Cryptocurrencies

Weekend column: What are UTXOs?


Goodday everyone,

Today we’re going to talk about UTXOs. UTX what? you may wonder.

UTXOs stands for “Unspent transaction outputs”. Knowledge about this is particularly important for those who have stored bitcoin under their own management. So let’s get started right away.

What are UTXOs?

As the name suggests, a UTXO is an output of a bitcoin transaction.

Unspent transaction outputs, or UTXOs, are specific amounts of Bitcoin that you have received but not yet spent. Each UTXO is like an individual bill in your wallet, each with a unique value. If someone sends you bitcoin, what you receive is a UTXO.

For example, a balance of 0.67 BTC in your wallet can consist of 4 different UTXOs:

  1. 0.3 BTC
  2. 0.12 BTC
  3. 0.17 BTC
  4. 0.08 BTC.

Compare it with a piggy bank:
As a child I used to have a piggy bank in my room. Every now and then my parents would give me some coins if, for example, I had helped in the garden. Or sometimes even money from my grandmother if I had a good report, for example. Every time you receive money from someone to put in your piggy bank, this is a loose UTXO.

So the piggy bank contains a number of coins such as nickels, dimes, guilders and some bills. But there is no balance sheet/balance. The way we get the total balance is by emptying the piggy once a year and counting how much money is in it.

A bitcoin wallet is exactly the same, only the wallet does the work of counting automatically. The bitcoin balance in your wallet is the total of all received UTXOs. It does not work like a bank account, but like notes and coins.

So a bank maintains accounts and updates the balance regularly. In contrast, the Bitcoin protocol keeps track of a series of transactions; it keeps track of the ownership history of notes and coins.

In short: An Unspent Transaction Output (UTXO) is a unique piece of bitcoin. Bitcoin does not use accounts and balance sheets. Instead, individual pieces of bitcoin are owned by individuals. An amount is linked to each UTXO. They are the pieces of bitcoin that you have not yet spent and you use them to make new payments.

How do Bitcoin UTXOs work?

UTXOs are created when existing UTXOs are consumed by transactions. Every bitcoin transaction consists of inputs and outputs. Inputs in a transaction use old UTXOs, while outputs generate new ones. When a UTXO is issued in a transaction, it is destroyed and one or more new UTXOs are created.

When you make a new transaction, your wallet will select enough UTXOs to cover the transaction amount. Because UTXOs cannot be split, you sometimes receive change back in the form of a new UTXO.

  1. Alex’s wallet selects the best UTXOs to get the precise transaction amount or more. Because UTXOs cannot be split, the wallet takes 2 UTXOs
  2. The wallet creates a new UTXO for Julia equal to the transaction amount
  3. The wallet creates a new UTXO for Alex equal to the “change”
  4. The transaction fee is not paid to the miner as an output of the transaction. But this is derived from the difference between the value of the inputs and the value of the outputs

Just like with cash payments, you cannot pay someone 5 euros by tearing a 10 euro note in half. You pay with the 10 note and get change back. UTXOs work the same way in that they must be spent in full. You will receive the change as a new UTXO.

Why are UTXOs important?

UTXOs influence the amount of the transaction fee. There are two components that determine transaction costs:

  • the rate (the amount of the fee)
  • the data size of the UTXOs involved.

For example, if you use many small UTXOs to make a large payment, the transaction size increases and so do the costs. You can think of this as paying a large bill with many small coins.

It’s like when you go grocery shopping and use your change from the butcher, the supermarket and the bakery, and then buy a large item. Just as it is cumbersome to pay with the many bills and coins you previously received in change, spending many UTXOs at once is cumbersome for the Bitcoin network.

The notes and coins you use are the change (output) from previous purchases and serve as INPUT for the next purchase. The more different notes and coins you use (UTXOs), the higher the data load of the transaction and therefore the higher the transaction costs. The amount of UTXOs your wallet uses as input is determined by how you received those UTXOs from previous transactions.

Back to our piggy bank:
Suppose you received 5 euros from 10 people because you had a good report and put it in your piggy bank. Now you want to buy a shirt for 50 euros. Your only option is to 10 UTXOs to use as input to pay for the shirt.

If you had a 50 euro note, you would only need to use one 50 euro note for the transaction. Each note, or UTXO, takes up space. So to get the transaction into the Bitcoin blockchain, you pay higher fees for transactions with more UTXOs because it takes up more space.

In practice, this means that the amount of bitcoin you send has no influence on the fee you pay.

A billion dollar transaction can have the same cost as a $10 transaction. This transaction for example, of $2 billion in 2021 cost only $0.78 in fees.

Sometimes users discover that their bitcoins can no longer be spent if the fees are very high. This situation occurs when fees reach a level where issuing UTXOs would cost more in transaction fees than the amount they are worth. That is why UTXO management is recommended!

This is mainly for people who DCA small amounts and automatically send them to their own wallet. Please take a look this video from river for a clear explanation on this subject.

UTXO management

UTXO management is the strategic handling of UTXOs to improve transaction efficiency and reduce transaction costs. In practice, this is done by generating a new address and sending all the bitcoin from your wallet there. You can also do it by sending a transaction to yourself.

This transaction combines all your existing UTXOs and returns the total amount as a single UTXO. While this process may seem strange, it makes your bitcoin assets more efficient for future use.

UTXO consolidation is comparable to exchanging several smaller notes at the bank for one large note. Although returning UTXOs to yourself will incur transaction fees, you can save more in the future.

NOTE: You want to consolidate UTXOs when network transaction costs are low.

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Bitcoin expert Rick Hutting writes a weekly weekend column on the subject. You can sign up for his free daily online newsletter by clicking here . You can also follow him on Linkedin.

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