What are Hard Forks?
In the previous article, we learned about the concept of forking in the cryptocurrency universe. We also understood that we can distinguish between soft forks and hard forks. Soft forks do not lead to radical changes in the fundamentals of a cryptocurrency. Hence, the volatility is not said to be that high. This is not the case with hard forks. Hard forks can be black swan events in the cryptocurrency industry. They can be catastrophic and extremely volatile. It is for this reason that even a casual investor needs to know what a hard fork is and how it could impact the value of their investments.
What are Hard Forks?
Simply put, hard forks are fundamental changes in the way the blockchain and cryptocurrency algorithm works. It could be something as fundamental as the hashing technique that would need to be changed. Once this chain is implemented, the new cryptocurrency will now be a completely new unit. This means that the changes are not backward compatible as was the case with soft forks. This is the biggest difference between hard forks and soft forks.
If a cryptocurrency decides to undergo a hard fork, then on the day of the switch, the previous rules and structures become completely invalid. This means that all the users, the nodes that they use, and the blocks that they have mined in the past need to be upgraded in order to be compatible with the new version of the software. Hence, if some users hold old versions of the coin and some others hold new versions, they will not be able to interact with each other. They will effectively become members of different blockchains which will not be connected with one another.
This is the reason that whenever hard forks occur, the old coins have to be converted into new coins. They could be converted based on a 1:1 ratio in which case, they will simply have to be mirrored. Alternatively, they may be converted based on a different ratio which would lead to the existing coins being split to form new ones.
Hard forks have also been used as a way to counterattack hackers. There have been cases where hackers have transferred large sums of money to themselves. The most well-known case is known as the DAO attack wherein the hacker stole 50 million in the form of Ethereum. However, the blockchain voted in favor of a hard fork which meant that new coins were given to legitimate coin holders. This made the hacking futile since the blockchain would not recognize and validate old coins and hence the hacker would not be able to derive value from it.
It is important to note that a consensus is required for a hard fork. If a consensus is reached, the old cryptocurrency will cease to exist and migrate to the new one. However, the idea of a hard fork may not always be agreed upon by all stakeholders. In many cases, there are some stakeholders who vote in favor of keeping the old framework. In such cases, the cryptocurrency splits to form two new currencies. Each group of stakeholders then gets the chance to move ahead based on their own ideas. This type of hard fork where all the stakeholders do not agree and there isnt 100% consensus is called a contentious hard fork. The result of this type of hard fork is that two separate cryptocurrencies come into existence.
Financial Impacts of a Hard Fork
The financial impact of a hard fork is quite severe as compared to a soft fork. It can introduce significant volatility in the system because of the following reasons:
- In the past, hard forks have been used by many large cryptocurrency traders to artificially inflate the price and make a quick buck. It is common for large cryptocurrency traders (whales) to go on a buying spree before the hard fork is about to happen. Their relentless buying gives them access to a large number of coins. Then, the old coins are exchanged for new ones as a result of the fork. The whales are aware that the price of the new coin is wildly inflated. Hence, they keep dumping them on the exchange over a period of time causing its value to drop. The whales just take advantage of the confusion created by the fork to convince existing investors that the coins are worth a lot more than they actually are.
- It is common for traders to abandon the cryptocurrency being forked altogether. This is because they know that there are certain manipulative elements trying to make a quick buck. Since the market is not regulated, serious traders end up abandoning the coin in favor of safer bets.
- Forking often increases the price of a cryptocurrency. This is because the new currency created is technologically more advanced. Hence, more people buy into the currency which could lead to an increase in value in the short run.
The fact of the matter is that forking can sometimes be quite disruptive for the crypto community. However, the impact of not forking can be even more disruptive. This is because cryptocurrencies are built on technologies and hence are meant to be updated from time to time. If they are not updated, they run the risk of becoming static. This could mean that they might have fewer features and may even be prone to attacks.
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