Key takeaways
- Unspent transaction outputs (UTXOs) are discrete chunks of Bitcoin received and not yet spent.
- Transactions can split UTXOs to accommodate payment, change, and network fees.
- Merging smaller UTXOs into larger ones reduces future transaction inputs.
- The UTXO model ensures each input references a previous output, sums inputs to outputs and updates UTXOs upon confirmation.
- UTXO provides a clear fund trail and enhances privacy, while the account model is simpler but faces scalability and security issues.
UTXO simply explained
Imagine you walk into a supermarket and want to buy a single orange for, say, $1, but you only have a $5 bill. Naturally, you’d give it to the cashier, who would convert the $5 into five individual $1 bills, keeping one while returning you four.
While the idea of unspent transaction outputs, or UTXOs, might seem daunting at first, they can simply be thought of as the hidden currency denominations you keep in your wallet.
If you plan to manage your own Bitcoin (BTC), it’s crucial to understand what UTXOs are, why they matter, and how to handle them effectively.
Without this knowledge, you could run into significant issues in the future.
What is UTXO?
A UTXO is a chunk of Bitcoin you have received but have not yet spent. Much like you hold different denominations of dollars in your physical wallet, such as twenties, fives, and several coins, every Bitcoin transaction you send is made up of one or more of these hidden UTXOs.
Your balance, therefore, is the combination of all the UTXOs that you hold in your wallet.
The following is a simple example.
The single UTXO scenario
Suppose you just mined a block and received newly minted Bitcoin directly from the network.
If your reward is 3.5 BTC, consisting of the block reward and transaction fees, this amount constitutes a single UTXO.
Think of it as a newly minted chunk of Bitcoin you now possess.
Now, say you want to send 1 BTC to your friend Bob. The network will take your single UTXO of 3.5 BTC and split it into three separate UTXOs (these example numbers are rounded for simplicity):
- Change: 2.5 BTC will be sent back to your wallet as change.
- Network fee: A small amount, say 0.000002 BTC, will be used to pay the network fee.
- Payment to Bob: 1 BTC will be sent to Bob.
Next, suppose you want to send your remaining 2.5 BTC to your sister, Alice. In this case, as there’s no change, there’s only the fee to consider:
- Network fee: Say 0.000001 BTC.
- Payment to Alice: 2.5 BTC will be sent to Alice.
You’ll also notice that the fee is lower. This is because Bitcoin transaction fees are determined by the size of the transaction data in bytes, not by the amount of Bitcoin being sent.
Thus, with fewer UTXOs in your wallet, any transactions you make are simpler for the network to process and, therefore, cheaper.
Such an example, where you only hold a single UTXO, is rare. So, here are some other scenarios.
The multiple UTXOs scenario
This will be a more realistic scenario, as most people will hold multiple UTXOs in their wallet.
Tom wants to send his friend Jerry 1.2 BTC.
This time, Tom holds a variety of small, medium and large UTXOs in his wallet. This means the network is required to form the larger transaction from many smaller UTXOs.
For example, if Tom has a total of 10 BTC in multiple UTXOs, the transaction breakdown might look like this:
- Change: 8.8 BTC will be sent back to Tom’s wallet as change.
- Network fee: Say 0.000009 BTC.
- UTXOs to be sent to Jerry as part of the 1.2 BTC transaction:
- Payment 1: 0.9 BTC
- Payment 2: 0.15 BTC
- Payment 3: 0.10 BTC
- Payment 4: 0.05 BTC
Of course, these examples are rounded for simplicity, but you’ll notice that the more complex the transaction is (i.e., the higher the number of UTXOs involved), the higher the cost.
You can view the UTXOs that make up your wallet’s balance through various online tools. Below is an example of a UTXO management interface.
It’s crucial to understand that Bitcoin balances are unlike traditional bank balances. Instead of thinking of “one Bitcoin” as a single unit, think in terms of how many UTXOs make up the balance in your wallet. Each UTXO represents a discrete piece of Bitcoin that can be spent in transactions.
Did you know? The concept of Bitcoin’s UTXO model was heavily influenced by earlier digital cash systems like David Chaum’s eCash from the 1980s and Wei Dai’s B-money proposal in the 1990s. These early attempts at digital currency used similar ideas of tracking individual transaction outputs to prevent double-spending, which Satoshi Nakamoto later refined and implemented in Bitcoin’s design. The UTXO model became a foundational element in Bitcoin, ensuring the integrity and security of the blockchain.
Consolidating UTXOs
You’re probably wondering at this point:
Surely, if transactions are continuously split due to the inevitability of fees and the uneven denominations of UTXOs to match a transaction, they will become more complex over time, meaning average fees will be on an inevitable upward trajectory.
In theory, yes, if “consolidation” wasn’t possible.
Have you ever taken your coins and small denominations to a Coinstar machine? These machines take your loose change, count it, and provide you with a voucher that you can exchange for cash at the store’s customer service desk.
Indeed, the same is possible with Bitcoin UTXOs. “Consolidation” is a process involving sending multiple smaller UTXOs to yourself as a single larger UTXO, reducing the number of future transaction inputs.
It’s important to do this; otherwise, you could end up with hundreds or even thousands of different UTXOs, making any transactional activity relatively expensive. However, it’s advisable to do this when network fees are low.
Did you know? Coinstar, best known for its coin-counting kiosks, also allows you to convert your spare change into Bitcoin! In 2019, Coinstar partnered with a crypto company to let users buy Bitcoin at select kiosks across the United States, making it one of the easiest ways to dip your toes into cryptocurrency.
How to consolidate UTXOs
When it comes to consolidating UTXOs, most wallets offer this feature, so the process should be fairly similar across platforms. This example will use Sparrow Wallet.
Step 1: Open Sparrow Wallet and obtain a receiving address
- In Sparrow Wallet, click on the “Receive” button.
- Copy the latest unused receiving address that appears.
Step 2: Select the UTXOs for consolidation
- Navigate to the UTXOs section within Sparrow Wallet.
- Select all the UTXOs you wish to consolidate by clicking on them.
- Click the “Send Selected” button to proceed.
Step 3: Create the consolidation transaction
- Paste the previously copied receiving address into the “Pay To” field.
- Add a label for this transaction if desired.
- Adjust the transaction fee according to your preference. Sparrow Wallet will automatically recognize this as a “self transfer.”
- Click on “Create Transaction.”
Step 4: Finalize and sign the transaction
- Review the transaction details. Ensure the inputs (selected UTXOs) and output (consolidated UTXO) are correct.
- Click on “Finalize Transaction for Signing” to proceed.
Step 5: Confirm the transaction
Wait for the transaction to be confirmed on the blockchain. Once confirmed, your UTXOs will be consolidated into a single UTXO.
Did you know? Unlike many other Bitcoin wallets, Sparrow allows users to connect directly to their own Bitcoin node, enhancing privacy and security. It also offers built-in tools for coin control, UTXO management, and integration with hardware wallets, making it a favorite among privacy-conscious Bitcoin enthusiasts.
How the UTXO model prevents double-spending
There are many reasons why the UTXO model was implemented, as outlined in the Bitcoin white paper, but at the top of the list, arguably, is the fact that it prevents double-spending.
Indeed, Bitcoin needed to be designed in a way that would prevent users from altering the ledger, giving themselves back the BTC they had already spent, or, more fittingly, spending the same Bitcoin twice.
The UTXO model was a key part of the solution, ensuring protection against double-spending in three main ways:
- Each transaction input must reference a previous transaction output: For instance, Alice received 1 BTC previously. When sending 0.5 BTC to Bob, her transaction references the 1 BTC she received. The remaining 0.5 BTC typically goes back to Alice as a new UTXO.
- The sum of inputs equals the sum of outputs: Suppose Alice’s input is 1 BTC. She sends 0.5 BTC to Bob and receives 0.5 BTC back as change. This prevents any discrepancy and ensures funds are correctly allocated.
- Once a transaction is confirmed, the UTXO is updated: Alice’s transaction of 0.5 BTC to Bob is confirmed. The original 1 BTC UTXO is marked as spent. New UTXOs are created: 0.5 BTC for Bob and 0.5 BTC (minus fees) back to Alice. These new UTXOs can be used in future transactions, while the spent one cannot.
The UTXO vs. account model
The UTXO model makes it easier to verify the integrity of the blockchain by providing a clear trail of funds, reducing the complexity of double-spending prevention and enhancing privacy through the use of multiple addresses.
However, it comes with the trade-off of more complex transaction structures and larger transaction sizes with limited smart contract support.
As such, the “account model” was proposed with the creation of the Ethereum blockchain, which went live in 2015.
Indeed, the account model is much easier to understand because it operates similarly to traditional bank accounts. When you initiate a transaction to transfer a specified amount from your account to Alice’s account, the bank verifies it and updates the balances in its ledger.
Ethereum, for example, maintains a global state that records the balances of all accounts on the blockchain, including both user-owned accounts and contract-based accounts. When a transaction is submitted, the Ethereum Virtual Machine (EVM) verifies it and updates the account balances of the involved parties accordingly.
While the account model is simple and efficient, it comes with scalability issues, security risks and greater privacy concerns. Consequently, the UTXO and account models are not the only approaches in the blockchain space.
For example, the extended unspent transaction output (EUTXO) model was proposed by Cardano in 2017. This model extends the capabilities of the traditional UTXO model by incorporating features typically associated with the account model, such as more complex scripts and stateful smart contracts.
Additionally, Iota uses the Tangle, a type of directed acyclic graph (DAG), to facilitate fast, feeless transactions suited for Internet of Things (IoT) devices.
It’s important to remember that while the UTXO model powers Bitcoin, the world’s largest and most well-known blockchain, the industry is constantly evolving. New models, such as Cardano’s EUTXO and Iota’s Tangle, are emerging, offering innovative solutions to the challenges faced by traditional models like Ethereum’s account model.
Written by Bradley Peak