Understanding UTXOs

January 3, 2025

January 24, 2025

When Bitcoin was created, it needed a way to track who owns what without using a centralised entity. Instead of maintaining account balances like your bank does, Bitcoin uses something called the UTXO model - a different approach to accounting that works very well.

What is a UTXO?

UTXO stands for Unspent Transaction Output. Think of UTXOs as digital notes in different denominations that you cannot tear or split – you must spend them whole and receive change back. Each UTXO is like an envelope containing a specific amount of bitcoin, and once you open (i.e. spend) that envelope, the system creates a new envelope with the remaining balance.

The Fundamental Difference: Account vs UTXO

Traditional banking uses an account-based system where your balance is a single number that gets updated. Your account might show $1,000, and the bank just updates this number when you spend or receive money. Simple, right?

But Bitcoin uses a different system. Instead of accounts with balances, Bitcoin tracks the bitcoin you own in UTXOs. Think of it like having a collection of digital notes rather than a bank balance. This seemingly small difference has huge implications for privacy, security, and how transactions work.

Why Choose UTXOs Over Accounts?

The UTXO system was chosen for several crucial reasons:

Decentralisation: Each transaction can be verified independently without needing to check an account's entire history
Double-spending prevention: Once a UTXO is spent, it can never be spent again, making it easier to prevent fraud
Privacy: UTXOs create a more complex transaction graph that is harder to analyse
Scalability: Transactions can be processed in parallel since each UTXO is independent

Did you know?

Double-entry accounting, which originated in the late 13th century among Italian merchants, was popularised by Luca Pacioli in 1494 through his influential book, making the method widely accessible. In 2008, Bitcoin introduced "triple-entry accounting," where the third entry is the public blockchain, providing an immutable record that serves as a universal source of truth. This innovation includes UTXOs, which create a transparent audit trail, allowing every satoshi to be traced back to its origin, akin to having a public notary verify transactions in real-time.

How it Works

Let us use ‘The Digital Envelope System’ analogy to illustrate.

Imagine you are at a yard sale with a $20 bill in your pocket. You find a beautiful vintage lamp priced at $8. When you pay, the seller needs to give you $12 in change. That $20 bill is now "spent," and you have new, smaller denominations in your wallet. This everyday transaction illustrates how UTXOs (Unspent Transaction Outputs) work in Bitcoin.

Let us break this down even further.

Alice controls three UTXOs:

One containing 1 BTC
Another with 0.5 BTC
And a third with 0.3 BTC

When Alice wants to send Bob 1.2 BTC, and either Alice or her wallet needs to figure out which "envelopes" to use. This practice is called ‘Coin Control’.

To make the payment, Alice or her wallet might decide, for various reasons, not to combine the 1 + 0.3 BTC UTXOs but to combine the 1 + 0.5 BTC UTXOs (totalling 1.5 BTC) instead.

The transaction would then:

Send 1.2 BTC to Bob (to a freshly created UTXO in his wallet)
Send 0.3 BTC back to Alice as change (creating a new UTXO in her wallet)
The original 1 BTC and 0.5 BTC UTXOs are now "spent" and can never be used again

Why Use UTXOs?

The UTXO model offers several advantages:

Enhanced Privacy

Each transaction creates new UTXOs, making it harder to trace funds and keep the sender's balance private. Users can generate a new address for each transaction, which makes linking them to a single identity more difficult. This enhances privacy compared to account-based models, where one address is typically used for multiple transactions.

Scalability

Multiple UTXOs can be processed at once, improving scalability. They allow parallel transaction processing, enabling miners to validate transactions independently. This contrasts with account-based systems, which process transactions sequentially and can become congested during high demand.

Impoved Security

The system is deterministic and easy to verify, much like counting physical cash. Each UTXO can only be spent once, which greatly reduces the risk of double-spending. The model ensures that only the owner of the private key associated with a UTXO can spend it, adding an extra layer of security and making fraudulent transactions highly unlikely.

The Importance of UTXO Management

While UTXOs are simple in concept, managing them efficiently is important for both privacy and transaction fees. Having too many small UTXOs is like carrying a wallet full of pennies – it is inefficient and can lead to higher transaction fees when you want to spend them.

Think of it like organising your physical wallet. You wouldn't want to carry around fifty $1 bills when you could have a single $50 bill instead. The same principle applies to UTXOs – sometimes you need to consolidate them for better efficiency.

Looking Ahead

In Part II of this series (coming next month), we will dive deeper into UTXO management techniques, including:

How to efficiently consolidate UTXOs
Best practices for UTXO selection
Advanced privacy considerations
Tools and techniques for optimising your UTXO set

Stay tuned for a more technical exploration of these concepts and practical guidance on managing your bitcoin more effectively.

Conclusion

UTXOs might seem complex at first, but they are mostly similar to a digital version of the cash system we have used for centuries. Understanding how they work is important for anyone interested in Bitcoin, as it affects everything from transaction fees to privacy.

Remember: Just like you don’t want your in-real-life wallet bursting with small bills and coins, you want to manage your UTXOs efficiently. Keep an eye out for Part II, where we will explore method on how to do just that.

This is Part I of our UTXO Management Series. Part II will be published next month, featuring technical details and practical guides for UTXO consolidation and optimisation.

Grace