Forks are a much discussed yet often misunderstood part of blockchains. While forks follow familiar patterns, each fork is unique and results in a different outcome. It’s important to know the context and details around each fork in order to take advantage of the drastic and sudden changes that often ensue.
Blockchain Forks 101
A blockchain fork is essentially a collectively agreed upon software update. Blockchains depend on decentralized groups of computers all working collaboratively. Each individual computer, commonly referred to as a “full node,” runs the software needed to verify the blockchain’s public ledger and keep the network secure. The more full nodes that concurrently run the software, the more secure the network.
Crucially, each full node needs to run the same piece of software in order to access the same shared ledger. In other words, each full node running Bitcoin’s core software (i.e. Bitcoin Core) has access to the Bitcoin blockchain’s ledger and can therefore verify Bitcoin transactions and access Bitcoin transaction history. But a full node only running Ethereum’s core software (i.e. Go-ethereum) cannot access the Bitcoin blockchain.
Hard Forks vs Soft Forks
The version of the software also matters. If the Bitcoin Core developers (or anyone else who is able to convince enough full nodes to switch to their software) update the Bitcoin code to install new features or change important parameters, the updated software may not be compatible with the older version of the software.
Forks that are incompatible with older versions of the software are called “hard forks.” Hard forks typically change consensus rules (i.e. block size, mining algo, consensus protocol) in a way that makes previous versions of the software incompatible. For example, Ethereum’s upcoming Casper update will change consensus protocol rules as Ethereum begins its shift from Proof of Work to Proof of Stake. When Ethereum eventually introduces their Casper update, the update will be a hard fork. Full nodes that choose not to update their software will no longer be compatible with the updated Casper nodes. Thankfully, Ethereum hard forks are not usually contentious, and the majority of the network agrees to update. Otherwise, a full node running the updated Casper software would not have the exact same ledger as a full node running the older version. Since each node would have different consensus rules, they would be essentially running a separate blockchain.
However, there are some forks that are compatible with older versions of the software. “Soft forks” are software updates that still work with older versions. For example, Bitcoin’s SegWit update was a soft fork. When SegWit activated, a new class of addresses (Bech32) was created. But those using older P2SH addresses were not affected by the addition. A full node running version 0.1 of the Bitcoin Core software could send a non-SegWit transaction to a node running updated SegWit software and the transaction would still go through. As long as at least 51% of the hashing power switches over to the updates soft fork, the older versions of the software will still work (if the older versions propose invalid blocks, they will temporarily form “old chain only” versions of the ledger that quickly get overtaken).
Contentious Hard Forks
Not all forks are unanimously agreed upon by the community of full nodes. In fact, most of the most famous (and notorious) forks were considered contentious hard forks.
A contentious hard fork occurs when a significant portion of full nodes disagrees about which version of the software to run. For example, the Ethereum DAO hack (where $55 million worth of ETH were stolen) caused a heated debate within the community. Many full nodes wanted to reverse the hack and return the stolen funds. However, many others argued that reversing the hack would fundamentally undermine the legitimacy of the blockchain. The two sides could not come to an agreement. The community that was against reversing the hack eventually split off and formed a new blockchain, Ethereum Classic.
Importantly, the owners of the original cryptocurrency will often receive proportional amounts of the new cryptocurrency created in the contentious hard fork. After the Ethereum Classic fork, ETH owners all received ETC proportional to the amount of ETH they owned.
The Ethereum price plunged after the DAO hack and Ethereum Classic contentious hard fork. Because of this, contentious hard forks were typically viewed as detrimental to the main chain.
However, that changed when Bitcoin Cash forked from Bitcoin. Bitcoin Cash was result of a multiyear debate regarding the best way to increase the number transactions within the Bitcoin network. Although several solutions were proposed, none received overwhelming adoption. One proposal advocated for, among other things, a larger block size. This eventually created a contentious hard fork which was called Bitcoin Cash.
Based on the Ethereum DAO Hack fork, many thought that this fork would lead to a price decrease in Bitcoin. But instead Bitcoin started a precipitous rise shortly after Bitcoin Cash’s launch in August 2017. Bitcoin Cash followed a similar pattern as Bitcoin, and quickly increased from about $300 a coin to a peak of over $3,000 a coin in December 2017. After Bitcoin Cash’s meteoric rise, the narrative around contentious hard forks changed. Now, contentious hard forks are often described as “free money,” or as an overall positive thing for the main chain because the group creating the contention is free to work on their own version of the protocol.
Context and Timing Is Key
Hard forks often create price volatility. It’s important to know the context and details around each fork in order to take advantage of these sometimes drastic and sudden changes. At Digital Asset Research we keep track of all the important events for crypto managers and are making our results available as part of our new Crypto Catalyst Calendar. These events include forks, but also include mainnet launches, airdrops, legal and regulatory events as well as anything else that might affect the price of a digital asset.
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