Hard Forks: Bitcoin Upgrades Harness the Free Market
Editor's Note: The following analysis is theoretical because a planned hard fork of this magnitude has never occurred before in the history of Bitcoin.
The recent block size debate has brought the issue of a hard fork front and center since it will be necessary if there is change to the Bitcoin protocol to allow larger blocks. A hard fork occurs when a new version of the core Bitcoin software is no longer backwards compatible with older versions. Many in the Bitcoin community fear the uncertainty of hard forks, but in reality it is a process that will allow Bitcoin to continuously upgrade based on free market consensus. There is nothing to fear, you will not lose your bitcoin, and the market will sort itself out in time.
The result of a hard fork is two block chains growing independently of each other from the point of the fork. Essentially two independent “coins” emerge (let's call them bitcoin1 and bitcoin2), and however much bitcoin you own pre-fork will be duplicated to both bitcoin1 and bitcoin2. This is important because it means that as long as you control your own private keys, you WILL NOT lose any bitcoin during the hard fork process.
“There is nothing to fear, you will not lose your bitcoin, and the market will sort itself out in time.”
1) You own 25 bitcoin before the fork
2) Fork happens
3) You now own 25 bitcoin1 and 25 bitcoin2
When a fork happens, miners, full node operators, and Bitcoin companies will be essentially “voting” on their preference by choosing whether or not to upgrade to the new version. It is important before a hard fork that the overwhelming majority of those entities are willing to go with the upgrade, in order to make sure the process goes as smooth as possible. Gavin's proposal requires a certain percentage of all miners to be operating the new software before the fork occurs and he has implied that he is in back room talks with many of the major Bitcoin stakeholders to make sure the new software has their support. However, an overwhelming majority may not always be attainable, and in that situation both block chains will be competing for dominance.
If one block chain doesn't become the dominant one right away, the free market will ultimately step in to decide on a “winning” chain. Exchanges will begin allowing users to trade bitcoin1 for bitcoin2 and vice versa, and the free market will decide on the value of each. As it becomes clear that one of the “coins” is valued much higher than the other, stakeholders such as miners, full node operators, and Bitcoin companies will end up choosing the fork with the higher value. As more of these stakeholders choose the higher value fork, the value difference between the two forks will diverge at an increasing rate, ultimately resulting in one fork having basically no value as users rush to sell all their coins in that fork for ones in the more valuable fork. This process should happen quite quickly as it is a positive feedback loop. If you are the gambling type, the situation presents an opportunity to make a lot of money (or lose a lot on the opposite side), but if you are conservative then you can just take a wait and see approach and your bitcoin will not be at risk.
How to be prepared for the hard fork?
The most important preparation for a hard fork is to make sure you control your own private keys. With or without a hard fork, we usually recommend users control their own keys anyway, making it much more difficult for malicious companies or governments from seizing or freezing your bitcoin. Now with a potential hard fork coming it is absolutely imperative that you control your own keys. Storing your coins in a custodial wallet such as Coinbase (where you don't have control of your own private keys) will result in you being forced to follow the fork that Coinbase chooses, rather than having duplicate coins on both forked block chains. If Coinbase chooses the wrong fork, then you are out of luck, the guarantees I mentioned earlier in this piece wouldn't apply to you, and you could lose all of your money. The easiest way to control your own private keys is arguably through the use of properly generated paper wallets. We have an easy tofollow beginners guide on generating cold storage paper wallets that you should follow, and store the majority of coins on those paper wallets before the hard fork occurs. By doing this, you will have complete control of both the bitcoin1 and bitcoin2 that are connected to your private keys and you won't have to depend on wallet developers to upgrade their code.
You can learn more about the block size debate here.
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