Forks In Cryptocurrency Trading

Last Updated June 18th 2021

7 Min Read

Cryptocurrency trading, for the uninitiated, can be quite complex and there could be concepts that need to be cleared. How did Bitcoin, as a digital alternative to physical currency, evolve and branch out into various specialised currencies? The answer to that lies in a technical phenomenon called forks.

This article discusses the evolution and concept of forks and its role in the world of cryptocurrency.

Contents:

What are Forks in Cryptocurrency Trading?
Different Types of Forks in Cryptocurrency Trading
Harnessing the Power of a Fork
How to Deal with a Fork Without Losses

What Are Forks In Cryptocurrency Trading?

Forking is a process undertaken by developers, also called miners, who are looking beyond the direction a cryptocurrency is taking. When developers choose to change an existing rule, they initiate a fork or a deviation from the normal.

Forks can be deliberate and happen due to a major hack or when developers have to upgrade the source code to add new safety features or change the fundamental rules of network operation.

Different Types Of Forks In Cryptocurrency Trading

Cryptocurrency forks are classified into two main categories - soft forks and hard forks. Though both soft forks and hard forks result from changes implemented to the original protocol code, where a new version of the protocol is created in parallel with the old one, they differ significantly in the way they co-exist, create a split and their compatibility.

Soft forks

If the changes implemented to the original protocol code create a new version that is backward compatible it is known as a soft fork. When a soft fork takes place, older nodes that validate, send, and receive blocks and transactions and maintain a copy of the blockchain will still consider the new transactions as being valid and accept data.

Unique characteristics of a soft fork:

➣ The software upgrade can still work with older versions

Soft forks, being backward compatible, are not totally removed from the network. In other words, users that do not perform software upgrades to the latest version will still be able to create blocks that will be accepted by older nodes.

On the contrary, the upgraded software is considered invalid by the updated nodes and will reject them, thus compelling users to upgrade. As more miners switch to the newer version, the blockchain becomes longer, encouraging the other miners to update the software and join the mainstream.

➣ A soft fork is caused by changes and implements additional functionality without affecting the network structure

If there is a rule that users need to strictly comply with regarding the block size, for instance, reducing block size from 1 MB to 500 KB, a soft fork is created. Users that have not upgraded their software will be compatible with continue to see and recognise incoming new transactions, but their blocks will be incompatible and would be rejected by the network. This is because the new block size does not comply with the rules.

➣ A soft fork happens when a majority of users choose to upgrade to the new version to enforce new rules on the whole blockchain

When a majority of users choose to upgrade to the new version, the soft fork formed is considered to be temporary as the chain with the biggest hashing power eventually absorbs the shorter one. Soft forks need the bulk of the network’s hash power. If not available, soft forks are at the risk of becoming orphaned from the network.

If more than 50% of miners upgrade to the latest version, then the older version will become redundant and vice versa. Both old and upgraded nodes recognise new version blocks.

However, users with nodes that are not upgraded will still read and recognise both new and old version blocks, ensuring smooth network functionality.

Examples of a soft fork

The size limit of a block: In the beginning, Bitcoin did not have a restriction for a block size; the size limit of 1 MB was introduced through a soft fork.
Pay-to-script-hash: Pay-to-script-hash (P2SH) was not available as a standard script. This function allows users to send Bitcoin with multi-signature requirements in place, thus enhancing the code without changing the structure.

Crypto asset investing is highly volatile and unregulated in some EU countries. No consumer protection. Tax on profits may apply.

Hard fork

If the changes implemented to the original protocol code create a new version that is not backward compatible it is known as a hard fork. When a hard fork takes place, older nodes that validate, send, and receive blocks and transactions and maintain a copy of the blockchain do not consider the new transactions as being valid and do not accept data.

Unique characteristics of a hard fork:

➣ The software upgrade cannot work with older versions

If the software is upgraded, the older and newer versions become incompatible. The newly generated blocks do not support old ones and vice versa. Users with nodes that are not upgraded will be completely separated from the network. New nodes can communicate with others but will not be able to participate in validating and verifying transactions.

So, once a hard fork happens, all users have to switch to a new version to stay in sync with the network. Or else, the blockchain will split, creating two separate networks. One network will be with the old rules and one with the new rules, both with a different data set registered in the ledger. Two chains can exist together and continue to propagate blocks and transactions, but not on the same blockchain.

➣ A hard fork is necessary to change essential parameters and relax certain rules of block validation

Some of the fundamental changes in the essential parameters include a block size increase, the difficulty of a cryptographic puzzle, limits to additional information, etc. If the size of a block is increased from 1 MB to 3 MB, then a 2 MB block will only be validated by a node with the newest version of the software as it allows the sizes to 3 MB.

On the other hand, nodes running older version will not only reject the 2 MB block, but will also ignore that block and attach its new validation to the previous one, compliant with old rules. Ultimately, you will end up with two blockchains; one with both new and old types of blocks and the other one with only old version blocks.

➣ Hard forks are either planned or controversial

For a planned hard fork, the upgrade was included in the roadmap and all the users move to the new chain, whereas the old one is abandoned. A controversial fork happens when there is a conflict between two sets of community members. Then, one group introduces significant changes to the code, creating a new chain with a new digital asset.

Examples of a hard fork

Byzantium hard fork in Ethereum: A planned hard fork occurred on Ethereum blockchain in October 2017 to improve its privacy, scalability and security attributes.
Monero: The coin hard forked in January 2017 to implement a new transaction feature, which was supposed to improve the privacy and security characteristics of the coin.
Bitcoin Cash: In August 2017, Bitcoin Cash was born when Bitcoin Cash wallets rejected Bitcoin transactions when the block size increased from 1 MB to 8 MB.
Ethereum Classic: This coin was forked from the Ethereum chain to reverse the adverse consequences of a DAO hack attack. The new currency retained the original coin as the majority of the community members supported it.

➣ Assessing the risks and opportunities of hard forks

Unlike the rest of the financial world, cryptocurrency is a much less centralised and regulated industry. The open source nature of the platform and tools such as forks are instrumental in the growth and expansion of the cryptocurrency world.

But this also brings with it an element of opportunity and an exposure to risk that both investors and traders have to balance.

Given their impactful presence and nebulous nature, how can you manage the risks and opportunities presented by hard forks?

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Crypto asset investing is highly volatile and unregulated in some EU countries. No consumer protection. Tax on profits may apply.

Harnessing The Power Of A Fork

Sometimes, hard forks lead to the creation of a new digital asset that provides free coins to balance the issuance.
News of an upcoming fork, normally, boosts the price of an asset. So, if you are game enough, you can attempt to buy ahead of the fork and sell it just before the split.
Some exchanges let you buy the new coin ahead of the fork via futures.

How To Deal With A Fork Without Losses

Avoid making transactions with coins that are being forked

When two different chains exist for a cryptocurrency, one chain will be blocked and the coins on that chain will be lost. Accidental forks are intimidating for users because it means that business may stop accepting the cryptocurrency until the situation clears out.

Diversify your crypto portfolio

Cryptocurrency is exceptionally volatile and the market can be unpredictable when there is a fork with a lot of conflicts between two sets of users. If the contradictions worsen, there are chances that the prices may fall. Make sure to diversify your crypto portfolio and keep the amount of forked coin at a minimum under such circumstances.

A private wallet

If you foresee an upcoming fork, move the coins to a private wallet or make sure that your cryptocurrency exchange promises that it will support the new coin. While downloading a new wallet for a forked coin make sure that it is not a malware. Never trust your assets to a new wallet before thoroughly checking and testing it.

Hard forks and soft forks are an important part of the long-term success of blockchain networks as they make it possible to integrate new features.