The topic of soft forks vs hard forks always results in intense debates among developers, as well as uncertainty and concern among speculators and traders. But what do cryptocurrency forks really mean? You’re about to find out!
Simply put, soft forks and hard forks are for blockchains what regular updates are for common computer applications.
The software responsible for implementing a blockchain consensus protocol is usually handled by a group of developers who continuously work to propose, define, and implement improvements and best practice solutions to the code.
When this group of developers introduces a new update to a software, the blockchain undergoes a fork.
If you’re a fan of common computer programs and understand how updates work, then I presume you’re familiar with the notion of backward incompatibility (or compatibility).
Don’t have a clue about it? No worries.
If the program’s update is such that files created with the updated version of the application can still be used and opened using the older version, then it’s a backward-compatible update.
On the contrary, if files created on the new version cannot open on the old one, then the update is backward incompatible.
Blockchain consensus protocols work pretty much the same way.
Now, let us look at the different types of forks in more detail.
What Is A Temporary Fork?
A temporary fork occurs when multiple miners mine a new block at the same time, thus resulting in two different (but correct) chains existing simultaneously.
Since the chain with the greater hash rate has a higher probability of finding a new block quickly, it’s the only one that will become longer, resulting in the short one getting dropped.
After that, miners will continue mining blocks on the remaining “real” blockchain.
What Is A Soft Fork?
Soft forks are blockchain protocols that are backward compatible, meaning they introduce several changes that don’t radically change the functional continuity of preceding versions. This implies that nodes can continue operating (mining new blocks and/or validating transactions); even though mining nodes risk trying to push invalid blocks into the blockchain depending on the new rules set by the new fork.
That said, all invalid blocks will be denied because nodes that have upgraded to the latest version will recognize them. This will result in a loss of computational resources, which will in turn force every node on the network to ultimately upgrade to the latest version of the blockchain protocol.
A well-known soft fork example is the adoption of SegWit. For a long time, the Bitcoin community had been debating on the best ways to increase the cryptocurrency’s transaction speed.
Since new blocks of transactions get mined every ten minutes on average, the general idea was to raise the number of transactions included in each block, and to do so, the community proposed Segregated Witness (SegWit in short) as a solution.
The goal was to free some space in every block that the platform could use to increase the number of transactions. And eventually, this update worked.
The change in Bitcoin’s consensus protocol was implemented in a manner that allowed blocks mined before to be processed and recognized. In other words, the update was backward compatible.
What Is A Hard Fork?
A hard fork is a blockchain protocol that is backward incompatible. This kind of software update permanently diverges from the preceding versions of the blockchain and nodes running on older versions won’t be recognized by the latest version.
This further implies that miners and nodes will have to upgrade to the new version of the blockchain protocol software if they want to benefit from the new forked chain.
Hard Forks are only implemented if there is sufficient support from the cryptocurrency’s mining community. Only after a majority of the community members give positive signals toward the fork or upgrade will developers of the Blockchain start working on the code.
And “positive signals” mean VERY positive. Typically, the support should be anywhere from 90 to 96 percent in order to green light the hard fork.
A well-known hard fork example is the split of Bitcoin into Bitcoin and Bitcoin Cash, which took place on August 1, 2017. As you may know, Bitcoin was the dominant player in the realm of cryptocurrencies for a long time. However, higher fees and transaction times pushed the community towards the creation of a new cryptocurrency promising better performance.
Bitcoin was becoming more like a store of value, and less an actual usable currency. This resulted in a political divide inside the coin’s community, with one half wanting the coin to remain unchanged and the other half feeling like it needed to change.
The first half thought that changing the coin would deviate from its original vision, whereas the second half claimed that Bitcoin needed to evolve to fulfill its goal of becoming the first decentralized currency in the world.
To fix the issue, the bitcoin community agreed to introduce a hard fork and split Bitcoin into two different asset classes, Bitcoin (BTC) and Bitcoin Cash (BCH). Bitcoin stayed a store value coin while Bitcoin Cash became a much cheaper and faster option to process payments.
Today, the two cryptocurrencies have their own value and prices.
At this point, it’s also important to remember that when a blockchain gets split, so does its underlying token. If that wasn’t the case, then all blocks with sizes compatible with the two protocols would get processed by both blockchains, thus resulting in double-spending problems.
This is avoided by creating the new currency that’ll share the same history as its parent currency up until the day of the split, but then becomes independently transacted and managed.
What Are The Effects Of A Hard Fork?
Hard Forks tend to have profound impacts on cryptocurrencies, and not just because of the uncertainty created. The creation of Bitcoin Cash is a great example of a quirk that can result after the introduction of a hard fork.
Note, when a new cryptocurrency is created, holders of the “original” cryptocurrency usually end up with the same number of units on the newly forked currency. Simply put, if you had 20 BTC before the Bitcoin Cash hard fork, you’d have 20 BCH after it.
This can result in some interesting ripples inside the market. Here is a hypothetical example.
Let’s imagine that a manager of large traders, or whales (large organizations that hold hundreds of thousands of Bitcoins) learns that a hard fork is about to take place and will result in them getting a new coin for every original coin they have.
This can give them sufficient motivation to increase their investment stake in the original token by buying up every coin they can find. And if they manage to secure a huge size of the cryptocurrency, then it implies they can artificially skyrocket the parent currency’s price in the days leading up to the fork.
What’s more? They will keep on doing it until the time of the hard fork split when they get new coins.
Now, since the company knows that the parent coin’s price has been inflated by its own actions, it goes on to dump both the parent token and new token on all exchanges. And needless to say, that causes the price of both the parent and forked tokens to crash.
Before you start searching for the closest forks on Google, keep in mind that this example reflects the effects of an extreme hard fork case. Not all hard forks result in “free” cryptocurrencies for holders.
Moreover, it is also possible that traders and speculators favor the new fork and abandon the original cryptocurrency, as it happened with Ethereum Classic and Ethereum.
Investing Before A Hard Fork: Is It Worth It?
Hard forks create instability for cryptocurrencies. Communities will often be divided due to the issue and the markets get extremely volatile (even by cryptocurrency standards).
With that in mind, how you react will largely depend on the kind of hard fork you’re looking at and the stake you have in the token.
If you’re dealing with a hard fork that will grant you “free” currency, then it makes sense to hold your current stake and even boost your investment. The only problem is that the large traders are doing the exact same thing.
So, if you’re worried that you won’t be able to react fast enough and sell off before the whales, experts recommend that you sell all your investment just before the night of the fork.
While that might not provide you with free currency, you might benefit from a bull run ahead of the split. You can then go ahead and use the cash you have to buy an even larger share after the cryptocurrency’s inevitable drop.