The Implications of Forking a Blockchain
Litecoin, the fifth-largest cryptocurrency according to CoinMarketCap, recently experienced a “hard fork.” In blockchain parlance, a hard fork implies that a fundamental change to a coin’s protocol transpired, causing previously invalid blocks or transactions to be made valid and vice-versa. As a result of the permanent divergence from the prior blockchain version, a new cryptocurrency spin-off of Litecoin was generated: Litecoin Cash.
Forking a blockchain involves upgrading the blockchain to new blockchain protocols. It is an event many cryptocurrencies have been faced with, including Bitcoin, which created Bitcoin Cash through a hard fork in 2017. The Bitcoin fork occured because some miners wanted to increase the block size from one megabyte to eight megabytes in order to increase the number of transactions possible. These divergences in protocol preferences lead to the creation of new types of coins which can have major implications for the forking cryptocurrencies.
Currently, when a coin forks, it creates an open legal issue because it is not currently regulated and its parameters remain unestablished. With a fork such as Bitcoin Cash, all holders of Bitcoin received Bitcoin Cash as well.There are both positives and negatives associated with hard forks. The positive implications usually include a surge of investment in the coin in order to receive the new type of coin when the forking takes place, as well as an increase in competition and innovation in the space. The negatives include misperception and lack of understanding regarding the fork and what it means, which can foster fear and uncertainty in the market. Rumors that the new types of coins being created are scams are of course harmful, which Litecoin Cash was accused of last week. If this gets out of hand, loss of investor confidence is bound to follow. Luckily for Litecoin Cash, there has been a recent rally and rise in the new coin’s value.
In the future, however, there are likely to be more instances with greater negative implications. For example, Monero, another cryptocurrency, has said that they plan to constantly change their proof-of-work algorithm (POW) and block rewards to dissuade people from building specialized hardware. Specifically, Monera uses “flag-day activation,” which is the process through which all nodes and miners switch to use a different code for each block. Flag-day activations create “soft forks” that strengthen the blockchain and make it more scalable, but do not cause new coins to be created the way “hard forks” do. A soft fork is also a change to software protocol, but has less drastic implications as hard forks and do not cause a new coin to be created. Legally, some investors who buy into a cryptocurrency and see a drastic change in it may want to sue over a breach of contract or any other type of associated harm that may come to transpire. Thus far, there has been no regulation regarding forking a blockchain regardless of the changes that take place to it.
There is also the challenge of reporting taxes with a forked cryptocurrency. This upcoming tax season is the first year the IRS plans to crackdown on digital currency holders to report their gains and losses from crypto. When reporting coin-to-coin transactions under current tax law, there is a major question mark as to how that should get reported. Holders of Litecoin during the fork, for instance, all of sudden found themselves with Litecoin Cash, which was not in their control.
With regulation on the horizon, it will eventually be decided how coins are viewed comparatively to each other under the eyes of the law, and this will likely be a determining factor on how forking will be handled.