Bitcoin uses a UTXO model, unlike traditional bank accounts that use a balance model.
This means that the balance in your wallet is the total of all the UTXOs you have received but not yet spent.
Unspent Transaction Outputs Explained
UTXOs are like individual bills in your wallet. Each UTXO has a unique value and can’t be divided.
When you spend Bitcoin, you don’t actually spend the specific UTXOs you received.
Instead, you use whole UTXOs to pay for the transaction, and any leftover amount is returned to you as a new UTXO.
This can result in having many small UTXOs, which can increase transaction fees.
Imagine you want to buy a coffee for $5 with a $10 bill and a $1 bill.
You can’t rip the $10 bill in half to pay for the coffee, so you use the whole $10 bill and receive $5 back in change.
Similarly,you can’t divide a UTXO to pay for a transaction. You would use a whole UTXO and receive any leftover amount as a new UTXO.
UTXOs are created when a coinbase transaction is mined, or when existing UTXOs are used in a new transaction.
Coinbase transactions are special transactions that create new Bitcoin when a block is mined.
Each UTXO has a unique identifier, a fixed value, and is tied to a specific Bitcoin address.
Security
Because each transaction must reference the specific UTXOs being spent, there is almost no possibility of an invalid transaction being added to the blockchain.
Transparency
The UTXO model makes Bitcoin more auditable and transparent than traditional financial systems.
Privacy
UTXO management can come at a cost to privacy, as unrelated transactions become connected.
Transaction fees
Having many small UTXOs can increase transaction fees.
There are a few ways to manage UTXOs and reduce transaction fees:
Consolidate UTXOs
This involves combining multiple UTXOs into a single UTXO by sending a transaction to yourself.
This is similar to exchanging multiple small bills for a larger bill at the bank.
While this will incur a transaction fee, it can help you save money in the future by reducing the number of UTXOs you have.
Withdraw larger amounts from exchanges
If you are regularly buying small amounts of Bitcoin and withdrawing them to your own wallet, consider increasing the amount you withdraw at each time.
This will help you avoid accumulating too many small UTXOs.
Use the Lightning Network
The Lightning Network is a separate layer built on top of Bitcoin that allows for faster and cheaper transactions.
It can be a good alternative to using UTXO management for small transactions.
UTXO management is an important concept to understand for anyone who uses Bitcoin.
By understanding how UTXOs work and how to manage them, you can save money on transaction fees and keep your Bitcoin spending efficient.
