What is a cryptocurrency fork?

Cryptocurrencies have already changed the face of the world of finance. An example of this is China's move to issue its very own crypto.

The first cryptocurrency was the Bitcoin, which was designed to be a decentralised alternative to standard national currencies. Over the years, other digital currencies have been popping up, such as the Tether and the Litecoin. These new currencies didn't appear out of nowhere, but rather as a result of the proverbial fork in the road (a bifurcation).

Forks occur when the currency developers or users decide that something fundamental needs to change. This can be due to a major security flaw, as was the case with Ethereum, or a general disagreement within the community, as we saw with Bitcoins and Bitcoin Cash.

A cryptocurrency fork can have a major impact. They often lead to a great deal of volatility and have been quite controversial. To understand why, let's start by defining what a cryptocurrency fork is:

cryptocurrency fork

What is a cryptocurrency fork? How do they occur?

Generally speaking, a fork is simply a change in a blockchain protocol (which determines the validity of transactions). This means that almost any discrepancy in the chain of blocks can be considered as a fork. As the above illustration shows, they come in two types: soft forks and hard forks.

A soft fork is a modification that is compatible with earlier versions. When a soft fork occurs, the former nodes (computers that connect to the currency network and validate transactions) still recognise the validity of new transactions. However, the blocks that are created will be considered invalid by the updated nodes. This means that, in order to be successful, soft forks require most of the network's hash power. Otherwise, they run the risk of being the smallest chain and becoming orphaned, basically becoming a hard fork.

A hard fork, on the other hand, is a change in the block chain protocol that breaks compatibility with previous versions. Computers using the old software will consider the new transactions to be invalid. This means that in order to use new "valid" strings, they must be updated. If a large enough percentage of the currency's community prefers to keep on using the old rules, then the chain will be split, resulting in two separate cryptocurrencies.

A hard fork requires the support of most network-connected currency holders. For a hard fork to be adopted, a sufficient number of computers must be upgraded to the latest version of the protocol software. This allows them to use the new token and its block chain.

Nodes that don't want to update their code won't be able to participate in the new blockchain. If an insufficient number of users are updated, this could lead to a broken blockchain. There are a few solutions to make sure that there is a genuine consensus so as to avoid this situation. This is to be done before any update is validated.

Soft forks sometimes use mine-activated updates, where the hash power of a new protocol must reach a certain percentage before the update is adopted. The Dash currency uses its master nodes to adopt major changes to its blockchain protocol. But regardless of the method used, the end is identical. Most community members must agree before big changes can be implemented, otherwise a "hard fork" can happen, an example being the Bitcoin and Bitcoin Cash fiasco.

The end result of a successful upgrade: a brand new currency break out from the blockchain, starting with the block where the upgrade took place. Two separate cryptos with distinct ledgers, each of them born from the same blockchain.

In the case of upgrades such as Bitcoin's SegWit, ideally all users switch to the new protocol, so that there is only one cryptocurrency. In the case of hard forks, such as Bitcoin Cash, two distinct cryptocurrencies and blockchains function simultaneously after the fork. The latter case is a good illustration of a hard fork. These types of events usually end with one of the following outcomes:

  • One blockchain dominates, and the other one suffers from low community value and a low level of adoption.
  • Both blockchains are adopted, coexist and operate independent of each other with a similar level of community value and adoption.

The first scenario is more likely to occur, an example being when Ethereum dominated Ethereum Classic. The other scenario doesn't happen much, but it nevertheless does. Bitcoin Cash and Bitcoin now coexist equally as the SegWit 2.X alternative software protocol didn't catch on.

Forks can be quite disruptive for a community, as visions of the future of a crypto are often contradictory, which can lead to a situation where traders and cryptocurrency miners feel they have to go in different directions.

Sometimes, a disruption can be enough to avoid a fork. The controversial Segwit 2.X fork was abandoned in 2018 because its proponents weren't able to agree enough on the block size. Fears that the upgrade would lead to a new hard fork and further destabilise the Bitcoin currency stopped things.

Why do developers decide to implement a hard fork?

There are many reasons why developers opt for a hard fork, such as eliminating security risks found in previous software versions, the introduction of new features, or the reversal of transactions. An example would be when the Ethereum blockchain sought to reverse "decentralised autonomous organisation" (DAO) hacking efforts. After the security issue, a huge majority of the Ethereum community decided to opt for a hard fork to reverse transactions that diverted millions of dollars of the currency to an anonymous hacker. This fork allowed DAO currency holders to recover their Ethereum funds.

The hard fork proposal didn't quite undo the network's transaction history. Instead, it transferred the DAO-related funds into a newly created smart contract for the sole purpose of allowing the original owners to withdraw their money. DAO currency holders can now withdraw their Ethereums at a rate of approximately 1 ETH per 100 DAOs. The DAO custodians have withdrawn and distributed the additional balance of funds and the remaining Ethereums after the hard fork to provide the organisation with "water-tight protection".

Given the security differences between hard and soft forks, almost everyone involved prefers a hard fork, even if a soft fork seems to be sufficient. Examining the blocks requires a lot of computing power, but depending on the causes of the fork, especially if they are related to security issues, it may be preferable to use a hard fork because of the long-term benefits.

What happens after a hard fork?

Hard forks can have a big impact on a currency, with the Bitcoin Cash situation being a good example. Holders of the original Bitcoin cryptocurrency were left with an equal number of the forked currency. For example, if a person had 95 Bitcoins at the time of the fork, then they had 95 Bitcoins in cash once the fork was done.

Also, large market players, or "whales", can cause large fluctuations in the market. Whales are large organisations that own hundreds of thousands of Bitcoin. Due to this, their decisions strongly influence the market's orientation.

What if a whale knows that a hard fork is around the corner and that it will receive a new coin for every original one it has. This will provide a strong incentive for the whale to increase its share of the original currency. Its size means that it can artificially increase the price of the main currency right before the fork, because large players like whales buy everything they can find until the day of the fork.

Whales are rewarded for their investment with new coins. Because the price of the original currency is inflated due to their actions, they quickly sell the new coin and the original coin on all the available cryptocurrency exchanges. This can cause the value of the original crypto and the forked one to collapse.

The previous example applies to an extreme case where the entire blockchain is cloned. Not all forks lead to a "free" cryptocurrency.

Many forks simply copy the underlying code, so that even if the new cryptocurrency applies a number of corrections to the original currency, it's not an actual copy. In this case, the reactions of market participants are a bit different.

Depending on the circumstances surrounding the fork, traders may shift away from the old currency in favour of "safer" investments until they consider that the market has stabilised. Sometimes, traders may even ditch the original crypto in favour of the new one, as was the case with Ethereum Classic and Ethereum.

Is it a good idea to invest in a crypto before a hard fork?

A hard fork signals a time of instability for a cryptocurrency. Holders of the crypto may disagree with each other, and the price of the crypto may become highly volatile. Traders will weigh their options, and this may depend on the type of fork that is proposed.

In the case of a fork where the holder can get coins "for free", it makes sense to keep your investments in this crypto (and maybe even increase your holdings). The downside is that other large players will likely do the same. If you are worried about selling before the whales, you should try to sell your holdings right before the actual fork.

You'ill lose the "free" forked coins, but you'll be able to profit from the actions of whales looking to increase their stake. You can then use your profits to buy a larger stake after the inevitable collapse of the cryptocurrency after the fork. If you plan to invest during a transition period, your options are a little easier.

If a trader thinks the fork will help increase the value of a crypto, the best solution is to start buying that crypto gradually, taking advantage of price fluctuations to increase the stake. But if the trader thinks the fork will be bad for the currency, then he should sell before the collapse.

Cryptotab