Why Hard Forks Are Rare

A hard fork occurs when a blockchain splits into two separate branches, effectively creating two different blockchains and native cryptocurrencies. Although technically it is easy to implement a hard fork, we do not observe that many occur in practice. In this post, we examine the reasons why hard forks are rare, using a political economy approach.

Introduction

Forking refers to a change in the rules or protocol of the blockchain network. The decision to implement a fork arises from a desire to improve the network's functionality, scalability, or security, but it can also stem from ideological differences within the blockchain community. While it is technically straightforward to create a fork and launch a new cryptocurrency, several factors make it more complex in practice. Key among these are the network effects that may work in reverse if the community splits, as well as the difficulty in developing a new ecosystem of dedicated developers, validators, and users. Using a political economy approach, we examine how the interplay between the network effects and the heterogeneous policy preferences in the community influence the equilibrium design of blockchains.

A fork can be either hard or soft. A hard fork is a permanent divergence from the previous version of the blockchain. Any nodes (computers participating in the network) running the old version will not accept transactions created under the new rules. This results in a split into two separate chains, each following its own new rule set. An example of a hard fork is Bitcoin Cash, which split from Bitcoin in 2017. Bitcoin Cash implemented a bigger block size, in order to allow faster transaction times and lower fees. A hard fork usually occurs because a minority of users wants to change the design of the blockchain but this is not accepted by the majority, thus generating two completely different blockchains.

A soft fork is backward compatible, as existing nodes will recognise the new blocks as valid, thus maintaining compatibility with the new rules. In a soft fork, the network does not split and there is only one native cryptocurrency. An example of a soft fork is the implementation of Segregated Witness (SegWit) in Bitcoin, also aimed at increasing the block size and decreasing transaction times. A soft fork occurs when the network of nodes broadly agrees on the future direction of the blockchain, therefore the community does not split.

Network Effects

Network effects are a key consideration when deciding to implement a hard fork, because the value of the network decreases as fewer people use it. Bitcoin and Ethereum, for example, derive much of their value from the extensive networks of users, developers, validators, and businesses built up around them. A cryptocurrency’s value also rises as more people use it, thus increasing the trading volume which in turn makes it more liquid and therefore more valuable. Implementing a hard fork will split the user base into two, so that all these network effects work in reverse. If a forked cryptocurrency has a very low user base and trading volume, exchanges may stop listing it, effectively killing the project. It is therefore not enough to simply create a new blockchain and token; to be successful, it needs to attract a network of users, developers, and validators, which is a significant challenge.

Another aspect of the network effects is the development of an ecosystem of tools and applications. For a forked blockchain to be successful, it needs infrastructure and services that support the use of the native cryptocurrency. These include wallets, exchanges, payment services, and decentralised applications. Creating these services requires significant investment of time and resources, and the more established a token is, the more developed its ecosystem is likely to be. In fact, one of the key metrics for valuating a blockchain is the number of developers that build projects on it and the number of decentralised applications. Ultimately, the value of a cryptocurrency will depend on the ecosystem economy build on top of that blockchain. This imposes a natural barrier for the growth and success of a forked token.

Summarising, while creating a fork of a blockchain might be technically straightforward, developing it into a successful cryptocurrency requires overcoming several substantial challenges. This is one reason why there are not more forks and why the most successful cryptocurrencies tend to have large, dedicated networks of users and developers, as well as well-developed ecosystems.

The Political Economy of Forks

We now examine how the interplay between network effects and the heterogeneous policy preferences of users about the optimal design of the blockchain, can explain why we do not see as many hard forks. We use a political economy approach, following the paper “The Political Economy of Blockchain Governance”.¹

We can imagine that different blockchain designs can be mapped on a line, for example describing how scalable it should be. Each user can have a different ideal point on that line. Users also care about network effects: they prefer to be in a less ideal blockchain but with more users. Given a status quo blockchain, when will a subgroup of users be successful at generating a hard fork? There are three possible outcomes: contentious, non-contentious, and null forks. Contentious forks divide the user base across two viable chains, while non-contentious forks result in complete migration to a new chain, making the original one unviable. Null forks occur when the new chain fails to gain sufficient support, resulting in users sticking to the original chain.

If network effects were absent and there could only be one blockchain, then the equilibrium would be a “moderate” design, which is the ideal point of the median user.² This is due to the famous Median Voter Theorem, which specifies that in a majority-rule voting system, the preferences of the median voter will always be the winning outcome when policies can be ordered along a single-dimensional spectrum.³

If, however, multiple blockchains can be created and there are network effects, then several different equilibria can emerge, depending on the distribution of policy preferences about the ideal design. Suppose that the initial blockchain has a moderate design and a group of users proposes a hard fork. If the proposal is too close to the existing design, it will most probably be rejected, resulting in a null fork. The reason is that the users who join the new blockchain will face a similar design but also suffer from the negative network effects, as their community will be halved. A proposal will be accepted only if it is an extreme one, either to the left or to the right, because the decrease in the network size for the new blockchain is compensated by the fact that the design is very close to the users’ optimal points, thus generating a contentious fork.  A non-contentious fork is generated if the community’s preferences shift to the right or left, so that the majority of users join the new blockchain and the old is completely abandoned. 

We conclude that if the ideal points for most users are distributed around the median, then no new blockchain will emerge and hard forks will be rare. There will be users with extreme policy preferences, either to the left or to the right of the line, but this will fail to generate contentious forks, because the network effects of the existing blockchain will be very strong. As the community’s preferences gradually shift to one extreme over time, then a non-contentious fork may emerge, and everyone joins the new blockchain. An example is the migration of Ethereum from Proof-Of-Work to Proof-Of-Stake.

Conclusion

We have examined how the interplay between network effects and the distribution of policy preferences can explain the rarity of hard forks. Using the same political economy approach, we can also describe the creation of completely new blockchains, which do not fork an existing one but split the community, as users join the new blockchain and abandon the old, at least partly. Ethereum was a radical change from Bitcoin, as it added a programming language and the ability of the blockchain to perform computations. This radical change compensated for the extremely strong network effects that were present in Bitcoin. The next generation of blockchains, such as Cardano, Avalanche and Solana, adopted the Proof-Of-Stake protocol, which was a radical departure from the Proof-Of-Work protocol, which was used by Bitcoin and Ethereum, as it was very energy efficient. At every major step in the evolution of blockchains, a radical proposal compensated for the very small initial network.

Footnotes

¹ Lee, Barton E. and Moroz, Daniel J. and Parkes, David C., The Political Economy of Blockchain Governance (February 8, 2020). Available at SSRN: https://ssrn.com/abstract=3537314.  

² The median user’s ideal point is in the middle, so that 50% of the users’ ideal points are above and 50% are below.  

³ In simpler terms, imagine that all voters in a population could be lined up in order of their policy preference from the most "left" to the most "right". The median voter is the person in the middle. According to the theorem, politicians will aim their policies towards this median voter to secure the majority of votes.  It is important to note that the Median Voter Theorem makes several key assumptions, such as a single policy dimension, a unimodal (single peak) distribution of voter preferences, and perfect information among voters. While these assumptions often do not hold up in real-world politics, the theorem provides a useful simplification for analysing voting behaviour.  The main reference for this theorem is Downs, A., An Economic Theory of Political Action in a Democracy. Journal of Political Economy (1957).

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