Bitcoin can be an intimidating place for the new investor.
Scrolling through your news feed, you’re more than likely to be greeted by apocalyptic headlines and strange terms – and you might not immediately understand the risks either poses to your investment.
Take the term “forks,” for example. They’re certainly a pertinent issue without an analogue for more traditional investors. So, what exactly is a fork? And why are they so important to the value of bitcoin and other cryptocurrencies?
The simplest answer is that all cryptocurrencies are software, and that a fork is a change to that software.
When you own an asset like bitcoin, what you really own is just a pair of network password keys. Those keys represent the ability to access the network that keeps track of who owns what and how much.
As such, when that software is modified, it can change the value of user’s claims dramatically. In a very real sense, the software itself defines the asset – and, therefore, the price that investors are willing to pay for it.
An example
While there are many types of forks, most are relatively simple in nature.
A hard fork makes transactions processed on the new software incompatible with the previous versions. In a soft fork, the new version remains backwards compatible.
Earlier this August, bitcoin experienced a high-profile hard fork when a subset of the community split off the software and created a new version called bitcoin cash.
The contention came from bitcoin’s move toward a certain scaling upgrade, one which the bitcoin cash contingent was against. With two competing and incompatible “bitcoin” blockchains and “bitcoin” assets, analysts anticipated considerable price volatility, with many believing that prices would trend down.
But, that’s not what actually happened.
On August 1, right before the blockchain split, bitcoin was trading at $2,759, according to CoinDesk’s Bitcoin Price Index. More than a week later, bitcoin was trading at an all-time high above $4,100. At press time, the price had passed $4,230.
While that might seem odd, several analysts theorized that bitcoin’s long-drawn-out scaling debate had posed a major headwind, and its culmination led to a relief rally.
Data shows the bitcoin cash price shooting up to around $700 24 hours after the blockchain split, but because of market dislocations, it’s difficult to know how reliable that data is.
In the following two weeks, the price of the new cryptocurrency has mostly hovered between $250 and $300.
The old narrative
While all this may sound a little wonky, the underlying narrative of headwinds and tailwinds should be familiar to anyone who has invested even casually.
In market terms, a headwind is a risk factor or negative trend that is likely to push prices lower. A tailwind represents just the opposite – a positive movement, a bit of favorable news, or a halo effect caused by some underlying trend.
Headwinds are often discussed when risks come into play that are specific to a company. When the risks diminish, the headwinds are said to subside, and the price of the stock often rises. Stock investors see this sort of rally in the stock market on a fairly regular basis.
The classic example of a headwind is when a company settles a lawsuit or agrees to pay a fine to end a government or regulatory investigation.
Markets despise uncertainty, so when a potentially risky situation gets resolved, investors often see it as a buying opportunity.
In the cryptocurrency space, most analysts have tended to think of forks as a headwind – an event that threatens to destroy value. As such, it’s reasonable to expect cryptocurrency prices to rise after the headwind created by a potential fork subsides.
Turning tide
Yet, this thinking is showing signs of shifting.
Every holder of bitcoin on August 1 had the potential to automatically receive an equal amount of bitcoin cash as part of the fork. So, if bitcoin cash is trading at $300 and bitcoin is trading at $3,000, bitcoin holders have received an additional 10% value because of a software change, all with no additional investment.
But, what if the rise in bitcoin prices after the fork isn’t a simple case of an asset price rising because risk has been reduced? What if investors don’t see forks as net destroyers of value, which must be discounted with lower prices, but as potential net creators of value?
In this scenario, the total value of bitcoin increases as new cryptocurrencies based on different technologies bloom. When investors hold on to cryptocurrencies in the face of potential forks, it’s possible they aren’t just weathering a storm, they’re emerging from the rain with a richer bouquet of assets in their portfolio
In that case, some forks may be poised to transform into a classic tailwind which could drive prices ever higher.
If we take price to be a reasonable proxy of sentiment, then the forks-create-value view of bitcoin is clearly ascendant right now.
Fork image via Shutterstock