A Crypto Crystal Ball? What If Traders Settled Bitcoin Forks

Any way you slice it, blockchain software upgrades are proving messy business.

And in some ways, this is by design. Due to the nature of blockchains as opt-in systems, changes to the rules of the code require broad agreement. Everyone with a stake in helping run the protocol must decide not to simply copy what's been created and start fresh, as they have with the ethereum classic and bitcoin cash forks.

But that's not to say technologists aren't searching for a better way, one that improves a process defined by death threats, name-calling, and increasingly, divisions that lead to splits.

So far, one idea that's beginning to attract attention is the use of prediction markets, where traders place bets on future events in an effort to inform the outcome. After bitcoin's most recent hard fork was abandoned, some argue similar markets could shed light on the outcomes of particular changes within the community.

For instance, during the run-up to bitcoin's Segwit2x hard fork, several cryptocurrency exchanges offered a market where traders could weigh in on whether bitcoin would remain the official bitcoin, or whether a Segwit2x chain would be created (and what it's value might be).

On Bitfinex, one of the exchanges that offered such trading tools, the Segwit2x coins traded at about one-tenth the value of bitcoin, leading some to take that as a sign that traders lacked confidence in its eventual approval.

Developer Anthony Towns even made an uncannily apt prediction during the Scaling Bitcoin event earlier this month before Segwit2x was suspended, saying:

"You don't know if that's a low price because the Segwit2x coin is not going to be very valuable, or if it's because the market's kind of saying that everyone's going to back off and the fork isn't going to happen at all."

And that prediction displays how futures trading within the crypto space could aid in measuring sentiment about proposed changes.

Towns told CoinDesk that prediction markets potentially offer better insight that other ways of measuring sentiment. For instance, Twitter and other social media polls can be easily manipulated when users create multiple accounts for which to cast a vote.

Plus, there are concerns about echo chambers.

"Without a market, it's easy to get into a bubble where you're only hearing from people who agree with you," he said.

Leading the way

In advance of this year's bitcoin hard forks – leading to chain splits and new cryptocurrencies – a handful of bitcoin exchanges have launched sophisticated futures markets.

But Bitfinex began futures trading even earlier, launching a new kind of token on its site as the Bitcoin Unlimited software took hold in April (that fork never occurred).

Bitfinex also launched futures trading ahead of the bitcoin cash split, and the predictions were fairly accurate. The bitcoin cash futures tokens traded at between 10–20 percent of what bitcoin traded for on the exchange; today, the value of a bitcoin cash token is about 14 percent of a bitcoin.

Ahead of the Segwit2x hard fork, Bitfinex allowed their users to trade in a bitcoin for two futures tokens – one "BT1" representing legacy bitcoin and one "BT2" representing the new coin that could be created if the Segwit2x hard fork caused a split.

Users could then buy or sell these coins, betting on which one they thought would fare better after the split.

When launching its so-called "Chain Split Token," Bitfinex argued it was offering the community a service (echoing Towns' sentiments) in a blog post, saying:

"We hope that this innovation brings some much-needed price discovery for the future of the bitcoin ecosystem."

Continuing disagreements

And in the case of Segwit2x, the futures market did, in a way, hint at the Segwit2x outcome.

Still, there remains uncertainty around what the prices actually mean, both in the short and long term.

What is certain, according to many developers, is that disagreements over future changes to the cryptocurrency protocol will continue, and futures markets could provide insight into the community's sentiment on those issues.

During his Scaling Bitcoin presentation, Towns said, "I contend that disagreements aren't going to go away. We can't get everyone in the same room ... and come to agreement. No, I think we will continue to have disagreements, and those disagreements will result in a split."

However, he also argued that prediction markets could be helpful, not only in determining how users feel about the backwards-incompatible hard forks, but also about less disruptive soft forks.

"I think the way things are going, they'll be needed for the next soft fork as well," Towns said.

He points to Segregated Witness (SegWit), a scaling upgrade that was recently added to bitcoin, as a contentious soft fork. Plus, so-called user-activated soft forks (UASFs) can have similar outcomes – splitting the chain into two blockchains with competing cryptocurrencies – if there's substantial disagreement.

Better predictor

So, with prediction markets looking to become valuable tools for measuring support or opposition to protocol changes, at least one researcher is already trying to improve this fortune-telling mechanism.

In October, Bloq economist Paul Sztorc proposed a way to make markets more fair for those participating by allowing people to get their money back if a fork is abandoned.

When Segwit2x was put on hold, users that had bet on that coin lost all their money.

With Sztorc's proposal, though, rather than create two tokens, exchanges would create eight futures tokens "arranged into two markets, in order to fully partition the space of possible outcomes." These eight tokens are settled in cash rather than on the blockchain "because they can allow users to speculate on scenarios/outcomes that may never actually happen."

And with that, users would be given their money back if no split happened at all.

Towns said he was "fond" of Sztorc's proposal, but argued it could be too "complex" or could potentially "draw in lawyers and regulators," since it relies on fiat money.

But still, more interest in these markets are likely to continue as crypto enthusiasts become more interested in how hard forks create new value.

When asked about the accuracy of these markets, Towns paraphrased a quote from former UK Prime Minister Winston Churchill, revealing a cautious optimism for how the mechanism could be used in the crypto community:

"They're the worst thing to rely on, except for everything else that's ever been tried."

Disclosure: CoinDesk is a subsidiary of Digital Currency Group, which has an ownership stake in Bloq.

Crystal ball image via Shutterstock