What is a hard fork and what does it mean for price action?

While bitcoin reaches all-time highs, different technological ideologies are causing the blockchain to split. What could this mean for the cryptocurrencies price action?

Source: Bloomberg

What is a hard fork and what does it mean for price action?

One of bitcoin's biggest issues at the moment is that the cryptocurrency has garnered significant enough media attention for people to have an opinion on it, without actually even understanding what it is. Without this understanding, it’s very difficult to see any value or potential in bitcoin, and blockchain technology in general. It also makes it incredibly difficult to get your head around what a hard fork is, and how this could affect any price action going forwards.

What really is bitcoin?

When you think of bitcoin, what do you think of? Most will have the surface level understanding that it’s a digital token that people have ascribed a USD value to, and that you can send it to any address in the world for a near instant transfer without a central bank or intermediary. This understanding is correct, however, getting to this definition requires us to first take a step back and think of it in an entirely different way. Hopefully this brief moment of reflection will not only increase your understanding of blockchain cryptocurrencies, but give far greater insight into why cryptocurrencies fork, and adequately set you up for any further bitcoin forking events.

Contrary to popular belief, I don’t think bitcoin is intrinsically a currency. It isn’t supported by any central bank or government, and it doesn’t have the same level of government backed assurance in the same way as the USD, GBP or EUR, for example. It certainly has value because of its limited supply and underlying utility, but this is where the ‘currency’ aspect of it stops.  

In my mind, bitcoin is a decentralised consensus network. I think those three words are quite profound and, whether or not you agree with me, it’s important to understand this concept, as it could change your opinion on blockchain technology, and provide a foundation on which to build a wider understanding.

When you send bitcoin from one address to another, your transaction is noted in a ledger. This isn’t a ledger on a centralised server like it would be with your bank, but instead it’s booked across thousands of different computers called nodes, who in turn compete to validate groups (or blocks) of transactions and a mathematical computational task. If all the computers validate the transactions and form a consensus then they are approved, the block is validated, and added to the pre-existing blocks to form a chain. This form of consensus is the core of the bitcoin protocol and the same logic applied for how and why bitcoin undergoes hard forks.

What is a hard fork?

Bitcoin software is open source. This means that the underlying protocol on which it runs can be viewed by everyone, independently validated, and (where appropriate) new software code can be suggested. These are referred to as Bitcoin Improvement Proposals (BIP) and are regularly suggested by the wider community. When a new BIP is broadcast to the network, all the computers that set about validating blocks can vote on which proposals to implement. Once again, this decentralised consensus network is making decisions on the direction of the blockchain technology, without the need for a central body, executive committee, or CEO.

Sometimes proposals will be ‘backward compatible’ in that the software update will still be compatible with the legacy system. This is referred to as a soft fork. A hard fork goes one step further and is a software update that introduces a new rule which isn’t compatible with the legacy network. The chain of validated blocks therefore ‘forks’ into two. Sometimes there will be enough computational power to support both chains (for example the bitcoin and bitcoin cash split), whilst other times only one chain will survive (for example the Ethereum network's ‘Byzantium’ upgrade).

In short, a fork occurs because of an update to the software. Sometimes this will be a technological upgrade which the whole community agrees on, other times it will come from two different and competing ideologies. In the latter case there is a sufficient consensus to upgrade the protocol, but not enough to simply pick one direction. Both result in hard forks, however, a hard fork doesn’t necessarily mean ‘two coins’.

What does a blockchain hard fork mean for price action?

The most important thing to remember is a hard fork isn’t the same as a stock split. Some people refer to it as this because it’s an easy concept to get your head around, and one that many people already understand. But if you think of it this way then you may be surprised with any price action over a cryptocurrency fork.

When a company performs a stock split it is specifically breaking up the business (and therefore the business value) into two forms of shares. This splits liquid and illiquid assets of a business, as well as things such as revenue stream and projected earnings over two separate companies or listed shares. If a company is worth £100m and it splits 10% of its business via a stock split, you’ll expect to see a new company worth £10m, with the existing company now worth £90m (assuming each part of the business, projections, revenue etc. are equal). The stock price of each, all other things being equal, should reflect this as well.

A blockchain fork wouldn’t fall under the same rules. Value from cryptocurrencies comes from a speculative expectation of utility and wider adoption at some point in the future, so when there is a split you can’t expect each chains price action to neutralise the price. For example if bitcoin was trading at $4000 and the chain split to give a new coin that the market priced at $500, you’re not necessarily going to see the original chain suddenly priced at $3500.

Leading into a fork does generally create a volatile market with significant price action. As with all things it’s the uncertainty which usually causes this. Will the new upgrade work? Will the benefits such as lower fees, faster transactions and increased decentralisation be evident? Shall I get into the original crypto before the fork so I have both coins afterwards? Shall I buy/sell immediately before/after the fork?

Trading over a cryptocurrency hard fork

It’s important to review any trading plan you have when you trade cryptocurrencies or the underlying technology is heading into a hard fork. You can expect high volatility and price action so it’s important to have any understanding of general daily movements and market swings. Review risk management and set your stops accordingly, and keep an eye on the news (twitter is great for crypto news) to keep up to date on any potential changes to the wider crypto landscape. 

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