The Bitcoin SegWit2x Hard Fork: Case Study in a Market Frenzy

January 16, 2018 04:00 PM
The Issue With Forecasting

At the end of 2017, all eyes are on the new player in finance and technology and the blockchain and cryptocurrency universe it is designed to serve. Bitcoin, more specifically, has been the focus of conversation at every financial holiday party. 

This volatile space has shown astounding returns to early adopters, and the public is following along hoping to cash in on this gold rush. The problem is that following the masses is rarely a strategy that achieves alpha, and the next round of big winners will have a deep understanding of this market that considers technical, financial, economic and social perspectives.

What does this trader archetype look like at this stage? Folks piling in from traditional finance roles seem to think they know. Early blockchain technologists think the same. But the truth is there are many unique attributes of these products that must be learned if one hopes to make a success of it. 

In the weeks and months ahead, more will be revealed regarding cryptocurrencies; how the technology works, how it fits into the greater economic system, what major moves are happening in the market and how these types of investments can fit into a modern portfolio. Data continues to emerge as the asset class, and individual coins, continue to grow in size and complexity. 

The study and handling of digital assets needs to be carefully considered. The assumptions we take for granted in modern equities, derivatives, fixed income and currency markets must be re-evaluated. Not because some of them do not hold but because digital assets are undeniably different. Valuation frameworks are still very much in a nascent stage. Quality teams and the resulting code matters. But so too does the technical mapping of the movement of these assets. 

A recent event highlights the complexity of these assets and the need for study before jumping in. 

Forks & uncertainty

Most markets do not react positively to uncertainty and for the most part cryptocurrencies follow suit. There are however times where uncertainty in the cryptocurrency market can create an opportunity for favorable trades and massive value creation. One such event in recent history was the failed attempt at a “hard fork” called SegWit2x. This hard fork was planned to take place because of disagreements over how the bitcoin blockchain should function and though the hard fork never actually took place, we were able to gain insight on how the market reacts to such events.

Let’s begin by reviewing what the bitcoin blockchain is and what a hard fork is. Bitcoin is a unique digital object whose history of ownership is stored in a ledger very similar to the ledger that tracks funds in your bank account. The difference in the bitcoin ledger is that tens of thousands of independent computers (miners) keep track of the ledger and verify its validity as a community rather than as a single central authority. In order for all of these miners to agree on the state of the ledger they all have to track it according to the same rules. 

SegWit is the name of a protocol that represents a new and possibly more efficient way of tracking the blockchain ledger that many miners wanted to implement on the bitcoin blockchain. The problem is that not all miners agreed that this new protocol was better and we were left with a situation where our single ledger of transactions was scheduled to split into two separate ledgers each of which shared the same history, but would use a different protocol to add all future transactions. We call this situation a hard fork.

While this situation introduced great uncertainty into the market, this fork drove demand for bitcoin through the roof. This demand was driven by the fact that each fork shared the same history, meaning anyone holding bitcoin at the time of the fork would instantly be the proud owner of a bitcoin and a SegWit2x coin. Free money! This frenzy was clear to see in the charts in the month leading up to the planned SegWit2x, Bitcoin’s price shot up 70% and its cryptocurrency market share went from 49% to 63%. You could literally see the value of all alternative coins going down as sellers consolidated their portfolios into bitcoin in anticipation of free tokens. This was a great time to buy non-bitcoin cryptocurrencies.

In the end, the miners came to a consensus and decided not to implement a SegWit2x hard fork. Many investors tried to sell their bitcoin off right away fearing that the lack of free tokens would drive the price down, but the opposite happened. Rather than a crash from no fork, speculators were pleased to see a level of certainty and stability in the bitcoin blockchain driving the price even higher. Once this frenzy cooled off, money started leaving bitcoin and made its way back to other tokens and bitcoins market share cooled down to 55% in the following month. This is an example of uncertainty generated within the cryptocurrency community driving prices up, and, why it may not be wise to jump right into to the cryptocurrency market without a fair amount of research.  

About the Author

Joseph M. Bradley is head of investor relations and a lead analyst for Neural Capital. Scott Hoch is the lead analyst for the Apex Token Fund.