Bitcoin simplifies finance. But in these early stages of its growth, we don’t have magic technology to take care of all the small issues for us.
Consolidating UTXOs is one of the simplest first steps you can take to ensure that your Bitcoin stack is optimized for the future. If you don’t practice proper UTXO management now, it may come back to bite you in the future when trying to spend small amounts of bitcoin during a high-fee environment.
What Is A Bitcoin UTXO?
A UTXO, or “unspent transaction output”, represents a particular fraction of a bitcoin that has yet to be spent. A single UTXO can hold any amount of bitcoin, from small fractions to multiple bitcoin.
In a standard Bitcoin transaction, each input is an existing UTXO being spent and each output is a new UTXO being generated.
You can think of your UTXOs as individual bills of cash, except that UTXOs can be denominated in any value, whereas traditional fiat dollars are limited to $1, $5, $10, $20, $50, and $100 denominations.
So if I had a UTXO of 0.01 BTC, and Bitcoin was trading at $75,000, then you could think of that UTXO like a $750 bill (denominated in a stable 1 million satoshis, of course).
When you spend a UTXO, that particular fraction of a bitcoin gets spent and becomes a new UTXO at the receiving address. When that receiving address goes on to spend it, the next recipient generates a UTXO from it, and so on…
This cycle continues forever as bitcoin circulates globally.
What Is UTXO Consolidation?
Simply put, UTXO consolidation is the act of batching groups of certain UTXOs together and spending them together in a single transaction, thus consolidating multiple UTXOs into one new larger UTXO.
For example, imagine I have five UTXOs, each of which contain the following amounts of bitcoin:
- 0.01 BTC
- 0.0055 BTC
- 0.02 BTC
- 0.0004 BTC
- 0.0008 BTC
If I were to consolidate these UTXOs, I’d be left with a single UTXO of 0.0367 BTC.
Why Do I Need To Manage My UTXOs?
Why does it even matter what size UTXOs are? You may wonder this, or why you should even bother to manage your UTXOs if bitcoin is set to become the global reserve currency. Can’t you just kick back and enjoy the ride?
Unfortunately, holding onto the world’s scarcest asset in history isn’t so simple. Consolidating your UTXOs now, however, will make it easier by saving you from headaches and wasted money in the future.
UTXO consolidation is not always necessary – and in certain cases you explicitly shouldn’t group certain UTXOs together – but if applied correctly, getting used to UTXO management now will pay off in the long run, helping you to:
- Save money when spending bitcoin during high-fee environments.
- Manage proper privacy by organizing UTXOs more effectively.
- Future-proof your bitcoin so you never have any issues with your stack’s spendability.
New attack vectors, privacy risks, demand catalysts, and other unforeseen turbulences are bound to hit bitcoin on its path to hyperbitcoinization. Therefore, it’s crucial to stay nimble, adapt, and optimize your Bitcoin stack accordingly so that it remains safe long into the future.
UTXO management is a crucial component of that, so let’s dive in and learn how to consolidate UTXOs yourself.
How To Consolidate UTXOs With Sparrow Wallet
If you’ve used Sparrow before and don’t need guidance installing it to your computer, feel free to skip to step three to dive straight into UTXO consolidation.
Step 1: Downloading Sparrow Wallet
To get started, you’ll first need to install Sparrow Wallet onto your computer. MacOS, Windows, and Linux all support Sparrow Wallet, so most desktop users shouldn’t have any compatibility issues.
Go to Sparrow’s home page and click one of the “Download” buttons at either side of the page.
Verifying Your Download
Before downloading Sparrow, you can also install GPG Suite to verify that you’re downloading a safe version of Sparrow.
Sparrow’s Download page contains instructions to verify the download for each operating system, so follow the instructions according to the operating system you’re on.
Step 2: Creating Your Wallet
After installing Sparrow safely to your desktop, now it’s time to create your first wallet.
With Sparrow open, from the top left of your computer, click “File”, then “New Wallet”.
Sparrow will prompt you to name your wallet. Feel free to use whatever name helps you identify the wallet. For the sake of this tutorial, I’ll call this wallet “utxo test”.
Click “Create Wallet” and then observe the wallet settings presented to you:
Here’s what each setting means:
- Policy Type: Specifies the number of signers required to broadcast transactions from the wallet. As implied in the name, Single Signature only requires one keystore (wallet or seed phrase), whereas Multi Signature requires multiple keystores (N) that need a threshold number (M) of signers.
- Script Type: Designates the script language this Bitcoin wallet will use. For basic wallet applications, we’ll stick with Native Segwit.
- Descriptor: Use this to adjust the wallet configuration. For standard Bitcoin wallets like ours, we won’t need to adjust the descriptor.
- Keystore: Where you’ll be deriving your wallet from. You can either connect an existing hardware wallet via USB or with an air-gapped solution, create a new software wallet from scratch or import an existing one, or upload your Bitcoin wallet’s xPub as a Watch Only wallet.
For the purposes of this tutorial, we’ll select “New of Imported Software Wallet” to create a new wallet from scratch. Keep in mind, however, that you can connect your existing wallet with a history of UTXOs that need consolidation.
Now, you’ll have to generate your seed phrase mnemonic words, derived from BIP39. Whether or not you choose to use 12 words or 24 words, or some other unique configuration, is your choice.
Let’s go with 12 words for this wallet to keep things simple.
Be sure to write your seed phrase down safely and privately. Do not share it on a screenshot it and save it your computer (like what’s been done here). You don’t want to store your seed phrase on material that can easily deteriorate or get damaged, and you don’t want to keep it somewhere that someone can easily compromise.
Learn proper seed phrase storage so that you’re covering all your bases and not leaving any potential security gaps in your seed phrase set up.
After writing it down, click “Confirm Backup” and re-enter the words to confirm that you’ve properly backed up your seed phrase. Then, click “Create Keystore”.
You’ll be met with a button to import your keystore. Verify that the derivation path is accurate (m/84’/0’/0’ should be set as the default), and then click “Import Keystore”.
Finally, you’ll see an overview of your Bitcoin wallet configuration, specifying the finalized details of your policy type, script type, script policy, and your keystore.
Assuming everything looks good, click “Apply” at the bottom right of the page to create your Bitcoin wallet!
After hitting “Apply”, you can choose to enter a password for your wallet for an added layer of security or you can just leave the wallet as is.
Adding a password will require you to enter it each time you open Sparrow on your desktop. If you skip the password, your wallet will open along with Sparrow automatically. If you choose to keep a large sum of bitcoin on Sparrow, then I’d recommend creating a password. This way, if a thief manages to get a hold of your computer, they still won’t be able to access the funds in your Sparrow Wallet without the password.
Step 2: Funding Your Wallet
UTXO consolidation is pointless if you have no UTXOs to begin with.
To receive bitcoin on Sparrow, first you’ll need to copy your bitcoin address from the “Receive” tab and paste it wherever you’re sending bitcoin from. Alternatively, you can use another Bitcoin wallet to scan the provided QR code associated with your first Bitcoin address in Sparrow.
Labeling each new receive address that Sparrow generates is a great way to keep track of where incoming bitcoin is being sent from.
You’ll see soon why labeling may be a good idea for UTXO consolidation, but for now, I’ll call this first receive address “KYC exchange 1”.
For the remainder of this tutorial, I’ll be operating in testnet for demonstration purposes. Everything about the process remains the same whether it’s your real wallet on mainnet or just a test wallet, but the receive address on testnet begins with “tb1” rather than the standard Bitcoin “bc1” Native Segwit address (as seen above).
Step 3: Identifying UTXOs
Over time, as you’ve received bitcoin to your wallet, you should have a history of UTXOs built up in the “UTXO” tab on Sparrow.
Here’s what they look like in the test wallet I’ve created and sent sats to from multiple different sources:
Notice how each address begins with “tb1”, because I am in testnet. For regular mainnet wallets, those addresses should read “bc1” unless your wallet has an alternative configuration set up.
I’ve labeled these transactions with “KYC exchange 1 / 2” and “NO KYC” to show that two sets of these transactions have come from KYC sources, such as traditional centralized exchanges, while the third set of transactions came from a non-KYC source.
Maintain Your Privacy
When it comes to your privacy, consolidating UTXOS from both KYC and non-KYC sources together is one of the worst ways to preserve it. It’s sort of like diluting a fresh drinking water supply with chemicals. Once they’re combined, there’s no separating them.
For example, if I consolidated these two selected UTXOs together, the NO KYC bitcoin would suddenly lose all privacy, as I’ve literally batched it together with a bunch of bitcoin that’s associated with my personal information.
Therefore, it’s crucial that you label or otherwise identify where all of your incoming bitcoin is from so that you can properly consolidate your UTXOs while maintaining privacy.
Additionally, you may have noticed the red exclamation symbol next to two of the “KYC exchange 1” addresses.
Sparrow is actually telling me that these addresses are actually the same.
When you send bitcoin to the same address over time, it’s very bad for privacy. If you sent all the bitcoin you ever received all to the same single source – and that address is somehow linked to your identity – anyone could identify your address, how much bitcoin you own, and any transactions made to and from that address.
Find The Right Balance Of UTXO Size
You don’t want to consolidate your UTXOs into too small or too large of batches.
For example, if I had a group of 10 transactions, each of which are 5,000 sats, batching them into one 50,000 sat UTXO wouldn’t do me much good during a high-fee environment, as I’ll pay a significant portion of that total on the fees alone.
Here’s what I mean:
I grouped together three UTXOs from KYC exchange 1 to consolidate, worth a total of 29,837 sats.
Now, let’s assume bitcoin is in a high-fee environment, and each transaction fee costs 50 sats/vB.
As you can see, I’ll pay nearly half as much as the total amount of sats that I’m trying to consolidate on transaction fees alone.
Understand that Bitcoin transaction fees are determined by how much data you use, not how much value you’re sending.
When you consolidate your UTXOs, you are bidding against others around the world for blockspace. You pay the going rate for transaction fees (set in sat/vB) for blockspace, so the more individual UTXOs you are trying to spend, the more blockspace you’re taking up (and data you’re using), and thus the higher total fee you’ll have to pay to account for each individual UTXO.
Now imagine that fee rates spike double, triple, or even quadruple that original 50 sats/vB. Very quickly, high-fee environments can price your small UTXOs out from being able to be spent at all.
Be careful, though. You may think that the solution is rather simple, then. “Why not just consolidate all my UTXOs into one large UTXO, so that I never have issues spending it?”
Too large of UTXOs can harm your privacy, because remember: UTXOs are akin to the paper cash bills we use to transact with in person. Since you can denominate UTXO “bills” into any size of your liking, having too large of a UTXO could risk your own privacy if you spend it on a very small purchase.
Imagine you were selling lemonade for 1,000 sats each, but someone used their 20 BTC UTXO to spend on a mere 1,000 sat lemonade. Now, I can verify on-chain that this person has at least 20 BTC to their name, which they may not want people to know about.
Step 4: Consolidating UTXOs
Now that you can properly identify your UTXO batches and which to consolidate, let’s select our first batch and consolidate them together.
Selecting UTXOs
For this UTXO consolidation, I want to consolidate all my non-KYC bitcoin transactions together. I’ll select each transaction labeled NO KYC, and click “Send Selected” at the bottom right.
Creating The Transaction
For the recipient, I’ll go to my “Receive” tab in Sparrow and copy the Bitcoin address listed there.
Of course, I’ve given it a label, “NO KYC UTXO consolidation”, to indicate what this transaction is.
Setting The Right Fee
To choose the right fee, we’ll rely on mempool.space to show us the current sat/vB rate for transactions.
You can see under “Transaction Fees” are “Low Priority”, “Medium Priority”, and “High Priority”.
Right now, they’re very cheap at just 3-5 sats/vB across low, medium, and high priority, making now a great time to consolidate UTXOs (Keep in mind that these rates fluctuate consistently).
Transaction fees are somewhat like an auction in how they’re determined.
There’s only one incoming block at a time, and users around the world are bidding to place their transactions early in the queue. The more demand there is for incoming blockspace, the higher the fee will be to add transactions to the block.
You can determine the optimal fee rate you’d like to pay based on how urgently you want the transaction to confirm. If it’s a high priority to get it through soon, then you’ll want to pay at least the minimum high priority sat/vB fee to ensure your transaction is higher up in the queue. On the other hand, if you’re in no rush at all, you could pay the low priority fee (or even lower) and wait for longer for the transaction to confirm.
I wouldn’t set your transaction fees too low; A 1 sat/vB transaction may never get confirmed under periods of high demand. You could end up waiting a very long time for the transaction to confirm, leaving you with three options:
- Replace-by-Fee (RBF): If you initially sent your transaction with RBF enabled, you can “bump” the fee higher to increase its priority in the mempool and thus confirm it faster.
- Child-Pays-For-Parent (CPFP): If RBF wasn’t enabled, don’t fret; You can spend the transaction UTXOs you created with another higher-fee transaction, effectively increasing the original transaction’s fee and thus raising likelihood of confirmation.
- Waiting it out: If you have all the patience in the world for that transaction, you could just wait for it to confirm, but keep in mind that how long you’ll have to wait varies greatly on demand for blockspace.
For this transaction, I’ll just set the transaction fee to 3 sats/vB, or “Medium Priority.”
As you can see, at 4 sats/vB, I’ll pay a total of 1,250 sats for a UTXO consolidation of 68,381 sats, or about a 1.8% transaction fee. Not bad at all for the headaches it will save you down the road.
Click “Create Transaction” at the bottom right, and you’ll see the transaction preview. Let’s examine it more closely, as it demonstrates a great way to think about UTXOs.
Remember that transaction fees are determined by how much blockspace your transaction uses.
In this transaction preview, you can see that there are four UTXOs listed on the left. Just thinking literally about it: Four UTXOs take up more “surface area” of the screen than just one UTXO would, just as they take up more blockspace than just one UTXO does.
The right half contains the transaction output, made up of the recipient address (ourselves in this case), and the 1,250 sat fee being paid to Bitcoin miners.
So as you can see, we are consolidating four small UTXOS into one larger UTXO.
Let’s finalize the transaction for signing and complete our first UTXO consolidation!
Signing Off
Double check your UTXOs and the recipient address, and once everything looks good, just click “Sign” and then “Broadcast transaction” to send your transaction out to the Bitcoin network.
Just after broadcasting the transaction, check your “Transactions” tab to verify that it went through:
And if we check the UTXO tab, you’ll see that the four previous NO KYC UTXOs have vanished, and a single larger “NO KYC UTXO consolidation” UTXO is all that remains.
And that’s it! You’ve now consolidated your first UTXO. The more you do it over time, the easier it becomes. Now feel free to go on and consolidate as many UTXOs as you need!
Practice Proper UTXO Management
UTXO consolidation is just one critical component of proper UTXO management and using bitcoin anonymously and privately. You want to use UTXO consolidation to optimize your bitcoin for the future, so be sure to consider future spending scenarios and consolidate UTXOs accordingly.
- Consolidate UTXOs regularly if you’re regularly buying bitcoin so that you don’t have to manage a huge build up of unlabeled UTXOs over time.
- Always label your UTXOs to make your life easier whenever it’s time to consolidate.
- DO NOT mix your KYC and non-KYC UTXOs together. You can feel free to consolidate two different sets of UTXOs that may come from two different KYC exchanges, as it makes no difference to that Bitcoin stack’s privacy. But if you’ve received bitcoin through direct non-KYC sources from friends, friendly, co-workers, or strangers – keep those UTXOs separate from the rest of your bitcoin.
- 1 million satoshi UTXOs are great to think of as large bills in your cash wallet. You can consolidate batches of UTXOs into multiple 1 million sat UTXOs to mitigate high-fee bottlenecks and spend from a simple round number, while also mitigating privacy by dispersing your Bitcoin stack across multiple UTXOs.
Keep these tips in mind along with all the other information discussed in this tutorial, and you’ll be well on your way to streamline your UTXO management.
FAQs About UTXO Consolidation
Q: How will everyday people interact with Bitcoin UTXOs?
A: The most likely answer: probably not at all. Think of the amount of time and energy being spent optimizing bitcoin for the user. While there’s still a long way to go, it’s clear that bitcoin is becoming easier and easier to use over time, and we shouldn’t expect everyday people to all be consolidating UTXOs. Most UTXO consolidation will happen at the enterprise and institutional level.
Q: Why does bitcoin implement a UTXO model?
A: Bitcoin’s UTXO model makes the blockchain more auditable, verifiable, and honest than traditional financial systems that rely on trust, accounts, balances, and the like.
Q: Can you only spend a UTXO once?
A: Yes. UTXOs only have one address associated with them. Thanks to bitcoin’s double spend solution, only one address can spend the UTXO one time. “Unspent” transaction outputs get “spent” after transacting on the network, which in turn creates a new UTXO for the sender and recipient.
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