20 Aug, 2019, 02:33 PM 56 Ausdruck

What is Forking?

Technology is constantly evolving, and the blockchain is no exception. In any blockchain ecosystem the various contributors make decisions, generally via consensus, on how the system will operate (see our article here with more info on the decision-making protocols). If a disagreement occurs over the common rules that all users adhere to, there is potential for this social conflict to trigger an economic and technical split.

At it’s core, a blockchain protocol like Bitcoin or Ethereum is software - a set of rules, written in computer code. To participate in a given protocol, one must run the protocol software. Users running the software form the network and help broadcast transactions. Some of them are also miners, who mint new coins and provide security.

If a group of users want a different set of rules to govern transactions and coins, they may choose to break off and run a modified version of the software which enforces different rules. This is known as a fork.

The network, where previously everybody ran the same rules, splits into two networks - one running the original rules, and one running the new ‘forked’ protocol.

Soft Forks vs. Hard Forks

A soft fork occurs when the new rules are compatible with the old rules. They don’t affect the integrity of the blockchain, and the network continues functioning effectively ‘as one’.

In a hard fork, the new rules are incompatible with the old rules. Nodes running the previous software can no longer interface with the new network. If participants from the old network want coins and transactions to be governed by the new rules, they must upgrade to the forked version of the protocol.

The Nature Of Hard Forks

Hard forks can be split into three major categories:

1) Planned Hard Forks are protocol updates that have already been hashed out by the community, and the project roadmap and is publicly known. Often the planned new features are aimed at enhancing network security, scalability and privacy. Generally these forks are well received, and transition for all contributors will be seamless and easy. The coin will simply be upgraded.

2) Spin-Off Coins - due to the open source nature of cryptocurrencies, anyone can copy the codebase, edit it, and create a new coin with significantly different characteristics. The spin-off coin will have novel features, such as the backing of some underlying hard commodity like gold. Well-known spin-offs are Litecoin, UnitedBitcoin and many others.

3) Contentious Hard Forks are born out of an internal conflict - usually a disagreement over how to solve a certain challenge on the network. In a contentious hard fork, a portion of the network chooses to run a new variant of the software, incompatible with the old. This causes a chain split, and a new coin is created. If the new network has enough support, it may pose a challenge to the original dominant coin. Bitcoin Cash and Bitcoin SV are the most well-known contentious hard forks.

If a Cryptocurrency Forks, What Happens to My Coins?!

At the moment of the fork, both networks have an identical ledger - that is, the record of ‘who owns what’.

Therefore, if you hold a cryptocurrency and it forks, you’ll retain your coins on the original network and you’ll receive the same amount of coins on the new network. This is similar to traditional assets, where one must hold shares until the ex-date in order to receive dividends.

Users can run into operational issues if their coin wallet does not support the forked network. In this case, a little technical leg-work is required to access the forked coins. It’s usually more convenient to move coins, pre-fork, to a wallet that will support the forked network.

In a crypto index fund, wallet management and all technical operations are taken care of - investors simply receive returns based on the performance of the tracked crypto-assets.

(For more on how our fund handles forked coins, see the end of the article.)

Starting from Zero: Why Most Hard Forks are Benign

From the moment the network splits, there are many challenges awaiting the fragile, newly forked network. It has a mountain to climb to establish trust, value and resilience.

Any forked protocol needs:

  • Miners to mint new coins and provide security

  • Users to run the software and form the network

  • Value to make mining profitable, and encourage people to hold or spend the coin

Bootstrapping these factors all at once is no small task.

Firstly, the newly forked coin must draw miners to the protocol via lure of profits. Miners are not easy to persuade - they have to abandon the surefire revenue on the original chain and switch to the new, untested one.

They must be convinced the protocol is a worthy investment in terms of scalability and market adoption, and that the profit will be worth the switching costs.

The forked protocol must also entice new users with value-added features that do not exist on the original coin.

The challenge is a chicken-and-egg scenario: to drive returns for miners, the network needs new users, and to drive new users, the network needs a large body of miners providing security.

Hard forks like Bitcoin Cash and Bitcoin SV are rare examples of forks that ‘made it’, and remain in the Top 10 by market capitalisation as of writing this article. These coins are focused on upgrading the scaling, energy consumption and transactional features of Bitcoin.

If the forked network does not manage to sustain early adoption and value, it can quickly enter a downward spiral as users leave, price drops, and miners revert to the original chain. The list of failed forks is long:

  • 1) UnitedBitcoin

  • 2) Lightning Bitcoin

  • 3) SegWit2x (B2X)

  • 4) Bitcoin Atom

…to name just a few. Most hard forks result in a swift collapse of the forked network, leaving the original unscathed.

If a Contentious Hard Fork Survives, Does it Pose a Threat?

There are many dynamics that may play out after a contentious hard fork survives.

Importantly, forks don’t cause value destruction. At worst, there is value transfer from the original to the forked coin, and at best, the new coin grows in value with little impact on the original.

There are a few possible scenarios:

l The forked network may stabilise and co-exist peacefully with the original.

l If it proves superior, it may progressively “eat” the value of the original network - continuing to draw users, miners and growing in value. It is possible that a forked network may greatly surpass the original in market cap and usage, making the original obsolete.

l On the merits of its novel features, the forked protocol may attract entirely new investment and users, and grow independently of the original. It essentially opens up a new market.

However - none of these dynamics need threaten investor returns. As mentioned, owners of coins on the original chain will own coins on both networks, post-fork.

An investor who simply holds coins on both forks will capture at least as much value as if the network hadn’t forked, and possibly more.

Do Hard Forks Dilute the Money Supply?

Economists and pundits fear that a major risk of crypto hard forks is the ease with which the supply of digital currencies can be increased.

If a cryptocurrency hard forks, the number of coins doubles instantaneously. Isn’t that massive, sudden inflation?

The answer is no. By definition, hard forks are changes to the network rules that are incompatible with the old. This means that coins on the new fork are a separate currency, and not interchangeable with coins on the original network. The fork does not increase the supply of the original coin.

The new coin is an entirely different entity: sending BCH to a BTC address will not increase the BTC balance, nor will it even register on the BTC blockchain. Transactions and balances are recorded on a separate ledger, and the market will decide over time whether the new coin is useful and valuable.

To that end, a merchant that accepts Bitcoin does not automatically accept Bitcoin Cash. They have to actively choose run the Bitcoin Cash software and accept payments in it. Every forked coin has to overcome the long, hard slog of gaining trust and adoption.

Forks Trigger Free-Market Competition

It is true that the new coin may compete with the old - and they’ll compete on their features and benefits. The forked coin will either find a critical mass of users and investors - possibly siphoning some value from the original chain - or adoption will collapse, and it will become obsolete.

Contentious hard forks, like Bitcoin Cash, do pose a challenge to the incumbent’s reserve status: it puts Bitcoin directly up against a competitor that appears more scalable, at the cost of being more centralised.

This means that if scalability features prove critical to mass adoption, Bitcoin Cash could gain more usage and value moving forward. Time will tell.

The Benefit of Forking - Blockchains Consolidate Over Time

Forking is an example of “governance by exit”: if a sub-group of users don’t like the rules, they are free to leave and make their own.

Major disagreements within a protocol ecosystem will bubble up and resolve sooner or later as dissenters either fork the protocol, or leave to start something completely new.

This allows the protocol to settle on a singular use-case, as those users with a passionately different vision exit the project. We see this with BTC and BCH - the former now functioning an investment asset, and the latter has stabilised as a payment system.

Hard Forks and Investing - Capturing the Value of Both Chains

Like any currency or asset, the value of the new coins born from a hard fork will depend on their utility and market demand. Therefore, investors often speculate during hard forks on either the new or the old coins.

If an investor maintains a diverse exposure to the top crypto-assets with consistent rebalancing, then over time they will maintain exposure to all successful forked coins and their originals.

In recent history, hard forks have been likened to script dividends in the blockchain for taking on the risk of supporting these new projects. The coins can either be sold shortly after issue or held for long term gains if they are successful. And as with script dividends, it is always better to participate and have the optionality than to sit on the sidelines.

SwissOne Capital Top50 Smart Index

Due to the passive nature of the SwissOne Smart Index, subjective opinions do not inform portfolio selection. Therefore, coins (post-forking) must meet the eligibility criteria for liquidity and market cap. While the coins may be included during the month of issue, they would fall out at month-end during the rebalance if they do not meet the strict liquidity criteria.

The cash raised from the sale of these forked coins are then distributed / invested into the rest of the coins in the fund. If, however, the coins do meet the criteria i.e. in the top 50 by market cap amongst others, then the coins become part of the fund.

For example, both Bitcoin Cash and Bitcoin SV would be included in the fund as of 1 August 2019. However, the likes of Bitcoin Atom and UnitedBitcoin would have fallen out of the fund during rebalancing in the first month of listing.

Forks and Forking - A Summary

Contentious hard forks occur when a blockchain ecosystem has an internal conflict between users. The network splits, and some users move over to the fork - which may survive, thrive, or collapse.

Hard forks don’t increase the money supply: rather, they create a different coin, incompatible with the old network. And regardless of the fate of the forked and original coins, shrewd investors who held the original cryptocurrency pre-fork are set to capture value from whichever dynamics play out.

Learn how SwissOne Capital brings qualified investors direct and sensible exposure to the uncorrelated and high growth of the crypto asset class.

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