If you have just started getting involved in Bitcoin or even if you’ve been using it for a while, you will have no doubt been hearing increasing noise from the community about the importance of ‘UTXO Management’.
This is for good reason. Good UTXO management can reduce the fees you pay, increase your privacy, and is vital for robust estate and inheritance planning. Mismanagement of your UTXOs on the other hand will risk you overpaying on fees, exposing private financial details, and leaving your financial affairs in disarray.
Read on to learn more about why you should be learning proper UTXO Management
First, if you want to improve your UTXO management it’s important to understand what a UTXO is. It stands for ‘Unspent Transaction Output’. To the non-technical amongst us this isn’t particularly helpful, so let’s look at a couple of examples involving two different Bitcoin users, Bob and Alice.
Example 1: Bob
Bob has been buying 0.1 Bitcoin at an exchange every month and each time he made a purchase he then immediately sent the bitcoin to his wallet address:
This results in Bob’s address having a total balance of 0.4 BTC made up of 4 individual UTXOs of 0.1 BTC each.
Example 2: Alice
Alice has also been buying 0.1 Bitcoin at an exchange every month just like Bob. The difference is that instead of transferring her Bitcoin out of the exchange each time she bought it, she let her balance build up in the exchange and only withdrew it in one transaction at the end of month 4:
This results in Alice and Bob’s addresses having the same balance of 0.4 BTC but in this case, because Alice sent the bitcoin via just one transaction her balance is made up of just one UTXO of 0.4 BTC.
For a simple analogy you can think of it as being like cash in a physical wallet. Your wallet could have a balance of $50 by filling it with 50 x $1 bills or similarly it could have a balance of $50 by putting in just one $50 bill.
Bitcoin works in a similar way. Just like putting more bills in your wallet, each time a bitcoin payment is sent to your address it increases your total balance and becomes a new UTXO.
Now that we understand how your bitcoin wallet address balance is made up of separate UTXOs let’s now look at how UTXOs are used when you want to make a payment with them.
Let’s use Bob and Alice to create another example. This time we are going to imagine that both Bob and Alice want to buy a ticket to a bitcoin conference for 0.1 BTC.
As shown earlier, Bob and Alice’s balances are the same at a total of 0.4 BTC. So, the transactions they make to send 0.1 BTC to buy a conference ticket would look the same right? Well, not exactly. Let’s take a closer look at how their different UTXOs change how their transactions are created:
Bob’s Bitcoin Transaction:
Bob’s wallet address has a balance of 0.4 BTC made up of 4 UTXOs of 0.1 BTC each. Bob intends to spend a total of 0.11 BTC to complete this transaction. 0.1 BTC to the conference organiser for his ticket and 0.01 BTC to pay the mining fee.
Because each of Bob’s UTXOs only amount to 0.1 BTC each he needs to use two of them as inputs (TXOs) for a total of 0.2 BTC to be able to cover the total transaction cost of 0.11 BTC.
This results in three new UTXOs being created once the transaction is processed:
1) A new 0.1 BTC UTXO for the conference organiser.
2) A new 0.01 BTC UTXO for the miner
3) A new 0.09 BTC UTXO for Bob’s change from the transaction
Fun Fact: What you might notice is that the inputs for the transaction equal the outputs. For a Bitcoin transaction to be valid this must always be true. If you think about it this makes sense… if any amount of Bitcoin is sent as an input, it must have a destination output and be accounted for somewhere. It can’t just disappear.
Now let’s look at Alice’s transaction when she buys the same conference ticket. She has the same balance but instead of 4 smaller UTXOs for 0.1 BTC she has a single larger UTXO of 0.4 BTC:
Alice’s Bitcoin Transaction:
Alice’s wallet address has a balance of 0.4 BTC just like Bob’s but hers is made up of a single UTXO of 0.4 BTC. Alice intends to spend a total of 0.109 BTC to complete her transaction. 0.1 BTC to the conference organiser for her ticket and 0.009 BTC to pay the mining fee.
Alice’s UTXO of 0.4 BTC covers the total transaction cost of 0.109 BTC so she can make the transaction. She uses the 0.4 UTXO as her only input to the transaction and this results in three new UTXOs being created once the transaction is processed:
1) A new 0.1 BTC UTXO for the conference organiser.
2) A new 0.009 BTC UTXO for the miner.
3) A new 0.291 BTC UTXO for Bob’s change from the transaction.
Once again the inputs to the transaction are equal to the outputs.
The key difference between the two transactions? Bob had to use two UTXOs to cover the cost of the transaction whereas Alice only had to use one.
An easy way to remember how this works is to think of it like using cash. Bob might pay a $7 tab with two $5 bills and receive $3 in change. Alice might pay the same $7 tab with a $20 bill and receive $13 change. They both completed the transaction but used different sized bank notes (inputs).
Ok, this is starting to make some sense but why should I care about the number of UTXOs my Bitcoin stack is made up of? Why does it matter if I have a few large UTXOs or loads of small ones?
Well one of the most important reasons you might want fewer UTXOs revolves around how transaction fees are calculated when you want to send your bitcoin to another address. The eagle eyed amongst you might have already noticed in the example above that Alice paid a slightly lower fee than Bob did for her conference ticket. But why?
Well, the answer lies in how transaction fees work…
Bitcoin transaction fees are calculated using a method called ‘Sats’ per ‘Byte’ (sat/vB). You are charged a ‘rate’ in satoshis (sats) for every byte of information your transaction contains.
The rate you are charged in sats will fluctuate depending on how busy the network is and how many other people are competing for their transaction to be confirmed. Higher network demand means a higher rate. To calculate your total fee this rate is then multiplied by the total size (bytes) of your transaction. The size of your transaction in bytes will be determined by how much information it contains not the value of the bitcoin being sent.
As you might expect, a transaction made up of lots of small inputs (UTXOs) requires it to contain a lot more information (bytes). This means you will end up paying a higher fee than if you had been able to create a transaction with just one large UTXO as your input.
In our example above Alice used fewer UTXOs than Bob in her transaction making it smaller. This is why she paid a slightly lower fee than Bob.
If you think about it, this makes sense. If your transaction contains more data, it takes up more space on bitcoin’s blockchain. Each 10-minute block on the network has a limited amount of space and if your transaction needs to take up a lot of it, you can expect to pay more than someone whose transaction is comparatively small.
If an analogy would make things easier to remember then imagine transporting $1,000,000, denominated in in $1 bills vs doing it with $100 bills. The $1 bills would be 100 times the weight and take up 100 times the room. You would need a bigger truck to do it and that’s going to cost you more.
Ultimately this shows that investing in learning proper UTXO management has a direct return on investment. Learning how to manage and consolidate your funds into larger UTXOs will make it cheaper to use your Bitcoin in the future.
Keeping your fees nice and low is just one of the reasons you should think carefully about UTXO management but it’s not the only one. Another key reason is to protect your privacy. Let’s explore in more detail....
Let’s imagine you’re a business owner or freelancer who chooses to get paid in Bitcoin. You will likely receive multiple payments from multiple people for invoices of varying sizes. This will leave you with multiple UTXOs from each payment you receive.
Given the information presented earlier you now know it’s preferable to have large UTXOs rather than lots of small ones. Because of this you might be tempted to combine your UTXOs by sending them all in a single transaction to a new bitcoin address. This would leave you with just one large UTXO to keep your fees down when you want to spend the bitcoin in the future.
It's a smart move to consolidate your UTXOs when network fees are low, but are you inadvertently negatively impacting your privacy?
Remember that every Bitcoin transaction is public and can be traced through the blockchain as you send it on. This means that each of the clients that originally paid you could track the funds they sent to you as you consolidate them with your other payments. This means that if they were so inclined, they could monitor your transactions and start gleaning information about your finances that you might have preferred to keep private. This could include things like how much Bitcoin you hold, how many transactions you have received, their size and frequency. Gulp! That’s pretty personal stuff!
Consolidating UTXOs is of course a good idea to keep your future fees down, but if you’re doing it without first considering your privacy you may be revealing more about your finances than you think. There are ways you can mitigate this by being organised, labelling transactions to remember where they came from and by using bitcoin mixing services to improve your forward-looking privacy. These require some learning and practice to get comfortable with but it’s a learning curve worth climbing and we would love to be your sherpas.
The lesson here should be clear. If you want to use Bitcoin efficiently, keep your fees down and maintain your privacy, you need to learn effective UTXO Management.
Feeling a little overwhelmed by it all? Not sure about the tools you need to use to get this right and the different trade-offs to consider?
Don’t worry, that’s exactly why we are here. Our expert training has been designed to give you hands on experience that will have you confidently managing your bitcoin and protecting your privacy in no time. It’s not hard, it’s just new and hiring a coach to get you up to speed is a great investment.
Book a call, join our Bitcoin dojo, and start your training with us. The heirs to your fortune will thank you for it.
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