the need for trusting any third parties, including the founders and developers themselves.

Imagine Satoshi had suddenly appeared out of nowhere with his great idea and a pile of bitcoins for sale at, say, a dollar each. Would he have won the backing of the countless people who have since invested their money, time and resources to build the infrastructure that is making Bitcoin successful? Or would people have instantly suspected some kind of pump-and-dump currency scam and steered well clear?

By opting to distribute all XCP by proof-of-burn, the Counterparty developers eliminated any speculation that they planned to get rich quick or redistribute risk unequally. On the contrary, they put themselves in the same position as everyone else, backing their ideas with destroyed bitcoin to obtain XCP in the hope of eventually benefiting financially from their own project and hard work.

It is hard to overstate how far removed Counterparty is from almost any other altcoin.

The strategy of taking on more personal risk than developers of competing projects and forcing themselves to produce results before they could see any benefits is already bearing fruit. Counterparty is the first (and so far the only) protocol to have a working distributed exchange, built in record time despite having no outside funding of any kind.

Obtaining XCP through proof-of-burn is ultimately equivalent to mining bitcoins

If burning bitcoins for XCP still sounds strange, consider that Bitcoin miners also destroy one resource to get another. Miners use electricity (which is ultimately burning fuel) and receive newly minted Bitcoins in return for processing transactions and keeping the Bitcoin network secure. Those who burnt bitcoin to get Counterparty XCP coins did the exact same thing, except the resource they destroyed was not more fuel, but bitcoins. The result achieved was establishing Counterparty’s legitimacy, as we have already discussed.

In a very real sense, the original energy used to create those bitcoins was repurposed and used to create XCP.

It is important to note that burning those bitcoins did not in any way diminish the value of the remaining bitcoins on the Bitcoin network, just like burning fossil fuels does not make the fossil fuels left behind any less valuable. How were the bitcoins actually burnt?

In proof-of-burn, bitcoins are “burnt” by sending them to an address that is guaranteed to have no known or discoverable private key, which means that those coins can never be used again.

The Counterparty proof-of-burn was set up so that anyone who sent bitcoin to the address 1CounterpartyXXXXXXXXXXXXXXXUWLpVr during the one-time burn period in January 2014 automatically received XCP in return in proportion to the amount of bitcoin they burnt. This ensured that all 2,648,755 XCP that will ever exist were created and distributed in a fair, transparent and public manner.

How do we know the burnt bitcoins cannot be used again?

The reason the bitcoins used in Counterparty’s proof-of burn are now gone forever is that the burn address is demonstrably a made up bitcoin address, instead of being created together with the corresponding private key that would be required to spend the burnt coins.

A standard Bitcoin addresses consists of a random string of characters that is simply generated together with its matching private key. It is also not too hard (with enough computing power) to create a so-called “vanity address” with a short chosen part (say the first 5 or 6 characters) and leave the remaining characters to chance. However, the difficulty of finding a fully-functioning address with a matching private key increases exponentially for every other character you want to choose.

The first 28 characters of the Counterparty burn address, 1CounterpartyXXXXXXXXXXXXXXX, are so perfectly ordered as to be obviously specifically chosen. (The remaining characters, UWLpVr, like the last 6 characters of any Bitcoin address, are automatically calculated and serve as a safety check feature to make sure that the address is indeed a valid Bitcoin address, much like the last digit of credit card numbers.) This guarantees that there is no known matching private key for this address. In other words, the chance of anyone guessing the private key to spend the burnt BTC at that address is the same as the chance of guessing any private key for any other bitcoin address: practically zero.

Before you shed any tears for those proof-of-burn bitcoins, take a look at Counterparty and see how this project in full swing (together with the enthusiastic community that owns and manages it) is building a new and exciting level of functionality in the form of a distributed financial system and exchange on top of Bitcoin. That’s a lot of potential benefits for the Bitcoin community as a whole in return for those burnt coins!

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