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If one proposal excited attendees at the recent Scaling Bitcoin workshop in Hong Kong, Bitcoin Core and Blockstream, it was developer Dr. Pieter Wuille's Segregated Witness. Praised by many within the technical community, Segregated Witness is expected to improve Bitcoin's performance in a number of ways, while some even hope it might be the scaling solution that helps bring some peace back to the Bitcoin community.

In this first part of Bitcoin Magazine’s three-part series on Segregated Witness: how it works.

What are Bitcoin transactions again?

In order to understand Segregated Witness, it is helpful to understand what Bitcoin transactions are on a more technical level. (Feel free to skip to the last section of this article if this is a familiar subject.)

For starters, it's important to realize that the Bitcoin protocol, at its core, consists of transactions. Nodes on the peer-to-peer network don't send each other bitcoin; they send each other packages that contain transaction data.

These Bitcoin transactions, in a way, are really sets of “locks.” More specifically, each transaction contains two main components. One half effectively unlocks bitcoin that were locked up in previous transactions, using pieces of data called inputs. Inputs include scripts, instructions on how to unlock the input, called scriptSigs . The other half consists of one or several new locks called outputs, which lock the same amount or less bitcoin up again. Outputs include scripts called scriptPubKeys. As such, bitcoin effectively move from inputs to outputs within a single transaction, and jump from transaction to transaction at the same time.

There is one main exception to this rule. A coinbase transaction (not to be confused by the wallet company and exchange with the same name) is the transaction created by a miner when he finds a new block, and contains the block reward: currently 25 bitcoin. Additionally, a miner can increase the coinbase reward by any amount of bitcoin that was unlocked in transactions, but not locked up again: the difference between the inputs and the outputs. These are the transaction fees.

All of this “unlocking” and “locking up” of bitcoin is done by senders of transactions, and subsequently transmitted over the Bitcoin network as packages of information. All nodes on the network, then, check whether this process of unlocking and locking up was done correctly. If everything checks out, they forward the transaction to other nodes. And if a node is also a miner, it might include the transaction in a block. Whether he actually does so is up to the miner, however; that's why it makes sense to include a fee.

It is of vital importance that the rules used by all nodes to verify transactions are compatible with the rules used by (almost) all miners. If some miners would include transactions in blocks that other nodes reject, the whole block would be considered invalid by that node. If that node is also a miner, this could lead to double spends and network forks.

These consensus rules – the rules all nodes agree on – allow transactions to lock up (and unlock) bitcoin in several different ways at once. But outputs that lock up bitcoin typically, at least, include a scriptPubKey along the lines of: “Prove that you own (or: know) the private key that corresponds to the public key that corresponds to this Bitcoin address.”

(It's easy to reproduce a public key from a private key, but it's basically impossible to reproduce a private key from a public key. Similarly, it's easy to reproduce a Bitcoin address from a public key, but it's impossible to reproduce a public key from a Bitcoin address. As such, it's also easy to reproduce a Bitcoin address from a private key, but impossible to reproduce a private key from a Bitcoin address. It's a “one way street.”)

The Bitcoin address used to lock bitcoin up in the scriptPubKey, of course, is the address provided by the receiving end of the transaction. Since the receiver created that address using a private key only he knows, he is the only one who can create a valid scriptSig, and therefore the only one who can create a new transaction and spend the locked up bitcoin.

Where do signatures come in?

To prove ownership of the private key that corresponds to the public key that corresponds to a Bitcoin address, one could theoretically include the private key in the scriptSig of a transaction. But, of course, that's not safe at all. Most importantly, anyone who sees the transaction could take the private key, and create a new transaction (or change the original transaction) to attribute himself as many bitcoin as are locked up before the original transaction is included in a block. In fact, if a miner did this, it would become a piece of cake to steal bitcoin, since he's the one picking which transactions to confirm.

Instead, therefore, the scriptPubKeys typically require the scriptSig to include one or more signatures in order to unlock bitcoin.

Signatures are a cryptographic trick which uses a private key in combination with any other data to calculate a unique string of numbers. And, using the magic of cryptography, the corresponding public key can be used to verify that the signature was created using that private key. As such, signatures prove both ownership of a private key, as well as approval of a specific piece of data by the owner of that private key, all without actually needing to reveal the private key.

In Bitcoin's case, private keys are typically used to sign the transaction data minus the inputs. (Hence, the scriptPubKeys, the locked amounts, and some additional details.) Subsequently, this signature and the public key from which bitcoin are spent are added to the input field of the transaction. This proves that the owner of the private key really intended to create the transaction and makes sure it cannot be tampered with.

Then, all of this transaction data – including the inputs this time – is hashed together, which creates the transaction ID, identifying the specific transaction. If a transaction is subsequently included in a block, the miner hashes the transaction ID together with another transaction ID to produce a new hash. And this hash is hashed again, this time along with the hash from two other transaction IDs. This process continues until there is only one hash left. This structure of hashes is called a Merkle Tree, and the remaining hash the Merkle Root . This Merkle Root is combined with additional block data to form the block header , which is used to identify the specific block. A hash of this block header, finally, must be included in the next block’s header, chaining blocks together.

Bitcoin is considered immutable because changing any part of any transaction retroactively would alter the transaction ID, in turn altering the block header. But this altered block header would no longer meet the proof of work requirement. And since the block header influences the make-up of subsequent block headers, neither would any of those.

What is a Segregated Witness?

The Segregated Witness proposal as presented by Wuille in Hong Kong is based on a concept used in Blockstream's sidechainElements, and a complementing idea by Bitcoin Core developer Luke Dashjr. It was conceptualized over the past couple of months in cooperation with Bitcoin Core developers Gregory Maxwell and Eric Lombrozo, and might be rolled out over the next year.

As such, from the perspective of Bitcoin nodes that don't use Segregated Witness (lets call them “old nodes”), some newly created outputs might soon use a strange type of scriptPubKeys. Strange, because these scriptPubKeys can hardly be considered a lock at all. Commonly referred to as an “Anyone can spend,” these scriptPubKeys basically proclaim they don't require a signature. Additionally, they will include some meaningless text.

Old nodes will consider these transactions crazy. They will think that anyone can create a new scriptSig, unlocking these outputs, meaning they're highly insecure. But at the same time, old nodes won't mind either. After all, it's not their bitcoin that's being messed around with, and other people are free to do with their bitcoin as they please. The meaningless text will be considered weird, but fine too. So they'll confirm the transactions as valid, and forward it to other nodes.

However, Segregated Witness-enabled nodes (lets call them “new nodes”) will notice something else. They will see the otherwise meaningless text in the scriptPubKey, but not consider it meaningless at all. Instead, new nodes will recognize this piece of text as another – very special – type of output.

Much like typical outputs, this new type of output will require one or several signatures to unlock the bitcoin. But unlike typical outputs, this new type of output will not require the signature to be included in the scriptSig of a subsequent transaction. Instead, it will require the signature to be included in a completely new part of the transaction: the Segregated Witness.

This Segregated Witness is basically an “add-on” that carries signatures and some additional data. Importantly, Segregated Witnesses are completely ignored by old nodes, but recognized by new nodes. Moreover, the data they carry is not hashed along with the other parts of a transaction into the transaction ID.

As such, both old nodes and new nodes will consider transactions containing signatures in the Segregated Witness valid. Old nodes validate them because from their perspective these transactions don't require a signature at all (and they don't see one), and new nodes validate them because the required signature is in the Segregated Witness. And since both old and new nodes hash the transaction data into the same transaction ID, everyone agrees on the makeup of blocks, and, as such, on the structure of the entire blockchain.

(Note that it is important that all miners – or a very large majority – should use Segregated Witness in order to prevent double spends and chain forks, or none of them should. If all miners do use Segregated Witness, old nodes on the network might wonder why some transactions aren't included in blocks, but since it was always up to miners to decide which transactions to include, and since these are not their transactions, they won't mind, either.)

But there is one problem: If signatures have no effect on the makeup of the blockchain, the blockchain no longer serves as proof that the correct signatures were included in transactions.

To make sure that signatures are embedded in the blockchain regardless, a Segregated Witness-enabled miner adds a trick, too. Rather than creating only a Merkle Tree out of all of the transactions, it also creates a Merkle Tree out of all Segregated Witnesses, to mirror the transaction tree. The Segregated Witness Merkle Root, then, is included in the input field of the coinbase transaction. As such the Segregated Witness Merkle Root changes the transaction data of the coinbase transaction, its transaction ID, therefore influences the block header and, ultimately, the makeup of the blockchain.

Wuille’s Segregated Witness proposal allows signatures to be removed from Bitcoin transactions, while maintaining Bitcoin's immutability, and without breaking any of the existing consensus rules.

The second part of this three-part story, to be published tomorrow, will explore why Segregated Witness is actually useful.

Thanks go out to Blockstream co-founders Pieter Wuille and Mark Friedenbach, Ciphrex CEO Eric Lombrozo, and Blocktrail CTO Ruben de Vries for providing information and added feedback.

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Litecoin creator Charlie Lee discusses the trade-offs developers are currently considering as they seek to increase the bitcoin network's capacity.

Litecoin creator Charlie Lee discusses the trade-offs developers are currently considering as they seek to increase the bitcoin network's capacity.

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SETL, a UK startup building technology for banks based on bitcoin, has lined up a former executive director of the Bank of England to lead its board and is raising between £20 million ($30 million) and £30 million ($45 million).

SETL, which launched in July, says Sir David Walker will join the startup as chairman once it closes its current funding round, which The Financial Times reports will be up to £30 million. SETL founder Peter Randall wouldn't confirm the figure to Business Insider but said it was in the right ballpark.

SETL has appointed Caroline Silver, a managing director at boutique investment bank Moelis & Co. to lead its fundraising efforts.

The appointment of Sir David as chairman is a huge coup for SETL and a big endorsement for blockchain technology, which SETL is working on. Sir David's glittering City CV includes: an executive director of the Bank of England; chairman of Barclays; chairman of Morgan Stanley International; and deputy chairman of Lloyds.

SETL is working on technology that would allow banks to trade cash and assets directly with each other, rather than the current system which requires them to work through an intermediary.

The startup's technology is based around the blockchain, the software that underpins digital currency bitcoin. The blockchain powers bitcoin transactions and records ownership, letting a wide network of users check the accuracy and utilising cryptography to prevent tampering.

Peter Randall, SETL's COO and co-founder, told Business Insider: "We feel that the SETL blockchain will do for payments and finance what containers did for shipping and world trade." In other words, unlock huge amounts of value and cut down on costs.

SETL's private blockchain can handle up to a billion transactions a day, based on simulating transactions at the same rate as the Bank of England gets them.

Sir David say in an emailed statement today:

I am very pleased to accept this position with SETL. Blockchain is an important advance in settlement technology and SETL has a compelling proposition for its deployment. By simplifying the process of payments and settlement SETL should be able to deliver significant operational efficiencies which will benefit all market participants and, most importantly, reduce costs borne by savers and investors.

'We decided this was the next space to bring into the 21st century'

Randall says: "A blockchain in itself is a relatively straight forward thing, it's just a distributed ledger.

"Instead of keeping one ledger in one place and letting people have access to it, you keep a copy of it in lots of different places. Everybody has access to it, but the entries on that ledger are encrypted in a way that means the identity of the person posting on that ledger is protected.

"The resilience of distributed network allows you to, first of all, run a much cheaper system but secondly a much more flexible system."

Santander and Oliver Wyman estimated earlier this year that blockchain technology could save banks $20 billion (£13.2 billion) a year.

Randall has experience overhauling financial technology, helping to found tech savvy stock exchange Chi-X in the 2000s. Chi-X was the first pan-European equities exchange to launch in 2007 and used technology to make trading cheaper and quicker. It was bought by BATS in 2011 and today processes around 25% of all European trading volumes.

We're going to try and do to the post-trade space what Chi-X did do the trading space

Randall says: "We're going to try and do to the post-trade space what Chi-X did do the trading space. What we did with Chi-X is we dropped 21st century technology into an environment that was running COBOL on mainframes.

(COBOL is a computing language used in business and finance. It was first designed in 1959 and is pretty old and slow.)

Randall says: "When we decided what we were going to do with SETL what we did was look around the City and find where all the mainframes are running cobalt. They all happened to be in the post-trade space and we decided this was the next space to bring into the 21st century."

'We don't think this is a technology project, we think this is an engagement project'

Randall is bullish on the potential of the blockchain — but he's not the only one. There are a plenty of startups looking at adapting the technology to traditional finance and banks themselves are looking at it. 30 top investment banks have joined an industry-wide effort to establish uses and standard for the blockchain.

So what makes Randall and SETL think they can succeed in such a crowded field?

"We don't think this is a technology project, we think this is an engagement project," Randall says. "It's a three stage equation. The first step is to get funding. Piece two is regulatory engagement. And piece three is engagement with users."

The connections of Sir David, Randall, and his co-founder Anthony Culligan, a former hedge fund manager, will likely help open doors too.

Randall says: "I certainly think having connections helps, I certainly think having experience helps — and I mean luck helps as well."

But he adds: "I think the more important thing is we've done the very hard thinking about what it is that the financial system actually needs from a blockchain application.

"We see many other people making claims about their services I don't see anyone else actually trying to attack the area we see as the critical piece, which is the ability to make payments and settlement between banks. That's the most critical part of any payment infrastructure — how does one bank pay another bank."

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Magister Advisors has produced arguably the most comprehensive report to date on what is happening in the world of bitcoin and blockchain startups.

Bitcoin is a digital-only currency not backed by any central bank, while the blockchain is the software underpinning it.

Blockchain uses complex cryptography to ensure transactions can't be tampered with and people sending and receiving money are who they say they are.

Jeremy Millar, a partner at technology bank Magister, told Business Insider blockchain is the fastest growing industry he's ever seen. There are a huge number of startups trying to use both bitcoin and blockchain to do a variety of different things.

Banks in particular are excited about the potential savings and benefits blockchain technology could offer them. Thirty top investment banks have joined an industry-wide group looking at potential uses and plenty of banks are experimenting with the technology themselves behind closed doors.

Magister's report is split into four sections — the bitcoin ecosystem, the blockchain ecosystem, and profiles of companies in each sector.

Magister has given BI permission to reproduce its presentation — check it out below.

The "Uber moment" in finance that the former CEO of Barclays warned about recently is already happening — 11 big banks have cut a combined 10% of their staff this year.

Analysis by the Financial Times shows that almost 100,000 banking jobs were cut this year, equivalent to 10% of the combined staff of the 11 big European and US banks that announced cuts.

They include HSBC, Morgan Stanley, Standard Chartered, Royal Bank of Scotland, and Credit Suisse. Barclays and BNP Paribas are expected to add to cuts early in the new year.

The analysis comes just weeks after Antony Jenkins, who until July was CEO of Barclays, warned in a speech that as much as half of banking jobs could be replaced by apps and algorithms over the next 10 years.

Jenkins' argument rests on the rise of fintech — financial technology — startups that do things like payments, lending, and investments in a smarter, cheaper, and often faster way.

Jenkins believes fintech startups will "disrupt" financial services in the same way Uber has disrupted the taxi industry. That will squeeze profit margins, forcing banks to cut staff, and also force them to compete on technology, another change that will reduce headcount.

Jon Peace, a London-based banks analyst at Nomura, acknowledged this pressure on banks, telling the Financial Times:

Digital transformation could also be a driver of further headcount reduction longer term, with retail banks cutting branches in favour of online services and investment banks cutting back offices in favour of online technologies such as blockchain.

Blockchain is the software that underpins bitcoin and uses complex cryptography to allow transactions between strangers to take place without the need for a trusted intermediary such as a bank or clearing house.

Banks are going wild for the possibilities of the technology, with 30 leading investment banks joining an industry-wide project to develop standard applications and regulation of the technology. Goldman Sachs said in a recent note that the blockchain could change "well, everything."

But while technology looks as if it could be a huge driver of layoffs in the future, right now it's actually a relatively minor factor. A bigger contributor to the 100,000 jobs cut this year in the increasingly regulatory burden big banks face around the world and low interest rates hitting client activity.

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