What is a Fork in Crypto? Understanding Hard vs Soft Forks
Read on to understand what forks in cryptocurrency are and how they impact investors
Read on to understand what forks in cryptocurrency are and how they impact investors
We often hear the terms hard fork and soft fork in crypto discussions or news. In this post, we will discuss these terms in detail. In addition, we will discuss how forking in cryptocurrency occurs and how these different types of forks affect investors as they plan their cryptocurrency investment strategy.
One of the main value propositions of cryptocurrencies is that the network's governance and decision-making are decentralised. Generally, the decision-makers of blockchain networks are the ones who own the said cryptocurrency. However, the right for governance is set up differently in different networks. Some networks use the same token as both a store of value and a governance token. Some networks have two different tokens, one used as a currency and the other used as a governance token.
Governance tokens are a type of cryptocurrency representing voting power on a blockchain project. Governance tokens are usually integrated into DeFi projects to distribute power and rights to users. It helps the projects to remain decentralised.
In general, in blockchain technology, the governance system is built with trust in the code (in terms and conditions embedded in the blockchain) and not necessarily with confidence in holders and their ability to make decisions, as opposed to traditional finance that works within centralised power. For example, in banks, top executives usually make significant decisions regarding rules and regulations for the entire organisation and the customers. Governance in the crypto world offers the opposite - it's decentralised, therefore, less likely to be manipulated.
For this article, the community of people who own the cryptocurrency are the ones who make the decision.
A fork is essentially a change in the protocol, in the code. In simple words, this is how a blockchain network decides against how the rules will be for the network, and a fork means a change in the network's constitution.
However, when many decision-makers need to reach a consensus, it can be hard to come to a decision. That's where hard and soft forks come in. A hard fork is making a decision without consensus. And a soft fork is decided with consensus from the cryptocurrency owners.
As we already mentioned, a hard fork is a change in the network protocol without consensus. There are a few reasons why hard fork events happen:
Sometimes, accidental hard forks might appear. For example, when two miners find the same block at about the same time. Accidental hard forks happen more often, but they are usually fixed before being noticed. Accidental forks happen when two miners find the same block simultaneously. They get resolved when the subsequent block is added to the chain, and automatically, that chain becomes the longest chain in the blockchain.
Hard forks usually result in a split in the network and can create two different divided networks because they disagree on the said protocol change.
A soft fork is a change in the network protocol that happens with the community's consensus. In simple terms, everyone agrees that a particular feature needs to be added or removed from the protocol. When everyone agrees, the "old" blocks and "new" blocks are both going to be valid. The blockchain remains one, and blocks created before and after are recognised as part of the block. Soft forks are the most favourable way to upgrade and change a network protocol. However, getting consensus is not easy. That's why some networks end up upgrading with hard forks.
Beyond consensus, other considerations determine whether a fork is classified as a hard or soft fork:
We often hear about consensus in the blockchain space — in simple words, it means that everyone agrees to a proposed update or change. Consensus is required for a soft fork but not for a hard fork.
In soft forks, changes happen at the network level. Since everyone on the network agrees to the proposed decision - there is no need to modify the protocol. As opposed to a hard fork, the protocol needs to be modified to make a change in the blockchain forcefully.
Think of your mobile software upgrades. You can use your phone nearly with no issues even if you don't get the latest version of iOS, for example. Similarly, soft fork allows the old and new versions of the cryptocurrency to work under the same umbrella. However, a hard fork requires all users to upgrade to continue using the cryptocurrency.
Hard forks create two sets of chains. The nodes that didn't upgrade (as discussed above) will be abandoned. That is the split. The main chain continues to exist and operate under the same name, and the split chain will no longer be used or become a separate cryptocurrency. For example, this is how Litecoin — the first alt-coin, has come into existence.
This is better explained in the case of the Ethereum DAO Hack. Long story short — Ethereum got hacked on the DAO project and $60M worth of ETH was stolen. Ethereum then had a hard fork by going back to the pre-hack version of the blockchain and returning the lost funds. Returning the funds is only possible with a hard fork because it happens on the Protocol level. If ETH chose to do a soft fork, none of the funds would be returned.
Forks often happen with different cryptocurrencies as different networks try to address "problems" that are not allowing the network's wider adoption and usability.
Read on to find out about some of the most recent forks that happened in prominent cryptocurrency networks, where soft and hard forks can be impactful enough to influence crypto investors' buy and sell strategies in the short and long term.
The most recent upgrade to the Bitcoin network is Taproot. It has been the most significant change in the bitcoin network protocol in the last four years. The upgrade entails more efficient transactions and extra privacy and anonymity. The way single and multi-signature transactions will look identical, bringing another layer of security and anonymity to the network.
Taproot is not a single fork but a combination of three main upgrades to the network that resulted from consensus. This consensus is rare for the Bitcoin network, and Taproot was anticipated for a relatively long time. It was first proposed by Greg Maxwell in 2018. Since then, the three Bitcoin Improvement Proposals (BIPs) codified Taproot were written by Pieter Wuille, Tim Ruffing, A.J. Townes and Jonas Nick and merged into Bitcoin Core in October 2020.
Before this upgrade, Bitcoin had a successful soft fork, SegWit upgrade, that went live in 2017. It helped make the transaction faster and cheaper by removing the witness data from the main block. However, in the big picture, SegWit made changes that increased the scalability and adoption of the Bitcoin network.
Before the Taproot fork, the London Hard Fork was one of the significant forks on the Ethereum network. It went live on August 4, 2021 - as a combination of five essential upgrades in the network protocol. Some have referred to the upgrade as "completely renovating your house while living in it". And we agree!
At its core, there are two significant improvements that London Fork has aimed at: more transactions per second and moving from "proof-of-work" to "proof-of-stake" to reduce gas fees. Instead of using electricity and miners to solve algorithms, "proof-of-stake" allows minting new blocks by randomly selected validators. Since this takes less time and energy — it helps the Ethereum network scale even further.
It all boils down to the Ethereum network's ability to scale as a significant network that many other NFT and DeFi projects are built on. It is crucial to keep the network relatively sustainable for different projects to increase adoption and demand for the Ethereum network. So as of November 2021, over 1 million ETH has been "burned" as part of the London Hard Fork.
While the upgrades happen step by step, the Ethereum network completes the London Hard Fork upgrades around June 2022, as developers Tim Beiko and James Hancock announced earlier this year.
However, the Ethereum network also implemented a hard fork following the DAO hack in 2016. Ethereum network had to roll back its blockchain to the time before the "attack" to get back 3.6 million ETH that was slowly leaked by exploiting the bug in DAO. These types of emergencies occur, and for this particular reason, there is a time and place for both soft and hard forks.
Both soft and hard forks affect the prices of the said cryptocurrency. However, the first fluctuations in prices might not always be deterministic in the long-term.
There are many other long term effects of forks, for example, scalability and adoption. SegWit upgrade helped the Bitcoin network to become more advanced and set the ground for Taproot Upgrade. If you think along the lines of traditional finance, if you are a value investor, you are investing thinking about the long term opportunity. You are better off buying stocks of a small but growing company. An ideal investment vehicle would be a company that is constantly making changes, improving, and upgrading constantly. The same logic applies to forks and cryptocurrency investments. While a change in protocol might not directly affect you today, it can make the network scalable. The more people use the network, the higher the chances of the cryptocurrency to snowball in the long term by making it a smart investment.
Another way that forks can affect crypto investors directly is in the infrequent case of attacks on the network like it happened with DAO startup and Ethereum. The hard fork that followed the attack returned the lost funds to the rightful owners. Although it occurs rarely, hard forks can bring an additional layer of security and stability to the network. Consequently, it will help make the prices of the cryptocurrency stay stable or grow further.
With the most recent Taproot Upgrade, investors will have the more effortless experience to use the Bitcoin network to invest in different DeFI and NFT projects that are potentially going to be built on the Bitcoin network.
Hard and soft forks help make cryptocurrency networks more advanced and further develop the market. As the market matures, there will be more opportunities to invest, create, and grow with it.
Buying, selling, staking or lending crypto as investment options have been around for a while. As the crypto market grows, more people wish they came to the game earlier on and saw the potential of cryptocurrencies when they first appeared.
It is still possible to start investing in crypto and make it a fruitful journey by diversifying your crypto investments to include crypto interest accounts, which offer high yield on stablecoins like USDT, enabling you to generate a steady stream of passive income. With Cabital, new and seasoned crypto investors can buy and sell crypto with EUR and GBP via SEPA and FPS, respectively.
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