Technology is all about progress. This progress can take many shapes and forms. Sometimes you can access the features of updates and new developments on your current system or device. Other times, you will need to decide if you want to keep using your current setup or switch to something different. Cryptocurrency traders experience something similar in the way of forks, which are a result of changes made to a blockchain.
But just what is a crypto fork? Read on to find out more about forks in cryptocurrency — what they are, the difference between hard forks and soft forks, why they happen and what they mean for crypto.
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What is a fork?
In the world of cryptocurrency, a fork is when there is a fundamental, foundational change made to a cryptocurrency. Forks can happen for a few different reasons, but generally occur when either the developers behind the crypto, miners or the user base of cryptocurrency traders decide that something about the blockchain needs to change. This can happen because, generally speaking, cryptocurrency is a decentralised community.
What is a hard fork?
A hard fork is when the nodes that form the foundation of the blockchain (holding its information and communicating with other nodes) are changed in a manner in which they are no longer able to communicate with old unchanged nodes. This leads to a split network in which the new versions of the nodes and the old versions of the nodes are both still valid; they just don’t interact with each other.
When a hard fork occurs, the software behind the cryptocurrency is modified and carries on — on a different trajectory. This is not an update, but rather creates a slightly different version of the software. Both the old version and the new version are legitimate. You can think of it like a fork in the road — it is something that gives you the chance to travel in another direction than the one you are currently travelling, but both routes started from the same stretch of pavement.
Hard forks can be implemented for a variety of reasons, including to:
- Patch up security flaws — by closing off access to the old blockchain, holes in security can also be closed off.
- Add new features to trading a certain type of crypto
- Create a new version of the cryptocurrency altogether
What happens to cryptocurrency after a hard fork?
When there is a hard fork, generally its related cryptocurrency will split into two forms — the original version and a new version. Holders of the original cryptocurrency will also have the equivalent amount in the new currency. Usually both types of currency will be accepted by the community, but one will stay dominant.
While this might seem like you will be doubling your money when a crypto you own forks, usually that is not the case. Often the price of one of the cryptocurrencies will fall in relation to the value of the other, so your total value will remain similar even though you will have more coins. The two types of coins must be traded separately.
Hard fork example: Bitcoin Cash
One good example of a hard fork is the one that took place between Bitcoin (BTC) and Bitcoin Cash (BCH). As Bitcoin became an incredibly popular choice for crypto traders, the ability to scale it up to process more transactions per 1MB block in the blockchain became an issue. Those who thought the process was too slow decided to create a solution with bigger 8 MB blockchain blocks of data that could be processed faster. But not everybody agreed with the idea. So there was a hard fork: the miners and developers who wanted to increase the block size split into a different crypto called Bitcoin Cash.
What, then, is a soft fork?
A soft fork is a fork that still allows the nodes of the new cryptocurrency to communicate with the nodes of the old one, and vice versa. That means that, while updates are made, there is no need to create an entirely new blockchain. Therefore, the original one remains. Simply put: when there is a hard fork, one blockchain becomes two, whereas a soft fork ends up in the modification of the one blockchain. It is like adding a new lane to a road that everybody agrees to drive on instead of the optional one-way turnoff of a hard fork.
Since old nodes can still interact with these updates, a soft fork does not require the same wholesale adoption or approval as a hard fork. “Backwards node compatibility” means it is just the miners who need to agree upon and adopt the new version.
Earlier we touched upon the fact that security measures can be a good reason for creating a hard fork. For this same reason, soft forks can often be less common than hard forks. Soft forks usually would not clear up any security issues, as the blockchain is not changed enough foundationally to remedy the situation.
Soft fork example: SegWit adoption
Remember above when we talked about the Bitcoin Cash hard fork? The reason for the hard fork was that miners and developers felt that Bitcoin was too slow because of its reliance on something called SegWit (a shortened version of Segregated Witness). SegWit had previously been implemented as a soft fork for Bitcoin.
In 2015, the Bitcoin community was looking for a way to speed up transaction times. So they developed SegWit as a way to free up space within blocks that could be used to hold more transactions. Developers enabled changes so that old blocks, which did not have the extra free space, could still interact with the new blocks. Thus, it was a soft fork. To be clear, the SegWit adoption impacted the technology behind the coin, rather than creating an entirely new cryptocurrency.
When some community members felt that SegWit still wasn’t fast enough, they initiated the hard fork that became Bitcoin Cash as mentioned above.
Are forks beneficial for cryptocurrency traders?
There can be pros and cons to crypto forks for different types of traders. Here are a few to keep in mind if and when you read about a crypto forking.
|Holders of the original currency get an equivalent amount of a new currency.||Crypto whales (who own thousands of coins) can purchase large amounts of coins just before a fork so they get a larger equivalent amount after the fork. This drives up the price of the parent crypto, which they can then sell afterwards, causing it to fall.|
|More choice for traders.||Potential software security issues.|
|Potential for enhanced blockchain capability in terms of storage and speed.||Increased market volatility as traders adjust to the creation of the new cryptocurrency.|
Forks are just one of the reasons why cryptocurrency represents one of the most exciting, dynamic trading opportunities out there, but it is important to remember that as they are often unregulated and volatile, they can be a risky investment choice. Keen to get involved? With the eToro trading platform, you will have everything you need at your fingertips to trade crypto. That includes access to our popular CopyTrader functionality, which gives you the option to mirror the moves of other traders across the world. If you prefer to test out your own strategy and trading skills, you can choose to trade manually too.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without having regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.