All original cryptocurrencies are based on blockchain technology. When users develop new coins or change the protocols of the original blockchain, it creates a divergence in the system. This is called a crypto fork. Read on to find out more about forks in cryptocurrency.
Technology is all about progress. This progress can take many shapes and forms. In the world of cryptocurrency, a change to a blockchain which results in a “fork” can result in the creation of new coins or an upgrade of existing ones.
The developments associated with a fork can make a cryptocurrency more appealing to investors, or the occurrence of a fork may make you decide to convert your crypto to fiat currency and switch to investing in other assets.
What is a fork?
In the world of cryptoassets, a fork is when there is a fundamental change made to the underlying code of a blockchain.
Forks can happen intentionally or accidentally, 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.
Generally speaking, cryptocurrencies are a decentralised community, so updates can occur at any time and with relative ease, as long as the community agrees.
What is a hard fork?
A hard fork is when the nodes that form the foundation of the blockchain (holding the information and communicating with other nodes) are changed in a manner in which they are no longer able to communicate with old unchanged nodes.
When a hard fork occurs, both currencies will continue in their own separate way. This is not an update, but rather creates a different version of the software, so both the old version and the new version are legitimate.
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 cryptoasset.
- Create a new version of the cryptocurrency altogether.
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.
The crypto miners who add new blocks to the blockchain must unanimously agree to a hard fork before developers implement it. That way miners can be sure to contribute new blocks correctly.
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. Both types of currency will be accepted by the community, but one will stay dominant.
Once the new currency is created – holders of the original currency can claim the equivalent amount of the new currency, thus increasing their holding with very little effort.
While this might seem like you will be doubling your money, when the cryptoasset 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.
Tip: The subsequent two types of coins must be traded separately, although each trading site will have its own regulations.
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.
Tip: Bitcoin has undergone a series of hard forks over its lifetime
What 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; everything still runs from the original protocol.
To continue with our road analogy, a soft fork 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.
Soft forks may sound like a less drastic approach and one more likely to achieve a compromise between the members of a blockchain, but the downside of soft forks is that they do little to address any existing security concerns. The blockchain is not changed enough fundamentally to remedy any system issues, which is part of the reason soft forks are less common than hard forks.
Tip: Always keep you cryptocurrency in a secure wallet to reduce the risk of loss
Soft fork example: SegWit adoption
In 2015, the Bitcoin community was looking for a way to speed up transaction times. So they undertook a soft fork based around developing SegWit (Segregated Witness) protocols as a way to free up space within blocks that could then be used to hold more transactions.
Developers enabled changes so that the old blocks, which did not have the extra free space, could still interact with the new blocks. This was a classic soft fork, where the adoption of SegWit 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 factors to keep in mind if and when you are building strategies for trading crypto.
- Holders of the original currency can claim an equivalent amount of a new currency.
- More choice for traders.
- Potential for enhanced blockchain capability in terms of storage and speed.
- Crypto whales (who own thousands of coins) can purchase large amounts of coins just before a fork so they claim 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.
- Potential software security issues.
- Increased market volatility as traders adjust to the creation of the new cryptocurrency.
Final thoughts
Forks are just one of the reasons why cryptocurrency represents one of the most exciting, dynamic trading opportunities out there. But holding an asset which undergoes a wholesale change presents risks as well as opportunities.
It is important to remember that crypto markets are unregulated and volatile, and a risky investment choice.
Visit the eToro Academy to learn more about the cryptocurrency markets.
FAQs
- Are there risks involved with changing to a new blockchain protocol?
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Yes. Any change to the protocol should be met with extra precaution. Crypto markets are associated with high volatility and are unregulated, so it is important to have a risk management strategy in place.
- Is it worth changing to the new crypto asset in a hard fork?
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Whether or not you switch to the new asset will be an investment decision based on the prospects of the respective blockchains. You can never truly know which version will become the dominant currency.
- Are there many examples of crypto forking?
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As cryptocurrencies have become more common over recent years, there have been quite a few examples of both soft and hard forks. The crypto sector is highly tech-orientated and forks represent a natural upgrade as technology develops to match the developing needs of a crypto community. You can keep up to date with the latest assets that are added to the eToro portfolio.
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