Understanding technical concepts like UTXO consolidation is critical to protecting your bitcoins. In this article, we will explore the meaning of UTXO, their consolidation, and why it is important for Bitcoin users.
The “unspent euros”
When you pay cash at the coffee shop or hardware store, you often don't have the exact amount with which to pay the shopkeeper. Let's say for example that you have to pay 1.50 euros for a coffee. You have just withdrawn cash from the ATM and you have no coins. You will be forced to pay using a 20 euro bill. The 18.50 euros that are returned to you are your change, which we can define as "unspent euros".
Unspent Bitcoins
Similar to the situation described above, when you make a bitcoin transaction, the outputs remain “unspent” until used as inputs in another transaction. These UTXOs, short for unspent transaction output, are essential for tracking ownership of funds on the blockchain.
Imagine you have a Bitcoin balance of 1 BTC and you want to purchase something that costs 0.1 BTC. You will send 0.1 BTC to the seller, leaving you with a UTXO of 0.9 BTC, which becomes your balance for future purchases. Exactly as happened with the euros at the bar, we will have a new set of "unspent money" to use.
Consolidate UTXOs?
If every time we were given change at the bar, we went and put those little red coins in some drawer in the house without spending them, we would soon find ourselves swimming in a Scrooge McDuck-style deposit . For this reason it is common practice to convert all those coins that accumulate in exchange for a convenient bill. On the other hand, waiting too long to convert them could imply significant costs and could make the value of those coins negligible.
Consolidating UTXOs into bitcoin is the process of combining multiple transactions into a single output to reduce transaction fees and avoid facing high costs in the future.
We know that Bitcoin transaction fees are calculated based on the number of transactions involved. The more transactions there are, the higher the commissions will be. Consolidation aims to protect your wallet against potential fee increases by grouping your Bitcoin into a single output. In other words, it's as if your wallet were to convert all those coins scattered around your digital home and give you a nice, large, light denomination banknote to carry.
UTXO Consolidation: Why is it Important?
Consolidating UTXOs is critical when fees are on the rise. By reducing the number of UTXOs, you reduce future fees.
Let's imagine we have a UTXO with a current value of €10 (around 25 thousand satoshi). With the current fees of around 50 sats/vB, this transaction can be spent for a fee of around 7 thousand sats, or 25% of the value of the amount itself. It will be enough for the fees to reach a level of around 150 sat/vB and spending that transaction will be uneconomical. In other words, those funds could be lost forever if the fees no longer fall below that threshold!
To overcome this problem, you could immediately combine this transaction with 10 other UTXOs of similar amount, bringing them to a total value of €60. Now the fees would have to be over 1000 sats/vB to preclude you from spending that transaction. You can sleep soundly for a few decades. You can calculate when fees will make spending on your UTXO uneconomical here.
How to Consolidate UTXOs
Not all wallets allow manual management of UTXOs. We recommend Sparrow, which is open source, completely free, and relatively easy to use by those with sufficient knowledge of Bitcoin.
You can connect Sparrow to your full node easily and connect your hardware wallet (or import your seed phrase) directly to the program.
The steps to follow are as follows:
- Generate a new receiving address in your wallet.
- Select all the UTXOs you want to consolidate.
- Enter the receiving address when creating the transaction.
- Make sure to include all UTXOs as input to consolidate them.
- Wait for transaction confirmation.
You can watch the following video to learn in detail how to consolidate transactions on Sparrow wallet.
Privacy and UTXO Consolidation
However, it should be noted that, in some cases, consolidation may reduce privacy by linking all UTXOs to a single address. However, it is a trade-off to optimize commissions. On the other hand, some consolidation techniques are used by major CoinJoin protocols. In general, it would be ideal to assign labels to each UTXO and address, so you know exactly what is being consolidated. Sparrow allows you to do this job in a very simple and intuitive way.
For example, it may not be a good idea to consolidate transactions that come from a CoinJoin with those that come directly from an exchange on which you have been KYC'd . In fact, as soon as transactions are merged, chain analysis companies will immediately know that all consolidated UTXOs belong to you.
Key Terminology:
- UTXO Consolidation: The process of combining multiple transactions into a single UTXO, reducing the number of individual transaction outputs in a wallet.
- UTXO Set: The collection of all unspent UTXO on the Bitcoin blockchain, represents the funds available for future transactions.
- Coin Selection: The algorithm used by a wallet to choose which UTXOs to include in a transaction when sending Bitcoin.
- CoinJoin: A technique that allows multiple users to combine their UTXOs into a single transaction, increasing anonymity.
- Fee Optimization: The process of selecting the correct level of fees for a transaction to ensure quick processing without paying too much.
- Transaction Size: The size of a transaction in kilobytes, depends on the number of inputs (UTXO) and outputs involved.
Translated from the original Italian article on Bitcoin 24 ORE
