Cryptocurrency can be a wild ride with all kinds of news breaking on the scene daily. This past year highlighted some major moments in the crypto lifecycle, including drastic increases in price, large amounts of capital being poured into blockchain projects and regulatory backlash from financial institutions. Similarly, the creation of currencies like Bitcoin Cash and Ethereum Classic mark another major trend in the crypto world. These coins were created due to “Forks” occurring in the Bitcoin and Ethereum blockchains respectively. Such events can have a considerable financial impact on all assets involved, which is why as a crypto investor, it’s important to understand how “Forking” works.
WHAT IS A FORK?
Forks can seem like a technically overbearing concept to learn, but it’s pretty simple. Blockchains run on a distributed ledger technology, and in order for that ledger to operate, all nodes on the network need to agree on the series of transactions that existed in previous blocks (the historical chain of blocks) and agree on what features and algorithms are in the current blocks.
When there are minor disagreements such as 99% of nodes saying “A” and 1% of nodes saying “B”. The 1% of nodes start to create their own block that branches off of the chain. This is called an “Uncle Block”. By the time the next block is complete, these nodes realized that no one is observing their uncle block and quickly return to the main chain.
However, there are other situations where a large portion of the network agrees to change the rules resulting in a fork to a new blockchain that isn’t compatible with the current chain (called a “soft fork”) or where a large group of nodes on the chain >35% want to start a new chain and branch off of the main chain (called a “hard fork”) this can create an entirely new blockchain and token.
Forking events happen in two ways: accidentally or deliberately. Accidental forking events occur when updated versions of a blockchain ledger are not compatible with all nodes on the network. In this case, two ledgers are produced, an old version and a new version. It is then up to the developers of the coin to determine how these versions will be reconciled. Deliberate forks in the blockchain occur due to disagreement in the community on the conditions of a software upgrade. If large parts of the community disagree with the upgrade or prefer to have an upgrade, they will create multiple versions of the blockchain ledger, thus causing a fork.
WHAT IS A SOFT FORK?
A soft fork is an upgrade to the blockchain ledger, where only previous blocks/entries are made invalid, thus creating a new version of the ledger. However, soft forks are backward compatible, so old nodes running previous versions are still accepted for the consensus protocol. Essentially, the network remains as a single blockchain after the forking event since all nodes are still accepted to make new entries. Only a majority of the nodes must agree to the software updates for a soft fork to be implemented and a new version of the ledger to be created.
Soft forks are very powerful tools to introduce software updates to a preexisting blockchain network. This is because a soft fork results in a single network without creating new chains.
WHAT ARE HARD FORKS?
Hard forks are how currencies like Bitcoin Cash and Ethereum Classic are created. There is a fundamental disagreement within a blockchain community that leads to the formation of two totally independent blockchain networks emerging from a single one. In these cases, all nodes still running the previous version of the blockchain will no longer be accepted to make new transactions. For example, a disagreement to increase the block size of new entries resulted in a hard fork occurring in the Bitcoin blockchain led to Bitcoin Cash being born.
Forks in cryptocurrency are becoming more ubiquitous, making it an important concept to grasp for interested investors. The communal aspect of crypto is what makes it so attractive to outsiders, but forks are something that shines a more nuanced light on the risks associated with these democratic currencies. Generally speaking, a fork event indicates a divide in a project’s community, making it an unattractive buy. Furthermore, a forks event’s effect on price can be incredibly varied based on if it’s soft or hard, and deliberate or accidental.