The Bitcoin Fork

Fri, Aug 4, 2017 - 7:58am

The Bitcoin Fork

Bitcoin’s wild gyrations have this year become even wilder, driven largely by an ongoing “civil war” within the community of coders and miners who make up the cryptocurrency’s ecosystem.

Source: Bloomberg

So what’s the nature of this civil war, what are the stakes, and what might the consequences be? On the surface, the conflict is pragmatic; underneath, it reveals two divergent visions of what bitcoin is and what its purpose should be.

The central issue is the speed at which the bitcoin network is able to handle transactions. Readers may be aware that one of the two fundamental technologies underlying bitcoin is the blockchain, a public distributed ledger of bitcoin transactions. Bitcoin “miners” compete to solve fiendishly difficult mathematical problems, which validate bitcoin transactions, and they are rewarded for their investment in dedicated computers and electricity with transaction fees and newly minted bitcoins. Together, the miners permit the entire bitcoin ecosystem to reach consensus on what transactions should be added to the ledger.

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The current bitcoin software is constructed so that the mathematical problems gradually increase in difficulty. The consequence is that as computer power is added to the network, the time it takes to validate a new “page” (or “block”) of transactions and add it to the ledger stays the same — about ten minutes.

Does Bitcoin Need to Accelerate Transactions?

Each block takes ten minutes to be verified and added to the blockchain. Though it may be surprising for some observers to learn, bitcoin as it stands is a relatively slow and expensive affair, compared to the speed and cost of mainstream financial transactions (such as credit cards). Visa’s [NYSE: V] network can process 1600 transactions per second globally — the bitcoin network processes about six.

The original architect of bitcoin, the pseudonymous Satoshi Nakamoto, set things up this way knowing that it would eventually be a problem — but in the early days, the original implementation served to entice miners to invest in the technology that supported the expanding network. Now, though, the problem is coming to a head as use of the digital currency has dramatically increased.

So does it matter that bitcoin is currently so slow? That depends on what you think bitcoin should be able to do. If you think bitcoin should primarily serve as a functional currency that you can use to buy a latte at Starbucks, it matters a lot. On the other hand, if you think bitcoin should primarily be a store of value to protect your assets against the predations of taxation, inflation, or appropriation, or a tool for conducting transactions of which governments disapprove, it doesn’t matter much at all.

Bitcoin Faces the Forks

Thus the conflict is revealing a philosophical schism among bitcoin users and adherents. How do such conflicts get resolved? Ultimately, the same way everything in bitcoin gets resolved: by consensus.

In the end, bitcoin is software that specifies how the blockchain is constructed. It is open-source software, so any user is free to modify it in any way they see fit. However, it would be pointless for a miner to alter it in a way that rewarded themselves, because unless a majority of the network’s computing power agrees with their new criterion for a valid block, the block would be rejected by the network and all the effort they expended in mining it would be wasted.

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That’s a lot of effort. Bitcoin “mining” is now an industrial enterprise. In the early days, anyone could set up a node on their PC and mine bitcoins. Nowadays, the validation process is so difficult and the competition is so fierce that miners are constructing factory-sized operations in remote parts of China, situated directly adjacent to hydroelectric power sources to minimize electricity costs. (For an interesting peek inside the world of Chinese bitcoin mining, have a look at this article.)

Although some in the bitcoin universe don’t mind if the status quo is maintained, and don’t care if bitcoin transactions get accelerated, many users and most miners are eager for a solution.

The trouble is, users and miners have different solutions in mind. Users want a solution that will minimize transaction expenses; miners want a solution that will maximize them. Therefore there are different solutions being proposed. They’re all variations on a theme: expanding the maximum size of a block. Exactly how this is achieved will result in different rewards for different participants in the bitcoin system.

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The bitcoin market has been gyrating because in one way or another, down the road, there has loomed the prospect of a “fork” — that is, that two incompatible versions of the bitcoin software will start operating, and consequently, the one bitcoin blockchain will split in two. (The currency’s most recent rally occurred because an imminent fork had been avoided.)

The first such fork in bitcoin’s history just occurred. It split bitcoin into two different cryptocurrencies — bitcoin and a new cryptocurrency called “bitcoin cash.” Anyone holding bitcoins before the split would now owns equal numbers of bitcoin cash. (We should note that the fate of your bitcoins could vary depending on whether you held them in your own system, or on an exchange; few exchanges have so far recognized the new currency, so those who held their bitcoins on those exchanges are out of luck. If bitcoin cash gains traction, most exchanges should eventually distribute the new coins to those who held bitcoin before the fork. Transactions occurring near the time of a fork could also be problematic and could lead to lost bitcoins; this happened to some users when ethereum weathered a fork in 2016.)

“Bitcoin cash” simply ramped the maximum size of a block in a way that will speed transactions up to about 50 per second. So far the new currency is holding some value although it’s extremely volatile; that may change as more exchanges start trading it and more holders are able to sell.

This doesn’t end the matter, though, as further forks are possible in the future if participants in the original bitcoin network decide to tackle the transaction speed issue in other ways. Another potential fork looms in November.

Look At It Like a Spin-off

Investors should look at the whole thing as a spin-off. The current bitcoin is the parent company. Owners of bitcoins own stock in that company. After a spin-off, current shareholders should own the same number of shares in the original company and in the spin. But the fate of each company will then be independent. And the lack of clarity could offer an opportunity to disruptive competitors to step in and take market share.

After any fork, the behavior of the new coins that arise from the split will be difficult to predict. Although holders of bitcoin who now also hold bitcoin cash have come out ahead, future forks could even precipitate a collapse in bitcoin and the rise of a rival, such as ether, which is already nipping at bitcoin’s heels in terms of market capitalization.

Does that mean that you should diversify your digital currency holdings ahead of another potential intra-bitcoin struggle that may emerge this fall? If you have been on the sidelines, and you want to buy in, should you buy bitcoin, bitcoin cash, or both? That decision, we will leave up to you.

Investment implications: Current holders of bitcoins should evaluate where their credentials are stored and consider whether they want to hold their bitcoins locally or in a virtual wallet. Speculators who are considering entering bitcoin should watch the news carefully for information about disruptive events surrounding potential forks. Speculators may also consider diversifying into other coins in the run-up to a bitcoin fork. We stress again that at this juncture, we consider digital currencies to be extremely risky but interesting speculative opportunities — not investments.

About the Authors

Chief Investment Officer
guild [at] guildinvestment [dot] com ()

tdanaher [at] guildinvestment [dot] com ()