Cryptocurrency forks: why do they happen and what happens after?

in #cryptocurrency4 months ago

This is my promised follow-up post to my previous post on the legal basis for cryptocurrency forks. In this post I’ll discuss some of the potential economic results of a cryptocurrency fork.

If you haven’t already read my previous post referenced above, I highly encourage it unless you consider yourself a cryptocurrency expert, since I’m assuming knowledge of the first three sections of that post: 1) How does a cryptocurrency start?, 2) Why does cryptocurrency have value?, and 3) What is a cryptocurrency fork? However, feel free to skip the remaining sections that contain the actual legal analysis, as they aren’t relevant to this post.

Perhaps surprisingly, writing this post was more challenging for me than analyzing the legal aspects of forking, because we’ve left the somewhat messy realm of human law for the even more murky realm of how humans decide to value things. So while I’m comfortable with conclusions of my legal analysis and how US court cases on the matter would play out, from what I’ve seen so far, I expect there’s never going to be complete agreement on how humans should place value on currencies (unless the population count drops to below “2”, and then it won’t matter anymore).

What are the possible outcomes of a cryptocurrency fork?

Just to refresh your memory, a cryptocurrency fork happens when the software that defines the rules for a cryptocurrency is changed, and one or more computer operators decide to run the modified software with the new rules. These rule changes can change literally anything about how the cryptocurrency operates, including generating entirely new coin balances for users (e.g. “money” can appear and disappear from your account).

When a fork occurs, the original cryptocurrency software may be completely abandoned in favor of the new fork if a large majority of the users agree that the changes are good. Alternatively, if there is significant disagreement about the new changes, both cryptocurrency networks can continue to operate and users have the potential to transact on both networks.

If both the original and the forked network continue to operate, the two networks are often seen as competitive to each other, because they both offer similar capabilities, but it’s not that unusual for individual users to decide to use both networks. I’ll discuss this point more later and how it affects fork economics, but first we need to cover a little background on why cryptocurrency forks occur.

Why do cryptocurrency forks occur?

In order to predict probable outcomes of a cryptocurrency fork, it’s very important to know the reason the fork occurred, because the potential advantages of the fork will naturally play a large factor in whether people will decide to operate on the fork. Below are some common reasons why forks occur:

Disagreement about technological direction

In this case, there is a disagreement between a coin’s developers about whether a change to the software is a real technical improvement or not (i.e whether a modification increases or decreases the utility of the cryptocurrency). Examples of potential technical improvements include: increasing the number of transactions per second that a network can support, decreasing how much it costs to operate the software, increasing privacy of user transactions, etc.

Probably the most famous case of this type of fork is Bitcoin Cash, a fork of Bitcoin. Bitcoin Cash developers proposed increasing the “block size” to allow for more transactions to be processed in a given period of time (which would lower the cost of sending bitcoin). But other bitcoin developers thought that increasing the block size would have negative effects on the privacy of the transactions, and they didn’t agree with the trade-off. Instead they were in favor of other solutions that could also enable higher transaction bandwidth.

If you found all but the first sentence in the paragraph above to be very confusing, you are probably standing on common ground with most people. Because the debate on this forking issue was largely technical, I think it left most cryptocurrency users somewhat confused or disinterested (including many technical people like me, that weren’t deeply into the internal workings of all aspects of the Bitcoin protocol).

What was the result in this case, where complex technical discussions were the primary arguments for and against the fork? Both cryptocurrency networks continue to operate and have value, although at this moment the original Bitcoin network is generally considered to be more “valuable” (I’ll talk more about coin valuation methods in a different post).

Disagreement about methods of distributing new coins

Disagreements about distribution of new coins is probably the most common reason for cryptocurrency forks after technical improvement forks. Typically this type of fork occurs when developers of a cryptocurrency either outright grant themselves a large percentage of the coins on their network, or arrange the cryptocurrency rules in such a way that they obtain a large percentage of the coins. This practice is generally considered unfair by most people, so such cryptocurrency networks generally don’t gain enough users to have long term viability.

Now depending on the rules of the cryptocurrency and the visibility of account balances and ownership, it may not be easy for users to even recognize that developers have engineered a large balance for themselves right away. But over time, this usually has an impact on the ultimate valuation of the coin, because a currency where a single entity has most of the coin may face severe selling pressure at some point as that entity decides to sell off some portion of their coins to diversify.

If a cryptocurrency with a perceived unfair distribution doesn’t provide any new technological advantage, then that’s usually the end of the story for that cryptocurrency, either when users reject the coin as unfair or because the valuation of the coin starts to drop due to selling pressure from a single outsized stakeholder, which in turn can lead users to flee the cryptocurrency to avoid losses.

But if there is some useful aspect to the new software, then other computer operators may just decide to fork the cryptocurrency and advocate for an alternative distribution that might be seen as more fair, and therefore likely to attract more users. This has happened fairly often.

But one way in which cryptocurrency developers have found to justify holding a good percentage of the coin supply, is to promise to use those coins for development and/or promotion of the coin. But still, in cases where users later decide those promises aren’t being kept, a fork again becomes more likely.

Coins gained by non-dev users in a manner perceived to be unfair

The most famous case of a fork that resulted from “unfairly” obtained coins by a regular user was when an Ethereum cryptocurrency user (referred to as the DAO hacker, as his identity is unknown) exploited a weakness in the code of an Ethereum smart contract called the DAO, that allowed him to unexpectedly obtain a huge quantity of Ethereum coins. Effectively speaking, he “stole” a large number of coins from this special account that held coins in custody for many Ethereum users.

I’m using quotes on the terms “unfairly” and “stole” because there was disagreement in the existing Ethereum community at that time about whether the hacker’s actions could be considered theft or even unfair. This was because the smart contract code allowed his actions, and the Ethereum community had previously promoted the idea that the only rules were the rules defined by the smart contract code, as opposed to traditional contract agreements, which are subject to human interpretation and oversight via the court system.

But, as a practical matter, the DAO hacker obtained so many coins this way, that the primary Ethereum developers decided to reject somewhat the notion that “Code Is Law” and they created a fork of the software that reverted the transactions that allowed him to obtain the coins (taking the coins back from him).

However, other computer operators acting under what I suspect were multiple different philosophical principles, one of which was certainly the “Code is Law” doctrine, protested the fork, and continued to operate the original code (Ethereum Classic, where the DAO hacker got to keep the coins he obtained, and the DAO investors lost those coins). Thus, two competing cryptocurrency networks formed, both of which continue to operate as of this writing.

In the end, what we see is that only the “natural law” of cryptocurrency (a coin’s value is set by voluntary agreement among network participants) held true, and like-minded users agreed to continue to cooperate via the rules of their choice.

What happens when existing users choose “sides” after a fork?

When a fork happens, existing users of that cryptocurrency will typically decide to operate on just the old network or the modified one. In this case, they will often sell the coins in the network they decide to stop using. If a large number of people choose one network over the other and sell their coins in the other, then coins in the network with the fewer remaining users will typically drop in value, but there’s also other factors, such as how many coins are owned by departing users, and thus how much “selling pressure” results from the users leaving the network.

Why would anyone keep coins in both the original network and a fork?

At first, it might seem like a user would always choose to just use the network he prefers, and sell the coins in the other network. But there can be good reasons to keep coins in both networks instead:

Acceptance by different user bases as a reason to operate on both networks

If there looks to be no clear “winner network” which will end up with most of the users, then holding coins in both networks means you can directly buy things from both user bases. If you only hold coins in one network, then if you decide to buy something whose price is denominated in coins of the other network, you’ll be forced to make one or more additional trades later in order to obtain the proper type of coin.

Investment hedging as a reason to operate on both networks

When a fork happens, it may not easy to judge which one cryptocurrency will be worth more in the long term, especially as each fork will have different developers and advocates. This makes cryptocurrency markets subject to potentially large price moves. Cryptocurrency investors will often hold coins in multiple forks to diversify their holdings to decrease the chance for catastrophic losses (e.g. if one of the two competing cryptocurrency networks loses all its users and becomes worthless).

Do existing users typically gain or lose “coin value” when a fork occurs?

To me, this is a very interesting question and the results are often surprising.

At first thought, it might seem that if all users migrated to the new fork with a relatively unchanged supply, then mostly the value of the network would remain the same (the value of the old coins would simply transfer to the coins in the new network). But of course, if the fork does provide some significant perceived benefit, the new coin will likely rise in value due to the increased utility or perceived fairness, and existing users will see a gain in the value of their holdings.

But what may seem even more likely, but has often proven not to be the case, is that if a fork happens and the user base splits between the two coins, then at best the resulting value of the coin holdings on each network would just be the sum of the value on the original network. In other words, some of the value from the old network would be retained in the old coins, and some of the value would “transfer” to the new coins. It might even seem like the total value should go down, since the original user base is now going to be divided into two smaller groups that can no longer directly interact as easily as before.

But human valuations are not subject to perfect logic and it’s also easy to miss variables when analyzing human behavior, so in practice, at least in the short term, this type of split in the user base has often resulted in an overall gain for the coin holders:

value of old coins after the fork + value of forked coins > value of old coins before the fork.

This apparent anomaly may be explained in part by the additional promotional efforts by both operators of the original network and the fork network, as they compete to gain user base, which could result in a larger overall user base between the two networks than previously existed in the original network.

Q&A from readers of my previous legal post that fit better here

If completely new coins can be created by a fork, is it crazy to think those new coins have any value?

It all depends on how people perceive the means by which the new coins were created and the utility which they think they will get from using the new money.

This same question actually applies to all traditional sovereign money such as US dollars and Zimbabwe dollars. Just like someone can fork a cryptocurrency to create new money, any sovereign government can create new money, and most do it all the time. And if a government produces “too much” new money, then that money/coin will likely lose value versus other currencies.

Note that this doesn’t apply to “hard currencies” like physical gold, where the available supply can’t be increased by altering a few numbers inside a computer. And for this reason, some people only trust hard currencies as a medium of exchange. But for most people, the convenience offered by non-hard currencies outweighs this disadvantage.

Cryptocurrencies were actually created as a way to offer an alternative money that wasn’t subject to creation and control by sovereign nations. The idea is that users of a cryptocurrency are voluntarily deciding to operate under a common set of rules for that money and can voluntarily leave that association, if they at any point begin to disagree with those rules or how the money is being created.

One of the appeals of cryptocurrency is that there are a fixed set of rules, and if you like those rules, you can always continue to operate under them, and trade with others who agree about those rules, unlike a sovereign currency, where the government decides the rules and you are forced to live with them.

If coins can be destroyed by a fork, is there any reason to think any cryptocurrency coins are “safe” (and therefore have any value)?

The safety of any currency (even hard currencies like gold) relies on other people being willing to accept that currency as payment for goods. As I’ve discussed elsewhere in this post, this largely depends on two things: 1) the utility of the currency (how fast can you transfer it, how easy is it to use, etc) and 2) how fair the rules are perceived to be, especially rules around creation of new money.

If someone creates a fork of the software where thee only purpose of the fork is to arbitrarily remove just your coins, for no good reason, then other people will likely decide not to operate on that fork but instead continue to operate on the original fork. On the other hand, if users decide that there was some good reason for you to lose your coins, then they will likely migrate to the fork and leave the original network.

Practically speaking, this means if a fork is created to remove your stake for an unpopular reason, most people will stay with the original network, and your funds will still have value. On the other hand, if for some reason most people think you don’t deserve the coins you have, you could very well find yourself on a cryptocurrency network with no users and a bunch of worthless coins.

More to come

One thing I’ve found when writing on a topic like this, is that it often leads me to want to talk about related issues, but I’m afraid that introducing too many ideas and details at once might obscure the primary points I wanted to cover in this post. So I’ve decided I’ll likely make one or more followup posts later when I have some time, so that I don’t “waste” some of the writing I’ve done that I decided to discard from this post because it was too distracting from the main points.

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Taking a historical look on cases of communities splitting (like the Ethereum and Bitcoin examples you mentioned), it seems quite clear that the result is a loss for everyone in the network which used to be a single whole.

While I can see a decent case for making that argument from a logical standpoint, I'm far from convinced it's true.

One of the big weaknesses in that argument, in my opinion, is that the actual size of the cryptocurrency community is small compared to the total population of potential users. This means 1) forking conflicts have often resulted in press articles that introduced more people to the idea of cryptocurrency and 2) forks often emerge as an opportunity for people that didn't initially get into cryptocurrency, to come in later, at less of an economic disadvantage to early holders, which is attractive to some people.

You can see this latter behavior in the large numbers of people that invested in ICOs rather than bitcoin (although ICO investment is often fueled by improved utility arguments as well).

Of course, a potential counter-argument to all the above, is to try to argue that Bitcoin would be worth more if there were no alternative currencies and that it would be worth more than all the other cryptocurrencies combined. I suspect most bitcoin maximalists hold this position.

Personally, however, I'm of the opinion that the utility improvements made by later coins have more value than the splitting effects they've caused.

Also, I'm happy that alternative cryptocurrencies were created regardless of the net effects on current cryptocurrency valuations, because I think the philosophical implications demonstrated by the forking process has more profound longer term consequences for organized human interaction than we've yet seen.

I think you are talking about cryptocurrency software evolution. I quite agree with the sentiment. But only up to a point. Up to which point? The point where human biological evolution stopped being relevant because human cultural evolution outpaced it by many orders of magnitude.

Some elaboration may help make this more clear.

It seems to me that if the cryptocurrency software allows for high flexibility of the governance/economics rules which the community creates for itself, then design iterations of these rules can readily happen within the same community. Yes, the biological evolution of organisms (if we use it as a parallel for the design evolution that I think you're talking about) requires forking out (new species created) and leaving the old species behind. You can't achieve the possibilities/behavior of the new organism while retaining the old biology (old governance/economics rules in our case). But, once you get sufficiently complex, like having a highly complex nervous system, then that allows you to readily change your behavior and achieve novel great things simply through learning (no requirement to change your biology).

So, do you think Steem has sufficient flexibility to allow for a continuous evolution of the rules (organized human interaction) within itself? Or does evolution need to happen some other place?

Some solid ideas there, and let me say how I see those analogies play out in blockchain tech: Forking is still the current way to make radical changes (biological evolution). Smart contracts are the current analogues to the cultural evolution you talk about.

In theory, any improvement implemented via a smart contract can be implemented via a fork, and from a technical perspective (speed, memory efficiency) the forked implementation can be designed to run better.

But smart contracts do have on major advantage, and that's a political one: smart contracts because of the sand-boxed nature in which they execute (assuming no bugs in your smart contract processing code) enable new functionality to be added to a cryptocurrency network without requiring consensus to add the new functionality (only people who want to participate in the smart contract's new rules need to care about it, everyone else using the blockchain can ignore it). And here we see the analogy to cultural evolution when looking at smart contracts: changes can be made on a smart contract system without requiring change to the base platform (the DNA, so to speak). With a smart contract, you "teach" the existing blockchain how to do new things without making a low level change to how it operates.

Steem doesn't have smart contracts of this sort currently, and it would require a hard fork to add them, but it's certainly doable.

There's also another alternative to smart contracts as a means of evolution without requiring full consensus and that's by linking up chains via trustless crosschain transfer. Then users can transfer value between networks with differing rules, enabling them in many cases to obtain the benefits of multiple blockchains. This could be viewed as cultural evolution, or maybe it's more like "emergent behavior" (it's easy to stretch any analogy too far). But in any case, it's a way to enable new behaviors on a blockchain without changing it's DNA.

As a side point, note that "trustless transfer" technology is different from atomic crosschain swaps (although they commonly get conflated with each other), it's a different and more powerful technology, which to my knowledge has not yet been implemented for any pair of chains. But it's definitely theoretically possible and I expect to see someone do the hard work eventually.

But to achieve all the evolution of rules that I think we need to see in consensus technology (a term I'm coining now that is similar to what people call "blockchain technology", but only requires consensus mechanisms and no actual blockchain) I believe the performance advantages of hard-coded rules will be needed for some time to create technology that operates at sufficient speed to solve some important problems.

In a perhaps an ironic twist, my own primary area of interest is looking at ways to use consensus technology to speed up the rate of our human cultural evolution.

Yeah, so the primary thing of concern seems to be how much the consensus technology (seems like a good term) can allow for different groups of people to meet their needs - the political aspect you talk about. One size does not fit all, so people have to be able to create their own rules and arrangements to suit their own needs. As you say, smart contracts allow for this since only people who opt into the smart contract are using it (i.e. we assume everyone else is pretty much unaffected, or they are affected (everything is connected to everything else from a systems science perspective) but to such an indirect and low extent that it's acceptable).

In the case of Steem, it seems that SMTs + Communities would allow for quite a lot of this - different groups making up their own rules without interfering with the other groups. It seems to me like the Steem base layer is allowing for lots of such cultural evolution.

What you say about inter-blockchain trustless transfers also seems quite interesting and I wonder how much it can be implemented with TRON and Steem. Any thoughts?

With regards to the evolution of design, I guess my overall point was that the Steem community can make progressive hardforks, as it has done many times, but the community remains as a single whole. There doesn't have to be a split in the community since the entire community accepts the evolution. It seems that this evolution of the base layer through hardforks is about smart ways of increasing flexibility so as to allow for cultural evolution to happen and groups to come up with their own tailor-made cultural rules.

traditional sovereign money such as US dollars and Zimbabwe dollars..? Can we just call it a fiat currency , forceD by the government Money?.

Traditional economists call it sovereign currencies, cryptocurrency and gold money advocates usually call it fiat currency. I often flip back and forth between the terms, they both make valid statements about the nature of government money.

Not to mention the fact that the administrators and the moderators of the communities can ignore/mute anyone without any given reason. Like they done it with me in the @dcooperation community. I did not do anything bad. I only expressed my opinion about various topics. I asked them multiple times why they ignored/muted me, but no one explained anything so far. This is pure censorship. Communities are gateways to censorship.

What a very insightful post, thank you for sharing this @blocktrades. You clearly know your stuff in the crypto world and I'm sure I will learn loads more about it with this post and others you've published. I also used your Blocktrades service to set my account up and power up my Steem, it was very smooth and simple so thank you.

👏 resteem. There is scientific evidence (you probably know) that the value of communication networks like facebook, tencent, ...even Bitcoin, Ethereum and Dash follow network laws like Metcalfes law (Alabi 2017,Peterson 2018, Civitarese 2018). Where the basic utility is dependent on the number of users. (Metcalfe = n² or at least n log(n)). So a doubling of the user-base n quadruppels the value of the network utility. There is also a Facebook internal study, that users only can be retained when they find at least 7 friends in the first 10 days (Palihapitiya). Currency is much more valuable the more people use it with .

Vitalik came to a verry similar conclusion like you. Normaly what we would expect was that after a 50:50 fork both ecosystems lose, since both are smaller. Linear loss of user = exponential loss of possibilities. But when a fork results in a liberation of what users really want, then there is a net growth of value (Buterin 2017: A Note on Metcalfe's Law, Externalities and Ecosystem Splits)

@blocktrades, I want to appreciate your efforts towards this very vital Knowledge Transfer session because currently many have mixed feelings towards the Soft Fork so in these kind of situations Community needs more Knowledge regarding important Terms instead of Speculative Information.

In my opinion only Change Is Constant and in Blockchain and Cryptocurrency Space, Fork is that Change.

Have a wonderful time ahead and stay blessed team.

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Hi there forgive my naivete but why do you give us such a poor conversion price for our steem on your exchange? Steem is $0.178 but you can only offer us $0.14 today. This seems unfair. Please can you explain.
Many thanks.

I can't answer your question in a specific way, unless I know not only what coin you're selling, but also what coin you are buying. But generally speaking, there is no single price for a cryptocurrency, the prices vary across exchanges for a variety of reasons. To see how extreme this can be, look at current prices on various exchanges for Steem Dollars (SBD): https://coinmarketcap.com/currencies/steem-dollars/markets/

We therefore have to make decisions about which prices are actually valid ones. One reason a price may not be valid is if most people are not able to trade on an exchange offering a price at variance with the rest of the exchanges. This can happen if the exchange disables deposits/withdrawals or if they only allow citizens to trade on their exchange (this is true for Korean-based exchanges, for example). Price aggregators like coingecko and coinmarketcap try to compute a "blended" price to account for this price variance and we do something similar, but we each use different techniques, so our decisions about a "fair" price will sometimes differ.

Help, steemit seems to be crashing. 3 top devs just resigned. Worse though, I can't sell my steem on Blocktrades, the only exit for us all, because steem is "under maintenance". Was there any explanation somewhere, like a post? How long do we have to wait before we can sell or buy? Who put this block on blocktrades? This really looks very suspicious.

Oh, one more thing I forgot to mention is that we also pass on the fixed fee we are required to pay when we send the cryptocurrency you are buying with your Steem to you (similar to a bank wire fee). So if you are buying a small amount of bitcoin, the fixed fee we have to charge you to cover our costs for sending can affect your price. In such cases, it's better to buy a somewhat larger quantity so that the fixed fee has less affect on the overall price you get. Also, different coins have different fees, so if your ultimate goal is to get to dollars or euros, you can save money by choosing an intermediate coin with cheap transfer fees. Here's an article with more details about this: https://steemit.com/blocktrades/@blocktrades/how-to-convert-steem-sbd-to-fiat-more-efficiently

Many thanks, I am referring to Steem traded for USDT or BTC. Your prices are way lower than Binance is offering as mentioned above. I see that your point about the amount traded changes the price for the better. I was comparing 10 Steem, but when I compare 1000 Steem traded for USDT or BTC it becomes normalized or closer to the Binance price for Steem. That answers my question.
Thanks again, I will check out the links you shared.

This is why a smart move will be for Justin to keep Steem, Steem. No coin flop, get it, no coin flop... haha Otherwise I guess we all lose.

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I think that Justin bought a sinking ship. Just see the statistics. But maybe Justin can save the sinking ship, and the ship maybe travel properly on the water again one day.

Very enlightening and for those of us who forget a lot these days a great refresher.

Good article.

I read your article and tried to understand. I think it is a good work. It can be a good road map for someone who has no idea about the subject.

I read your article and tried to understand. I think it is a good work. It can be a good road map for someone who has no idea about the subject.

most people dont understand difference between a fork and a split-chain

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One thing I’ve found when writing on a topic like this, is that it often leads me to want to talk about related issues, but I’m afraid that introducing too many ideas and details at once might obscure the primary points I wanted to cover in this post.

So far, so good

Soin essence, the economic implication of Forks is not necessarily dependent on traditional mathematics/economics models because of the unpredictable nature of human valuation of a product?

Continuing with the unpredictable fashion of the human factor, I imagined a scenario where a fork happens in coin AB and after the split, and coin B is formed. People with Coin B can as well decide to pump in more funds to Coin B becasue the new coin aligns with views and has cut out out aspects of coin AB that they didn't like. Does this capture the idea?

I don't want to say they can't be mathematically modeled (in a purely theoretical sense they can), but it should be apparent by now that it's very hard to do well. I wrote a post on this particular issue a while back: https://steemit.com/writing/@blocktrades/alice-has-5-ice-cubes-bob-takes-3-how-many-ice-cubes-does-alice-have-left-for-her-afternoon-thai-iced-tea

On your second point, sure. Any change in rules can potentially cause the coin users to place more value in the coin, even removal of rules they don't like.

That means a fork that leads to division isn't necessarily a bad thing. Prior to reading this, I thought it's occurrence is generally a sign or indication of the end of a project.

Congratulations @blocktrades!
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This is not a fork. The Problem wouldn't exist if you'd made a new STEEM with your own rules. Real fork. This way you're just thieves. I can see you are rich. Why don't you collect enough coins and do what are you doing right now, but fair.

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