Everything a New Trader Should Know about Forks in Cryptocurrency

To get into cryptocurrency trading, all you really need is to open a crypto exchange account and to credit the minimum amount of conventional cash required by your chosen blockchain network. From there, you’re free to trade or speculate using whatever strategy you’re comfortable with. If you want better security, you can also get a crypto wallet that’s compatible with whatever coin you’re trading, such as a Monero wallet for Monero (XMR).

Of course, the reality of crypto trading is much more complicated than that. Crypto forks are one such complication that you’ll need to get a handle on before you can move to more complex trading strategies.

Before defining what crypto forks are, let’s do a quick recap on how decentralized, open-source currency blockchains work. As you probably already know, cryptocurrency transaction records are kept in chains of data blocks. However, these chains do not always go in a single path. 

Blockchains can split into two different paths, leading to a fork. These are commonly caused by system updates but also have other causes that will be discussed here. Within the world of crypto, forks are quite significant since they can dramatically change how a given cryptocurrency network works. Let’s look at the types of forks and the implications that can arise from their creation.

Types of Forks

1) Unintentional Forks

Unintentional forks are created thanks to the inherent randomness within blockchain consensus mechanisms. These are generally classed under two subtypes:

• Orphan/Stale Blocks. This occurs when two miners produce valid blocks right at the exact same time. When this happens, the network temporarily splits until one block is accepted by the majority. Once that happens, the other is discarded and the fork is no more.
• Uncle Blocks. This is specific to Ethereum's (ETH) former Proof of Work (PoW) mechanism, though other emerging cryptocurrency networks may have similar mechanisms. When uncle blocks occur, competing blocks are recognized but not added to the main chain. Ethereum currently uses Proof of Stake (PoS) to help reduce this occurrence.

2) Soft Forks

The first soft forks are backward-compatible updates to a blockchain's protocol. Along with hard forks, they are a kind of intentional fork. They are often created to facilitate fixes or new features that do not require a complete overhaul of the entire blockchain system. Sometimes, they’re used to increase network capacity without seriously altering the underlying protocol.

3) Hard Forks

As the name implies, hard forks result in a permanent, non-backward-compatible split in the blockchain. When this happens, the original network is split into two separate cryptocurrencies. The original continues on its path while the new one goes under a different set of rules, albeit usually quite similar to the original coin’s frameworks.

What Every New Trader Must Know About Forks

Community Disagreements

Hard forks often stem from disagreements within the original community. Most often, these involve disputes on updates. However, they can occur for pretty much any reason. This is partly why cryptocurrency holders need to always keep tabs on their coin developer communities.

Protocol Updates

Forks are not always bad. In fact, both soft and hard forks tend to enhance security, add functionality, or fix bugs with the original protocols. As such, when looking into news about forks, it’s prudent to investigate what changes actually take place.

Economic Implications

Because hard forks create new cryptocurrencies, they can potentially dilute the value of the original coin due to the increased supply. Even benign soft forks can impact market dynamics, causing price fluctuations and influencing trader sentiment. Of course, the overall economic effects all depend on how much of a crypto community is going to completely jump ship. 

Soft Forks Are Usually Planned

Soft forks typically arise from formal proposals made according to existing processes. For example, Bitcoin (BTC) has the Bitcoin Improvement Proposals (BIPs) framework. The idea of these structures is to avoid chaotic changes that may dilute the value of the network.

Consensus Mechanisms 

The consensus mechanism of a blockchain (Proof of Work, Proof of Stake, etc.) influences the nature and frequency of forks. Proof of Stake, for instance, can reduce unintended fork creation by decreasing the odds of data blocks being created at the same time.

User Rights

When hard forks are created, users of the original cryptocurrency often receive equivalent amounts of the new coin. This usually depends on how they hold their assets, such as whether they have control over their private keys. Rights may also hinge on the decisions made by exchanges and the community politics surrounding the fork event.

Ethical Considerations

As implied in the previous point, the human factors that create forks can also pose ethical dilemmas. For instance, network developers and users may disagree on whether to restore funds lost due to exploits. There is also a widely-held but not universal principle within the blockchain community that "code is law," suggesting that the immutability of blockchain transactions should always be preserved, regardless of the circumstances.

Fork-tune Favors the Informed

Forks are a fundamental aspect of blockchain technology, ultimately shaping their real-world functionality. In cryptocurrencies, blockchain forking can even have serious consequences on the viability of a coin as a real currency. 

Knowing about the types and implications of forks can help you see the wider context of blockchain asset developments, helping to reduce your risk when trading these highly volatile assets. Whether you’re dealing with a soft fork’s backward-compatible updates or the behind-the-scenes politics of a hard fork’s creation, being better informed will help you avoid making decisions that you might regret.