We have many times heard about Bitcoin UTXOs. However, few really understand what UTXOs are and how they work. This is why it is very important to clarify this term and help the community understand what Bitcoin UTXOs are, how they work and more.
If you are interested in learning new things about Bitcoin, then this is the right guide for you. If you have heard the term in the past and you are not sure what it means or how it works, we will cover all these aspects in this guide.
What are Bitcoin UTXOs?
The term UTXOs makes reference to an Unspent Transaction Output, which is, essentially, an amount of BTC that has been sent to an address. If you have a Bitcoin wallet and you receive two different transactions to this address, your wallet will display the total amount of BTC, however, you have two different UTXOs.
That means that if you received five different transactions to your wallet address, then, you will have five different UTXOs. The wallet that you use, just to make the whole experience easier and more user-friendly, will group all these UTXOs and give you the total amount of BTC that you have received.
One of the best ways to understand that is by thinking of each BTC transaction as a banknote. Suppose that you receive 1 BTC, 0.5 BTC and 0.25 BTC. You have different BTC denominations and three UTXOs. You hold 1.75 BTC from three different UTXOs. However, if you want to buy something that costs 1.4 BTC, you will have to use two different UTXOs.
Therefore, when you process this transaction of 1.4 BTC, you use two inputs: 1 BTC and 0.5 BTC. Then, there will be three outputs created: 1.4 BTC, 0.1 BTC (that stays in your wallet), and fees for miners that will be taken from the transaction you processed.
A UTXO can be any amount of BTC larger than 1 satoshi. Therefore, the whole number of Bitcoin in circulation can be analysed thanks to the UTXOs implementation on the Bitcoin network. Bitcoin Unspent Transaction Outputs have a very important role on Bitcoin and this can also be seen especially in merchants and exchanges.
In the example shown above, we had a total balance of 1.75 BTC but three different UTXOs. These UTXOs could be totally different and create the same balance amount. They could be 0.75 BTC and 1 BTC. Or they could be 0.10 BTC, 0.20 BTC, 0.30 BTC, 0.40 BTC and 0.75 BTC.
The larger the number of UTXOs, the more expensive it will then be for the consolidation process for these transactions. This is why it is very important to keep an eye on all these UTXOs that accumulate in different wallet addresses. Understanding UTXOs and how they should be consolidated is also a key thing in managing Bitcoin transactions and planning future fees. We will get into the details of UTXOs consolidation in the next few sections.
Understanding Bitcoin UTXOs
Bitcoin merchants and those companies that receive regular Bitcoin transactions must take into consideration all their Bitcoin UTXOs and make sure that they properly understand the way they work. Why is that important, it could then be more expensive for them to manage their funds and process transactions.
Basically, it becomes more expensive for them. Why? Because as we have seen in the previous section, the wallets that receive many different Bitcoin payments will have a large number of UTXOs that will sum up and add a large balance. This is a great thing at the end of the day. They are supporting the Bitcoin network and using Bitcoin on a daily basis, which is very positive.
Now, there are also some things to take into consideration about that. When they will want to make a transaction, they will have to use many different UTXOs depending on the amount that they want to transfer. This is where having a large number of UTXOs becomes more “troublesome.”
This happens as the larger the number of UTXOs used, the larger the transaction size. Therefore, there will then be a higher fee to pay to the miners. This is usually not a problem when we are at a moment in the Bitcoin network where fees are relatively low. However, this could become a problem in the future as the Bitcoin network gets adopted by a larger number of users.
Block space is limited and there is a clear market for investors to pay higher fees if they need to process a transaction. Therefore, it is very important to understand that the larger the number of UTXOs in a transaction, the more expensive it would be for users to send a transaction to another address.
This happens as each transaction occupies space in a block. The larger the transaction (consolidating all your UTXOs into one) the higher the fees paid at the end of the day. Understanding how UTXOs work and how to handle them is a very important thing for users and investors.
This is especially true for those companies and users that receive regular transactions and create different inputs and outputs when handling transactions. Over time, understanding how to manage UTXOs would bring many benefits to Bitcoin holders and users. Therefore, one of the best things to do when processing a transaction is to use the smaller number of UTXOs as possible.
Disadvantages of Having Many UTXOs
As we have already described how Bitcoin UTXOs work and how they affect merchants and transactions, we should analyse their disadvantages and the issues that they create on the Bitcoin blockchain.
Coming back to our example of comparing Bitcoin UTXOs to banknotes, you can think of having €500 in €2 coins. That means that you will have 250 UTXOs that give you a total balance of €500. If you want to process a transfer of €500, then you will have to use 250 inputs to create just 2 outputs (the receiver address and the miner fees).
This would not be easy for you. Imagine that you want to pay using €2 coins for something that costs €500. You will not only have a problem transporting all the coins and counting them, but you will also create a problem for the person that receives the payment.
On the Bitcoin network happens something very similar to this. When you use many inputs to perform a Bitcoin transaction, you will be taking block space. Block space is quite demanded, knowing that Bitcoin blocks are usually full and can process a little bit over 1 MB of transactions. The larger the transaction size (due to the larger number of inputs), the larger the fees that you will end up paying to miners.
Block space is limited, and this is something that is demanded by the whole Bitcoin network. Investors would be more than happy to pay for valuable block size. This is why understanding how UTXOs work would help you better understand how to manage your Bitcoin.
Another thing that is worth taking into consideration is that if you perform a UTXO consolidation (we will get into the details later), you will be harming your privacy. This happens because you will be consolidating transactions and addresses that were before unrelated to each other into a single address.
Blockchain analysis firms and intelligence companies will definitely realize that all these transactions belong to a single person, user or company. Hence, it could be harmful to you if you want to keep your information private. Remember that Bitcoin is a public blockchain with information about transactions being displayed to everyone.
If you care about privacy, working on UTXO consolidation would not only be expensive (if you are a merchant) but it would also harm your privacy and connect a large number of uncorrelated transactions to your personal wallet. Therefore, there are a large number of benefits to understanding UTXOs and how they have an impact on our wallets, addresses fees and transactions.
As a public entity that does not need to be worried about anonymity, consolidating transactions and understanding UTXOs could be a good thing. Now, if you are a person that wants to remain as private as possible, you will have to pay a higher price for your transactions (when processing a transfer), or you will be giving away privacy.
Working on UTXO Consolidation
So what exactly UTXO consolidation is? UTXO consolidation lets you transform your many UTXOs into a single UTXO and a new address. Rather than having 1 BTC, 0.5 BTC and 0.25 BTC (three UTXO) and a total balance of 1.75 BTC, you will now have 1.75 BTC (one UTXO). Obviously, for this transaction, you have to discount the fees processed to the miners.
When you consolidate your UTXOs, you are simply merging them into a single address with one UTXO. Therefore, this would help you pay lower fees in the future (as you will only process a transaction with just one input rather than a transaction with three inputs).
UTXO consolidation is a key thing if you are a cryptocurrency exchange, a large company handling Bitcoin payments or a user that received a large number of transactions and wants to save fees in the future. Knowing that the Bitcoin network continues to grow is something that is pushing companies to perform a UTXO consolidation.
With a large number of users, there is also an increase in the number of transactions. The larger the number of transactions processed by the network, the larger the fees that investors will have to pay. Therefore, analysing the right moment to process transactions and consolidating your UTXOs could be a great way for investors to save on fees.
If you have to process a transaction in the future, you don’t know which fees you will be charged. Instead, if you decide to consolidate UTXOs now, you can be sure of the fees that you will pay for processing all these inputs. This could create a situation in which you pay fees beforehand. This could create a problem for you now (pay fees to consolidate your UTXOs into a wallet address with one input) but it would definitely reduce the fees that you will pay in the future (no UTXO consolidation will be needed).
Another thing that you can do when you consolidate your UTXOs is to move your Bitcoins from a legacy address to a Segregated Witness (SegWit) address. SegWit addresses will reduce even further the fees that you will have to pay in the future as SegWit addresses are they contain less information than legacy addresses (therefore, they are not as large to be processed by miners).
According to data shared by Satoshi Info, the number of Unspent Transaction Outputs has been growing for several years now. This has created a situation in which there are more than 80 million UTXOs right now on the Bitcoin blockchain.
Another thing that you can do if you want to consolidate transactions is use “Coin Control” features from wallet services providers. This would let you select the inputs that you want to use to process a transaction. In this way, you can reduce the number of inputs to process a transfer and avoid performing UTXO consolidation.
It is up to you to decide whether you perform a UTXO consolidation or if you select different inputs to create a transaction. Additionally, you should think about your privacy and whether you would like all these addresses and wallets to be aggregated into one.
Final Words about Unspent Transaction Outputs
As we have seen, in this guide, UTXOs are very important for us to understand how wallets and addresses work. Moreover, if you had doubts about inputs and outputs when handling Bitcoin transactions, this guide helped you clarify these terms and understand how UTXOs have an impact on fees.
UTXO consolidation could be one of the best ways for users to reduce their future fees and plan the fees that they want to pay for processing a transaction. Moreover, thanks to Coin Control features offered by different service wallet providers in the market, users can select the outputs that they use to process a transaction.
Another thing to take into account about UTXOs is the fact that you are in control of each of the payments that you receive. That means that the balance that is displayed in your wallet is just the sum of all the inputs (UTXOs) that you have received from other wallets. The larger the number of transactions you receive, the larger the UTXOs you will eventually have to consolidate in the future.
Understanding UTXOs, Coin Control and UTXO consolidation will let you better manage your Bitcoin in the future and reduce the fees paid during peak times.