UTXO consolidation is the process of producing a single UTXO from a set of multiple UTXOs by creating a transaction to send Bitcoin from one address that you manage to another.
Consolidating UTXOs is proactive Bitcoin wallet maintenance that can help mitigate future expenses during high fee environments by creating transaction(s) to send Bitcoin to yourself during a low fee environment.
Sending Bitcoin from an address you manage to a different address that you manage can optimize transactions and can help to save on network fees in the future.
Fees are typically higher during Bull markets and lower during Bear markets. Every 210,000 blocks, every ~4 years, the block reward for miners is halved and higher fees have historically been the outcome.
The halving in 2024 could be another catalyst where fees are also likely to go up during the next bull market cycle.
Not having a strategy for UTXO consolidation could be a costly mistake, especially in anticipation of a high fee environment.
Your strategy could be as simple as a calendar reminder to consolidate and clean up UTXOs every 3-6 months.
For example: If you have accumulated 10 BTC over the past 6 years with a weekly recurring buy you will have 312 UTXOs. Consider a strategy of transferring 1 BTC at a time to your new wallet or across multiple wallets. You’ll end up with 10 Unspent UTXOs each with 1 BTC.
Keep reading to learn more about the importance of consolidating UTXOs.
First things first. New Bitcoin enters the market through mining. Miners are specialized nodes on the Bitcoin Network that validate a new block through a process called mining.
Miner’s costs include electricity rates and hardware (mining rigs). Miners make money from transaction fees and are rewarded with a Bitcoin block subsidy for every successfully mined block added to the blockchain.
The most common ways to acquire Bitcoin are by purchasing from an exchange, directly via peer-to-peer (P2P) transaction or by collectively participating in a mining pool.
Buying Bitcoin on an exchange, like Coinbase, does not necessarily create a UTXO for each recurring buy until you send Bitcoin off-exchange. The only exception to this is if your exchange has a dedicated wallet and you’re in possession of the recovery seed.
Sending Bitcoin from your exchange account to the public address of your software (hot) or hardware (cold) wallet creates a UTXO which is cryptographically locked by your keys until/unless you initiate a transaction to spend it.
Each transfer out creates a new UTXO. These individual UTXOs are added up to display your wallet/account balance.
Your private key grants you access to your funds and is used to sign or verify future transactions.
Over time, as you receive Bitcoin the number of UTXOs in your wallet increases.
You might be wondering, “how much does it cost to use multiple UTXOs in a transaction?”
Transaction fees are not calculated based on the amount transferred, rather the number of UTXOs used as inputs to complete the transaction.
For example, if the transaction fee is 50 sats/vByte you will pay 0.0000005 BTC per virtual Byte (vByte). The average size of a UTXO is ~250 vBytes which will cost 0.000025 BTC (50 x 0.0000005). If your transaction requires more than one UTXO or if you use multi-sig the data size of the transaction increases by 68-148 vBytes per additional UTXO input.
The more UTXOs in your wallet, the more expensive it becomes to exchange your Bitcoin for goods, services or dollars due to rising network transaction fees.
UTXO consolidation is the process of combining your total UTXO set into fewer UTXOs of a higher denomination.
A UTXO Consolidation strategy is the execution of your personal plan to determine what UTXOs to group together as inputs to create a single (or more) UTXOs.
The strategy behind how you consolidate your UTXOs can be as simple or as complex as you’d like to make it.
Here’s an example of how a UTXO consolidation strategy works in real life.
Example: Imagine you had a wad of 200 $1 dollar bills in your pocket and wanted to exchange them for fewer bills of higher denominations so it’s easier to carry around.
There’s no limit to the number of options you can choose from and that’s the point.
The most important consideration when consolidating Bitcoin UTXOs is to keep coins (UTXOs) in groups based on how you acquired them to maintain your privacy on the blockchain.
Once your strategy takes the source of your Bitcoin into consideration, you’re left with three primary decisions:
The goal of your strategy is to make sure you’re not holding a bunch of dust UTXOs that are unspendable because you were too lazy to spend an hour putting a plan into action.
If you have more than 3 UTXOs from a common source, you’re a candidate for considering consolidating UTXOs.
UTXO consolidation is a good wallet maintenance practice that can be costly to overlook because of Network Transaction Fees which are variable based on supply and demand.
The more transactions competing to be included in the next block the higher the fee (sats/vByte) because each block on the Bitcoin Blockchain is fixed in size up to 4 million weight units (WU) equivalent to 4MB of data.
As Bitcoin adoption increases, we expect a correlated fee environment which would increase transaction fees over time due to competition based on supply and demand economics.
You can bet that Exchanges and Bitcoin payment processors (like Square) have people on staff responsible for managing UTXO consolidation given the transaction volumes they process.
Individual investors (like you) may not even realize the impact that fees could have on your wealth when you finally decide to transfer, spend or cash out some Bitcoin.
Dollar Cost Averaging is great for helping investors ignore the volatility of Bitcoin, but it’s really important to have a UTXO consolidation plan in place.
When I first learned about Bitcoin in 2017 I immediately set up a weekly recurring buy. In hindsight, I wish I increased my buying levels but it is what it is.
Before Stratus, I was dollar cost averaging into Bitcoin weekly with a fixed amount recurring buy on Coinbase. I’m still using Coinbase to execute the trades but with Stratus, I have a bot to automate weekly DCA investments which buys the intraweek dips using smart limit orders.
I went from buying on the same day of the week, same time of the day to filling 3 or 4 limit orders depending on volatility.
I upgraded from at the same time and same day of the
Rather than a recurring buy that executes on the same time and same day each week, Stratus fills 3-4 orders per week to lower my cost basis and save on fees even with more executed trades.
Thankfully I knew about UTXO consolidation but didn’t consider a strategy until I got my first hardware wallet and paid more attention as network fees increased over the years.
Pro Tip: When you purchase Bitcoin on an Exchange, like Coinbase, UTXOs aren’t created until you transfer out to a non-custodial wallet because the exchange controls public and private keys and your balance is their liability.
I wasn’t one of these savages transferring from Coinbase to cold storage every week or I would have ended up with over 100+ UTXOs and in desperate need for consolidation.
My indecision saved me from dealing with 26,784 vBytes worth of data that cost 1,339,200 sats (0.01339200 BTC) or ~$500 (at $40,000 BTC:USD) in network fees assuming a 50 sats/vByte rate.
Here’s an example of what a UTXO consolidation looks like in the mempool during a low fee environment:
UTXO consolidation is not a common practice for most Bitcoiners and there’s still a lot of uncertainty surrounding the questions getting asked online or warnings to consolidate before it’s too late. Note – be careful whose advice you’re taking.
Main benefits of consolidating your UTXOs:
.The disadvantages of UTXO consolidation are relatively insignificant including short term network fees and a loss of privacy if you don’t have a strategy in place.
You either pay now to consolidate or later when you transact.
If network fees reduce over time, paying to consolidate now could be a disadvantage to the future unknown.
Over a long time horizon, fees will likely increase. The key to overcoming the disadvantage of current network fees is to set a target fee that you’re willing to pay based on the 30/60/90/180/365 day moving average of fee rates.
Privacy is the most overlooked disadvantage for consolidating Bitcoin UTXOs.
Dusting is a tactic used by hackers AND marketers to send small amounts of crypto to addresses with the goal of getting the dust UTXOs batched or consolidated in a transaction. Read this post on mitigating Bitcoin dusting attacks for more information.
Can you imagine paying a bill and having your bank account balance displayed to the vendor?
The major risk for consolidating UTXOs is not too dissimilar. If you inadvertently connect a bunch of previously unconnected transactions and their respective outputs you could expose your identity and the total amount of your stack.
Sticking with our previous example, let’s assume you have accumulated 10 BTC over the years, congrats!
Your exchange recurring buys, mining at home, and consulting on the side created 3 sources of Bitcoin.
If you were smart, you generated a new address every time you received Bitcoin. You run the risk of outsmarting yourself if you have too many addresses and no metadata describing them stored in your wallet’s interface, on a spreadsheet, or written down.
If you consolidate ALL of your accumulated UTXOs into one UTXO, the next time you transact with someone, they will be able to see the transaction input was a 10 BTC unspent UTXO.
Even though the United States no longer issues bills in $500 or $1,000 denominations, those notes are still considered legal tender.
In theory, you could walk into a store and purchase a pack of gum with a $1,000 bill if you had one. But, you never would. This logic is no different than spending a 10 BTC UTXO in a small transaction or conversion to fiat.
You’re basically telling the recipient or anyone with a blockchain explorer tool how much Bitcoin you have and the source of origination.
At the very least, make sure that you consolidate Bitcoin from each different source into different wallets and keep them segregated ideally with varying amounts.
Pro Tip: If you are a wholecoiner are consolidating UTXOs when you perceive fees to be low, consider splitting up your wallet transfers into smaller, more conspicuous amounts.
Any Donnie Brasco fans out there will remember Pacino showing Depp how a wiseguy carries a roll of money, “Always put a beaner on top.”
When it comes to spending Bitcoin, you don’t necessarily want to flash your 10 BTC UTXO to the recipient when you could use a 0.25 BTC UTXO to make the (0.015 BTC) transaction.
UTXO Management is seldom discussed and a topic I struggled with early on.
You need to have a process in place to ensure you aren’t making a hasty, irreversible decision which can create significant financial (fees), security and privacy vulnerabilities.
Even though UTXO consolidation is as simple as generating a new address (same or different wallet) and creating a low priority (fee) transaction to “send Max” or “sweep” your Bitcoin balance to the new address…it’s still a component of a broader UTXO management strategy.
We thoroughly researched this topic and drew from personal experience to produce our definitive list of best practices for UTXO management. (ps – if you have something to add to the list please email us at hello@stratus.io)
Some wallets, like Electrum, have an easy to find itemization of your UTXOs. Other wallets may not be as user friendly and you’ll have to search each address on a blockchain explorer and manually count the number of outputs.
Bitcoin bought and held on an exchange remains in a ‘pool’ until you transfer off exchange into self-custody.
It’s similar to how banks work, specifically the difference in using a bank vs. a piggy bank is similar to an exchange vs cold storage device. Here’s an example:
Let’s say you have $500 cash to deposit with your bank. After deposit, the teller places the 5 $100 notes into the cash drawer and the bank pools your money with all of the other deposits. Your 5 $100 bills are not reserved specifically for you. The guy standing in line behind you may request to withdraw $500, and the teller could give them the notes you just deposited. Your $500 is credited to your balance and an IOU is displayed as the total sum of your account balance. When you choose to withdraw $500, you receive 5 different $100 bills.
This time, instead of depositing your 5 C-notes at the bank let’s slide them into your piggy bank. When you’re ready to spend your saved $500, you simply open the piggy bank and pocket the same 5 $100 bills.
When you purchase Bitcoin, your exchange holds your crypto in their custody. If you DCA with a weekly buy, at the end of the year you DO NOT have 52 UTXOs on exchange. The exchange keeps a transaction record (for tax purposes) but a UTXO is only created for each withdrawal to an off-exchange wallet because you are not ‘spending’ the same UTXO created when you purchased the BTC. Similar to a bank, your Bitcoin is pooled together with everyone else and your account has an IOU from the exchange reflecting your balance.
If you had a weekly withdrawal schedule from the exchange, then at the end of the year you would have 52 UTXOs (1 UTXO for each withdrawal) in your cold wallet. You are a prime candidate for UTXO consolidation. Even if you withdraw once per month, consolidating 12 UTXOs into 3 is going to save on fees down the road.
Banks and Exchanges manage customer deposits similarly.
Whereas piggy banks and self-custodial hardware wallets store your deposits physically which is the essence of self-custody.
Let’s say you have private keys for Bitcoin (BTC) saved to your Ledger cold storage device.
Short answer: you can’t.
Remember, the Exchange balance that you see when you login references your trade confirmations and liability for the exchange to pay out from their treasury.
These confirmations are IOUs, not UTXOs. The CEX has an obligation to execute a transaction off-exchange which does not consume a UTXO input that Coinbase unlocks and on confirmation, the transaction locks one UTXO to your address.
Pro Tip: An exchange withdrawal to an external wallet of more than 0.5 BTC should be split up into varying sizes with delays between each transfer to increase your privacy.
If you have 1 BTC on exchange to withdraw here’s an example plan of action:
Adjusting network fees when transferring BTC from a Coinbase account is not an option unless you’re using a Coinbase Wallet to customize the network fee but you still need to pay network fees to transfer crypto from Coinbase to the Coinbase Wallet.
If you’re uncomfortable keeping your Bitcoin on Coinbase, create a plan to withdraw at regular intervals but try to adjust timing and always use a fresh address to receive.
—In Summary—
You can clean up your wallet’s UTXO count by sending batches of Bitcoin to a different address that you manage. This is UTXO consolidation.
Regularly consolidating these UTXOs by sending smaller transactions to a secondary wallet address can preserve wealth, save on future fees, and help you transact more efficiently.
The riskiest position presently is having A LOT of transaction’s of smaller denominations (under $10, under $25, under $50).
Don’t just take our word for it. The unofficial recommendation from the r/bitcoin community is transferring 0.01 BTC at a minimum (1 million sats) to avoid getting crushed on fees or ending up with Bitcoin dust.
Given the current market conditions, if you’re transferring BTC from an exchange to your cold wallet (Bitbox02, Trezor, Jade, Coldcard) check out the math and consider the marginal cost of transacting with Bitcoin.
It’s all relative and you’re welcome to reach out to us with any questions (team@stratus.io)
Note: Stratus does NOT provide investment, legal or tax advice. All information in this article is for educational purposes and should not be interpreted as investment, legal or tax advice. The opinions expressed are those of the author for informational purposes and neither Stratus nor the author are liable for any errors, inaccuracies or omissions. Digital assets, such as cryptocurrencies or decentralized finance, present unique risks for investors. For investment, legal, tax, or other financial guidance you should consult your own advisor.
The post How to Consolidate UTXO Guide & Best Practices first appeared on Stratus Crypto.
WhatsApp
Telegram
