What are bitcoin forks and how do they work?
With the interest in bitcoin, it’s vital to know the technology behind this cryptocurrency and the factors that influence its price. Learn all you need to know about bitcoin forks, and the difference between soft and hard forks.
Bitcoin forks explained
The term ‘bitcoin fork’ can be used to describe two types of events. The first is a change to its underlying software – a ‘software fork’. The second is a divergence in the cryptocurrency’s blockchain – a ‘blockchain fork’. The reason each of these events is called a ‘fork’ is because they present two or more potential routes for bitcoin to follow, much like a fork in the road.
The key to understanding forks is to know a little about how bitcoin and blockchain technology works. Put simply, bitcoin runs across a network of computers – each running the bitcoin software and maintaining their own copy of the blockchain file.
What is bitcoin? Learn more about it here
For bitcoin, the blockchain stores the entire transaction history for the network in chronological order; the most recent transactions are recorded in the newest block at the top of the chain, while the oldest are at the bottom in what is known as the ‘genesis block’.
Crucially, there is no central authority in charge of bitcoin’s software or the blockchain file. Instead, any update must be proposed by a user and approved by a network majority before it can take effect. Users sometimes propose different updates at the same time – or there can be a lack of consensus about a proposed update – so it is this system that can give rise to forks.
Software fork: bitcoin hard forks vs bitcoin soft forks
A software fork is what happens when a developer takes bitcoin’s source code, which is open source, and proposes changes to the protocol. There are two types:
Bitcoin soft fork
A ‘soft fork’ is a ‘backwards compatible’ software update, meaning users running the old software will still recognise blocks created by computers that have chosen to update theirs, and vice versa. It is called ‘soft’ because both groups of users will continue to mine new blocks on the same blockchain, so there is no ‘hard’ line dividing them. As both groups of users remain part of the same network, a soft fork will never result in the formation of a new cryptocurrency.
Learn more about how to trade bitcoin
A soft fork is considered complete once the majority of machines in the bitcoin network have updated their software. If this doesn’t happen, the minority group may eventually decide to abandon the proposed update, or move to implement a hard fork instead.
Bitcoin hard fork
A ‘hard fork’ is an update that isn’t backwards compatible. This means that users running the old software will not recognise blocks created by those running the new software, and vice versa.
For this reason, hard forks usually lead to a split in the blockchain with a group of users effectively leaving the old network to form a cryptocurrency of their own. In this scenario, the new network takes an exact copy of the blockchain as it was at the point of the split, with both versions remaining separate thereafter.
Users who owned bitcoin at the time of the split can often claim new coins on the forked network. However, it can be risky to claim the coins if the new network does not include ‘replay protection’ measures – to prevent the old network from erroneously recognising its transactions (and vice versa) – as spending one set of coins could result in the loss of those on the other network.
Blockchain fork
Computers compete to generate new blocks in a process known as ‘mining’. A blockchain fork is what happens when two or more computers mine separate blocks at exactly the same time, creating two competing versions of the blockchain file at different points in the network.
What is bitcoin mining?
This type of fork is generally resolved quickly because one of the proposed updates will propagate through the network at a faster rate than the other, soon becoming the consensus blockchain.
Any data contained within an ‘orphaned’ block on the rejected chain is returned to the pool of pending data to be mined again. For this reason, a bitcoin transaction should generally not be considered final until at least six blocks have been mined on top of the block that contains it.
Why are bitcoin forks important for traders?
Many traders pay attention to news regarding software forks for signs of where bitcoin’s price is heading. This is because technological updates – for example those enabling the network to process more transactions each second or reduce its energy consumption – could increase adoption and cause bitcoin’s value to skyrocket.
Alternatively, its price could fall if the network is unable to reach consensus on a popular update, or a hard fork occurs, as a new cryptocurrency could reduce demand for bitcoin.
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.
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