Bitcoin Braces for a Blockchain Split

Users of bitcoin are preparing to activate a so-called soft fork in the currency on August 1, if an agreement is not reached over a proposal for a new feature that could enhance the scalability of the currency—but others have threatened a more radical move that could split the blockchain.

The Segregated Witness feature, known as SegWit2x, has been proposed by the Bitcoin Core development team and will allow for a greater amount of transactions on the network by transforming the way signature data is recorded in blockchain transactions. The lack of scalability in bitcoin’s current form has been seen as a major impediment to wider adoption by corporates, and to further institutional involvement in trading. SegWit is due to be implemented by a user-activated soft fork (UASF) on August 1.

However, bitcoin miners, who generate bitcoins by solving complex mathematical issues, have proven to be skeptical of the features, which require 80 percent of blocks to approve the change in order to go through. Some have said that they will activate a hard fork (UAHF) on August 1 in response. If that occurs, it would result in a permanent split in the blockchain that would, in effect, create two versions of bitcoin.

If the remnants on one side are overtaken in popularity by the other, there is then the potential for transaction records to disappear from blocks that do not accept SegWit, known as a “wipe out.”

“The activation of UASF may create two blockchains,” says Adam White general manager of Global Digital Assets Exchange (GDAX), one of the largest digital currency exchanges. “Should this occur, there are two likely outcomes: One blockchain becomes dominant, resulting in the other blockchain having low community adoption and value; [or] both blockchains are adopted, coexisting and operating independently of one another with roughly equal community adoption and value.”

GDAX parent Coinbase has already stated that it will not support the UAHF blockchain, and has advised any traders who wish to use it to withdraw their bitcoin from the exchange by July 31. It will suspend withdrawals and trading on August 1 up to four hours before the activation of the soft and hard forks.

Forking Bitcoin

The concept of “forking” is peculiar to digital currencies, and requires a basic understanding of how the technology underpinning bitcoin, ether and others works—a system known as the blockchain, which distributes the ledger of transactions among participants and requires agreements to verify new transactions.

The etymology of the word derives from software development, where a fork is a spin-off from the main body of an existing project. As such, hard forks create new, distinct blockchains that cannot interact and thus maintain a different record of transactions, while soft forks create different versions that are potentially compatible.

Put simply, a hard fork is a permanent divergence in the blockchain, the underlying technology that records and verifies transactions. One such hard fork occurred in Ethereum after a hacker stole $55 million of ether from users by exploiting a bug in the ledger’s programming. A team of white-hat users pulled off a daring move that saw them steal back the money and redistribute it by creating a hard fork, effectively leaving two versions of Ethereum running—one hacked, and one not.

The incident has raised questions over the stability of digital currencies such as bitcoin, which are far more volatile than traditional fiat currencies. At press time, confidence in the SegWit fork had pushed the price of Bitcoin to over $2,800 per coin, with most agreeing that it could surpass an all-time high of over $3,000 reached in June. The sensitivity of the price to external events has some concerned, says Sean Maher, founder at research firm Entext.

“If you go back to something like gold, you always had the gold fix in London, and you can call it a cartel if you like—and this is true for oil as well—but the price was set at the margin by the main participants sitting around a table and deciding that is the price,” Maher says . “You have no order of any kind in this system right now, so if you get a flurry of initial coin offerings, or random, left-field stuff, it can suddenly goose the price of all cryptocurrencies.”

The ability for two separate versions of a currency to theoretically exist is problematic for money managers, particularly those used to investing in reliable currencies backed by government guarantees.

“The fact that we’ve gotten to this point,” Maher continues, “where some owners of coins could lose their transaction history in what is supposed to be the most mature cryptocurrency in this space, that’s clearly indicative of some big structural problems in governance.”

The problems are further compounded by a lack of mature market structure surrounding digital currencies, which have been prone to flash crashes, and in extreme cases, fraud in recent years. Efforts to create an institutional structure around bitcoin have also been slow to materialize—the US Securities and Exchange Commission (SEC) rejected a proposed rule change by Bats Global Markets that would allow it to list an exchange-traded fund in March 2017, citing the lack of maturity in the market and its vulnerability to manipulation.

The SEC later said it would review the decision, after Bats appealed in April. Bats declined to comment on the progress of the review.

This article forms part of an in-depth feature that Waters will publish on institutional involvement in digital currencies—and the obstacles that are still in the way of them becoming a bona fide, tradable asset class—in its August issue.