Understanding UTXO Consolidation for Bitcoin Users
Bitcoin blockchain fees are currently low, so it's time to get familiar with UTXO consolidation!
What is UTXO consolidation and why should you care?
Many Small UTXOs Can Incur High Transaction Fees in the Future
If you've been dollar-cost averaging small chunks of bitcoin to a self-custody wallet, you might have a lot of small-value UTXOs (Unspent Transaction Outputs) in your wallet.
When transaction fees will rise again, spending these UTXOs can incur hundreds or even thousands of dollars in transaction fees!
When you transact in Bitcoin, fees paid to miners are determined by the network demand, and how much data the transaction requires to be sent.
The Bitcoin network is designed to handle only a limited amount of data every 10 minutes on average in order to keep the data on the blockchain small enough for average users to run nodes and audit the blockchain.
The trade-off is high transaction fees during high network demand.
You can always set a lower fee for your transaction, but then you will often have to wait longer for your transaction to be included on the blockchain.
The total fee for a transaction is calculated by multiplying the transaction size with the fluctuating fee rate.
The fee rate is measured in satoshis per virtual byte (sat/vByte).
A good website to familiarize yourself with the current Bitcoin fees is Mempool.space.
You can learn more about it in this post: #657963
The transaction size increases the more UTXOs it has.
The monetary value of BTC being spent doesn't have an effect on the transaction fee.
You can send $50 or $1 billion worth of BTC with the same transaction fee.
What Is an UTXO?
Your bitcoin balance consists of UTXOs.
When you receive BTC, you receive a single UTXO.
The more often you receive, the more UTXOs you will accumulate.
When you're sending BTC, your wallet software picks UTXOs from your wallet and sends them to the receiver.
Your wallet might have to pick many different UTXOs.
If the BTC amount of your UTXOs exceeds the amount you're sending, you will receive a new UTXO as "change".
Conceptually, UTXOs are very similar to physical cash.
You can think of UTXOs in your Bitcoin wallet as different denominations of a currency, e.g. $10 bill, $20 bill etc.
Except that Bitcoin doesn't have specific denominations: a Bitcoin UTXO can be of any amount!
The balance of your Bitcoin wallet is the sum value of all your UTXOs in that wallet.
UTXO is like a bill in your Bitcoin wallet that hasn't been spent yet.
When your wallet has to pick many UTXOs to make a transaction, the network fees you pay will be higher.
You can think of it as sending someone $1000 in coins vs. sending $1000 in hundred dollar bills.
Coins will weigh more and their postage costs will be higher.
Bitcoin wallets automatically select the lowest number of UTXOs to minimize transaction fees, and some have coin control features that let you select UTXOs manually.
A recommended wallet for desktop is Sparrow Wallet.
Sparrow also works with the most popular hardware wallets.
You can learn more about Sparrow in this Twitter thread I wrote in September 2023.
How to Consolidate UTXOs?
You're just selecting UTXOs of small monetary value and sending them to yourself when fees are low, and you will receive one UTXO with a larger monetary value.
Here it can be demonstrated with some testnet coins on Sparrow Wallet.
The process is exactly same with real BTC.
In the "UTXOs" tab, you select the UTXOs you want to consolidate, and proceed to "Send Selected".
On the "Pay to" field there's a dropdown that automatically chooses a new Bitcoin address in the same Sparrow Wallet that you own (it's labelled as a "consolidation" address).
Alternatively, you can copy/paste any address there.
If you want to verify that you really own the address, you can go to the "Addresses" tab, find the address in question and sign a message with it.
If you're e.g. using a hardware wallet like Coldcard or Trezor, the signing device's firmware will at this point verify that it manages the address.
It's important to label your UTXOs, so you will know in the future what UTXOs to spend and in what situations.
Labels are only for your own reference.
Do it.. your future self will thank you!
You can see the flow of UTXOs on Sparrow.
Two small UTXOs turn into one (minus the miner fee).
It's a bit like exchanging small coins to larger bills!
When you go back to the "UTXOs" tab, you can see that you now only have one larger UTXO, but the same amount of BTC (minus the miner fee).
Mempool.space gives you nice visualizations for UTXO consolidation.
In this transaction, 4 UTXOs were consolidated into one (minus the miner fee).
Since Bitcoin is digital gold, UTXO consolidation is like melting small gold coins into one gold bar!
UTXO Consolidation Reduces Privacy
A major trade-off with consolidating UTXOs relates to privacy.
People who sent you the small UTXOs you want to consolidate can follow the movement of those UTXOs and link them to your now larger UTXO balance.
It's not an absolute proof that you own those UTXOs (you could be sending them to someone else!), but it might be a strong indication.
It's always the best practice to assume that whoever sent you those original UTXOs is watching and knows that you own all that bitcoin.
Also, there are privacy concerns if you spend after consolidating.
If you spend from a large UTXO (let's say 1 BTC), and buy something worth $50 (0.0008 BTC) with it, the receiver can see that you will get a change and are the owner of an UTXO of 0.9992 BTC.
"Dust" UTXOs
When you have smaller UTXOs, they might become economically infeasible to spend in a high fee environment (fee higher than the monetary value of the UTXO).
It's hard to know exactly what the future fee market will look like, but it can be assumed that the Bitcoin blockspace will be in high demand and the fees will rise.
Here's a good article by Unchained about unspendable "dust" UTXOs.
Jameson Lopp has created a useful tool called "Economically Unspendable Bitcoin UTXO Calculator" that can be used to project transaction fees in different fee environments with different address types.
To Consolidate or Not?
It depends on your personal preferences and how you're intending to spend your bitcoin in the future.
It's good to strive for a balance, taking into consideration the future fee market and the privacy concerns, and still remember that it's better to have spendable UTXOs that have lost some privacy than unspendable private UTXOs.
Never consolidate KYC coins with non-KYC coins!
The consensus among Bitcoiners is to avoid dust UTXOs as much as possible, and try to keep your UTXOs at 1 million sats minimum (0.01 BTC and around $600 in August 2024's prices).
It's been estimated that this threshold would secure your UTXOs being spendable even in a prolonged high-fee environment.
If you're ever in an emergency and need to spend your bitcoin, it's good to know that you will not spend most of your coins on fees!
Some recommend striving for even larger UTXOs, like 10 million sats (0.1 BTC) in case Bitcoin becomes a world reserve currency or hits mass adoption.
UTXO consolidation is extremely important for Bitcoiners with many small value UTXOs (e.g. Bitcoiners in Global South that have been saving $10 per week in BTC on-chain to self-custody wallets).
If fees go high, a Bitcoin UTXO worth $10 might become unspendable.
If you're mostly a hodler and you've been buying BTC in large purchases at a time, you generally don't have to worry too much about UTXO consolidation.
Send Small UTXOs to the Lighting Network for Spending!
Instead of consolidating UTXOs to an on-chain address, you can also open Lightning Network channels with them or send them to a Lightning wallet for easier spending.
Lightning Network also adds a layer of privacy to the UTXOs.
If you're buying bitcoin through an exchange, it might make sense to accumulate a large enough UTXO before you move the funds to self-custody.
Or you can use e.g. Liquid Network @liquid as an intermediary layer for storing coins in self-custody.
As a federated sidechain, Liquid has its own trade-offs.
You can learn more about Liquid in this Twitter thread I wrote in February 2024.
UTXO consolidation reduces the number of UTXOs in the network, which makes it easier to run a full Bitcoin node.
So consolidation has benefits to the network as well!
It can also streamline your own wallet experience.
Signing data-heavy transactions can be a burden to older hardware wallets that might even crash in the process!
What's your strategy for UTXO consolidation?
What's the ideal size of an UTXO in your opinion?