Segregated Witness (SegWitness, SW) is being presented in the context of Scaling Bitcoin.  It has useful attributes, notably addressing a major malleability vector, but is not a short term scaling solution.

Import Fee Event, ECE, TFM, FFM from previous email.

Older clients - Any software not upgraded to SW

Newer clients - Upgraded, SW aware software

Block size - refers to the core block economic resource limited by MAX_BLOCK_SIZE.  Witness data (or extension block data) is excluded.  Requires a hard fork to change.

Core block - Current bitcoin block, with upper bound MAX_BLOCK_SIZE.  Not changed by SW.

Extended transaction - Newer, upgraded version of transaction data format.

Extended block - Newer, upgraded version of block data format.

EBS - Extended block size.  Block size seen by newer clients.

One proposal presents SW in lieu of a hard fork block size increase.  This email focuses directly on that.

Useful features outside block size context, such as anti-malleability or fraud proof features, are not covered in depth.

SW creates two views of each transaction and block.  SW has blocks and extended blocks.  Similarly, there exists transactions and extended transactions.

This view is rendered to clients depending on compatibility level.  Newer clients see extended blocks and extended transactions.  Older clients see blocks (limit 1M), and do not see extended blocks.  Older clients see upgraded transactions as unsigned, anyone-can-pay transactions.

Each extended transaction exists in two states, one unsigned and one signed, each of which passes validation as a valid bitcoin transaction.

4.2.  Observations on behavior of older transaction creation

Transactions created by older clients will not use the extended transaction format.  All data is stored the standard 1M block as today.

SW complicates block economics by creating two separate, supply limited resources.

The core block economic resource is heavily contended.  Older clients use core blocks exclusively.  Newer clients use core blocks more conservatively, storing as much data as possible in extended blocks.

The extended block economic resource is less heavily contended, though that of course grows over time as clients upgrade.

Because core blocks are more heavily contended, it is presumed that older clients will pay a higher fee than newer clients (subject to elasticity etc.).

5.1.  Problem:  Pace of roll-out will be slow - Whole Ecosystem must be considered.

The current apparent proposal is to roll out Segregated Witness as a soft fork, and keep block size at 1M.

The roll-out pace cannot simply be judged by soft fork speed - which is months at best.  Analysis must the layers above:  Updating bitcoin-core (JS) and bitcoinj (Java), and then the timelines to roll out those updates to apps, and then the timeline to update those apps to create extended transactions.

Overall, wallet software and programmer libraries must be upgraded to make use of this new format, adding many more months (12+ in some stacks) to the roll out timeline.  In the meantime, clients continue to contend entirely for core block space.

A simple hard fork such as BIP 102 is automatically compatible with the vast range of today's ecosystem software.

SW requires merchants to upgrade almost immediately, requires wallet and other peripheral software upgrades to make use of.  Other updates are opt-in and occur more slowly.  BIP 70 processors need some updates.

The number of LOC that must change for BIP 102 is very small, and the problem domain well known, versus SW.

5.3.  Problem:   Due to pace, Fee Event not forestalled.

Even presuming SW is merged into Bitcoin Core tomorrow, this does not address the risk of a Fee Event and associated Economic Change in the coming months.

Splitting blocks into two pieces, each with separate and distinct behaviors and resource values, creates two fee markets.

Having two pricing strata within each block has certainly feasible - that is the current mining policy of (1) fee/KB followed by (2) priority/age.

Valuable or not - e.g. incentivizing older clients to upgrade - the fact remains that SW creates a more-complex bidding structure by creating a second economic resource.

This is clearly a change to a new economic policy with standard risks associated with that.  Will that induce an Economic Change Event (see def last email)?  Unlikely, due to slow rollout pace.

5.5.  Problem:  Current SW mining algorithm needs improvement

Current SW block template maker does a reasonable job, but makes some naive assumptions about the fee market across an entire extended block.  This is a mismatch with the economic reality (just described).

5.6.   Problem:  New, under-analyzed attack surfaces

Less significant and fundamental but still worth noting.

This is not a fundamental SW problem, but simply standard complexity risk factors:  splitting the signatures away from transactions, and creating a new apparently-unsigned version of the transaction opens the possibility of some network attacks which cause some clients to degrade down from extended block to core block mode temporarily.

There is a chance of a failure mode that fools older clients into thinking fraudulent data is valid (judgement: unlikely vis hashpower but not impossible)

6. Conclusions and recommendations

It seems unlikely that SW provides scaling in the short term, and SW introduces new economics complexities.

A "short term bump" hard fork block size increase addresses economic and ecosystem risks that SW does not.

Bump + SW should proceed in parallel, independent tracks, as orthogonal issues.

7. Appendix - Other SW comments

Hard forks provide much stronger validation, and ensure the network operates at a fully trustless level.

SW hard fork is preferred, versus soft fork.  Soft forking SW places a huge amount of trust on miners to validate transaction signatures, versus the rest of the network, as the network slowly upgrades to newer clients.

An SW hard fork could also add several zero-filled placeholders in a merkle tree for future use.