What is a bitcoin UTXO and why do they matter?
UTXOs are central to Bitcoin and blockchain technology and you should know about them. Here, we explain the basics.
We’re too familiar with a lot of concepts we barely understand. That’s the magic (and the trap) of traditional finance: it just lives with us, we know how to use it, we barely deal with it (poorly, on most cases) and we move on with our busy day-to-day problems. When Bitcoin, crypto and DeFi entered the stage, a lot of educational content followed. How can you change the way our economy works without knowing how to take advantage of it?
Problem is most of us normally can’t even properly define what a blockchain is, so podcasters, educators and content creators approached the Bitcoin revolution from a high-level perspective. The result is a lot of underlying concepts, like UTXO, are redacted or simplified in order for you to feel like you know. Even when you don’t.
Okay, so now you feel kinda stupid. We’re sorry. We’re gonna fix that. UTXO means Unspent Transaction Output. There you go. Oh. You want to know more? Grab a cup of your liquid of choice. It’s going to be worth it.
Your Bitcoin wallet works like an actual wallet
When you put your money into a bank account, your money doesn’t actually stay there. Your balance is a “note” of all of your transactions: your bank is instructed to make a payment, for instance, and transfer it to the recipient’s account. But your actual money is out there doing the work to multiply itself and make the economy grow. They are forced to keep just a small percentage (depending on the country) in the vault for withdrawals.
So, with traditional banks, if you deposit $100 in $20 bills, it adds up to the money pile the bank stores. And when you make a withdrawal, let’s say, of $30, they give back to you the denomination of your choice. It’s not the same bills you deposited and that wouldn’t make any sense. Why would you want that? The bank stays as the middleman and you let them manage your money. Everything’s cool.
Bitcoin, on the other hand, works more like your actual wallet. If you have 5 $20 bills in your wallet, it stays that way forever. And if you want to buy a $10 shirt, you give the $20 bill to the store and they give you back the change. Both you and the merchant are aware of that transaction and there’s no middleman. You get a receipt of that transaction and that’s it.
UTXOs, Unspent Transaction Outputs, reflect the status of your Bitcoin wallet and tell you how much BTC you have and in which “denomination” you have it. Mind you, since Bitcoin is completely digital, there are no even numbers. You could have bought 0,05 BTC one day and 0,003 another day, so you would have two UTXOs, one for each transaction. And then, when you spend or move your bitcoin to another person, the blockchain ledger makes account of that transaction. That’s your receipt, shared around the blockchain so everything’s transparent and everyone’s accountable.
How UTXOs work
UTXO is a very complex name for a very simple process. When you send or receive Bitcoin, it’s kind of like handing someone a dollar bill. Just like a dollar bill can only be in one person’s possession at a time, a Bitcoin can only be in one “address” at a time.
Each Bitcoin “address” is like a wallet, and it can hold a certain amount of Bitcoins. When wants to send Bitcoins to another person, they create a “transaction” that takes some Bitcoins from their address (their “wallet”) and puts them into the other person’s address (their “wallet”).
So, following the previous example, a bitcoin transaction would be as follows: you have bought 0,05 BTC one day and 0,003 another day, and the UTXOs from those reflect those values. You spend 0,01 BTCs and send that money (input) to a merchant. That UTXO is deleted and new UTXOs are generated: one for the recipient of the 0,01 BTC, one for the miner that manages that transaction, and one for you. Let’s simplify and say you get 0,04 BTC back as your new UTXO, even though that’s not entirely true because of the aforementioned miner fee. The previous UTXO holding 0,05 is deleted and the new, remaining UTXO becomes the new Unspent Transaction Output.
Now, let’s say you want to spend 0,052 BTC on a transaction. How would that work?
Two inputs from your UTXOs with a total value of 0.053 BTC.
One output for the recipient of 0.052 BTC.
One output for your change, which would be a new UTXO with a value of 0.001 BTC (minus miner fees).
One output for the miner with no input, as the newly minted bitcoins are created out of thin air and do not come from any previous UTXOs.
… And why is this important?
If you leave bitcoin in the hands of a third party, let’s say like Coinbase or Binance, all of this process is seamless to you the same way it’s seamless to use a bank. The optimal way to take advantage of the Bitcoin technology is to be aware and leverage how UTXOs work. Fortunately, most self-custody wallets make this process seamless so you don’t have to think about it. But the same it’s important for you to know which bills are in your real-life wallet, being aware of your UTXOs can help you in two major ways:
Privacy: Bitcoin’s blockchain works as a public ledger. So the UTXO reflects the transaction history for that specific denomination. Choosing which UTXO to use for a transaction can help you control the information you send to the recipient. Good rule of thumb: chosing smaller UTXOs when sending bitcoin helps preserve your privacy.
Miner fees: The less UTXOs you use to make a transaction, the better. Since each UTXO is independent, if you use multiple UTXOs miner fees would add up accordingly. There are multiple factors that determine the miner fee, such as the cost per byte of data and the amount of data your transaction requires. But as you would deduct, the more UTXOs you hold, the more fees you’ll pay when you make a transaction.
Then, how do I do it?
When managing your UTXOs, there’s different methods to help you dealing with them. If you buy bitcoin every day, you could use a process that sends it to your wallet as a single UTXO as often as you want (weekly, monthly, etcetera).
Other method would be performing an UTXO consolidation. Basically you’re sending your Bitcoin back to yourself as a single UTXO using the same process described previously. And in order to avoid more expensive fees, there’s moments when miner fees are low, so timing it correctly becomes a plus.
We hope that with this article we clarify the basics of how UTXOs work and why it’s important for you to know about it. You might be storing your Bitcoin through a third party, but we’ll always recommend you hold your assets as privately and securely as possible. That’s what makes Bitcoin special and you should leverage it.
