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.