Impact of Forking on the Value of Tokens

A key question about the viability of public blockchains is whether the native cryptocurrencies can retain their value in the long term. If it is easy to create a new cryptocurrency and increase overall cryptocurrency supply, either through a hard fork or by creating a new blockchain with different specifications, why would any token hold its value? In this post, we examine the sources of value and under what conditions it can decrease through forking.

Introduction

Forking refers to a change in the rules or the protocol of a blockchain, resulting in a split that leads to the creation of a new blockchain that shares the history of transactions with the original one up to the point of the fork. There are two types of forks: hard forks and soft forks. A hard fork is a permanent divergence from the existing version, whereas a soft fork results in a blockchain that is backward-compatible. Hard forking can occur to improve the networks’ functionality, scalability or security. It can also occur if there is disagreement within the community of users and nodes about what should be its future direction. In a companion post, we discuss the incentives for a minority of network nodes to create a hard fork and break away, using a political economy approach.¹

In this post, we address the impact of forking on the value of the native cryptocurrency. As it is technically easy to implement a hard fork and create new tokens, why should the original cryptocurrency retain its value? We answer this by examining the sources of value and how they are impacted by a hard fork. This question is relevant not only for forking a blockchain, but also for forking a decentralised application, or more generally when splitting a network.

Sources of Value

The main source of value for cryptocurrencies is the utility they confer on their users. Bitcoin, for example, was designed as a decentralised digital currency and payment platform without a central bank, capable of conducting peer-to-peer transactions and acting as a digital store of value. Ethereum offers smart contracts and applications, where computations are paid using its native cryptocurrency, Ether. Each crypto platform has different optimal use cases given its design trade-offs, and their value is derived from the services that it offers. Forking a blockchain and creating a new native cryptocurrency does not mean that the holders of the new token can access the same services. If it is a hard fork, so it is not backward compatible, the holders of the new token may have no access to the contracts and applications of the original blockchain. This means that the supply of the original token is effectively unaffected.

The second source of value comes from network effects: the more people use it, the more valuable it becomes. The relationship between the network value and the number of nodes is best described by an S-curve: initially, the value increases exponentially, leading to a significant advantage for large, established networks over new or smaller ones. As the network matures, the increase in value occurs at a decreasing rate. This dynamic can lead to a situation where one or two networks dominate a particular use case, creating an oligopoly or a market characterised by imperfect competition. In the context of decentralised cryptocurrency platforms, we can draw parallels with social media platforms where strong network effects have led to a natural monopoly or oligopoly. Just as one or two social media platforms dominate a distinct segment of the social media landscape due to their vast user bases, one or two blockchain networks will likely dominate specific use cases. For instance, Bitcoin is currently the leading crypto platform for storing value, and Ethereum is leading platform for smart contracts and decentralised applications, though it may specialise in specific use cases in the future such as NFTs. The dominance of these networks is self-reinforcing - as more users join the network, it becomes more valuable, which in turn attracts even more users. This limits the ability of new entrants to gain a foothold, generating a market structure where a few players with high barriers to entry. However, there is a significant difference between social networks and public blockchains. Users of a blockchain are able to have control of their data. They can prove that they own assets and access services, independently of any intermediaries, and a new blockchain can import the whole blockchain state. With social networks, such as Facebook and Twitter, users cannot easily port their data to a rival network and the company has the right to exclude them or delete their data. This means that there are more competitive pressures on public blockchains, as opposed to centralised social networks.

The third source of value stems from how secure a blockchain is. Security does not depend only on the design characteristics of the protocol but also on the distribution of the tokens across the network nodes that validate the transactions, as well as its history of withstanding attacks.³ A new fork will have to prove that it is secure, hence users may be initially reluctant to adopt it. The more secure the blockchain becomes, the more trust it engenders, and the more valuable its associated cryptocurrency. The more valuable the cryptocurrency, all else being equal, the harder the blockchain is to attack.

Finally, a significant source of value is the rate of adoption and the volume of transactions, which in turn determines how liquid the token is. The value of any currency depends largely on its usage for transactions and the greater the usage, the more valuable it becomes. Liquidity is relevant not only for users but also for developers who build applications for the wider ecosystem, as well as the validators of the blockchain. Tokens that have very little transaction volume may not be listed by centralised exchanges, making it very difficult to onboard new users which can ultimately kill the project. A new blockchain that is generated by a fork will start with no adoption and no transaction volume, hence significant investment is required to attract users and kick start the network effects.

A Fork and Vampire Attack

The ‘vampire attack’ of SushiSwap on Uniswap in 2020 shows why liquidity and network effects are much more difficult to achieve than the actual fork.⁴ Uniswap is the largest decentralised finance (DeFi) platform and it has an open-source code, like most projects on Ethereum. Traders exchange tokens using an Automatic Market Maker (AMM) on a liquidity pool, where liquidity providers (LPs) deposit tokens of the trading pair, in exchange for LP tokens, which represent their share of the pool and earn fees proportionally.

SushiSwap was created by forking the Uniswap code, but this was the easy part. The problem was how to incentivise users to join and provide liquidity, when Uniswap was already enjoying significant network effects, so that it was preferred both by users and liquidity providers. SushiSwap provided two incentives. The first was that joiners would receive SUSHI tokens by providing their liquidity and they could even get a share of the protocol’s total fees if they staked their SUSHI tokens. This was at a time when Uniswap did not have a token of their own, hence they could not provide similar incentives. Second, and most importantly, new joiners had to deposit not just any token but specifically Uniswap LP tokens. This was possible because both protocols were on the same network, Ethereum. This incentive meant that SushiSwap grew by draining the liquidity from Uniswap, hence the name ‘vampire attack’. Within a few days, SushiSwap managed to acquire more than half of the liquidity of Uniswap. As a result, Uniswap was eventually forced to issue their own token and share more of the fees with their liquidity providers. Uniswap came out stronger from the attack and the liquidity providers also benefitted, which shows that competition can be beneficial. In a centralised network, such an attack could not have happened because the LP tokens would not be transferrable.

Conclusion

The SushiSwap attack shows that whereas forking and copying the code is easy, replicating the sources of value that enable the price of a token to be high is difficult. This is true for all types of networks and it also applies in blockchains and decentralised applications. If the new blockchain or application is superior in terms of functionality, security, and scalability, then it has the opportunity to attract users, realise strong network effects and high value of services provided, which in turn will support a high price for the token. 

Footnotes

¹ See “Why Hard Forks are Rare”.

² See https://multicoin.capital/2018/05/09/on-the-network-effects-of-stores-of-value/ for more details on network effects.

³ For more details, see “The Security Aspects of Proof-of-Work and Proof-of-Stake” at https://en.aaro.capital/Article?ID=15bf7c9b-b554-4cb2-9ef0-4e9fbb0f74b8. 

⁴ See https://www.gemini.com/cryptopedia/sushiswap-uniswap-vampire-attack#section-what-is-a-vampire-attack for more details on the SushiSwap attack.

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