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Why should you 'consolidate' your bitcoins?

Tue 06 Feb 2024 ▪ 6 min of reading ▪ by Nicolas T.
Getting informed Wallet

In light of the recent rise in bitcoin transaction fees, it’s a good time to talk about UTXO consolidation.

bitcoin

Bitcoin Transaction Fees

The 21M limit is protected by decentralization, which in turn is ensured by the slow growth in the size of the blockchain. Bitcoin’s transaction throughput must remain low to avoid centralization and, ultimately, collapse.

This low throughput is offset by the Lightning Network, the “layer 2”. LN allows bitcoin to outperform major payment networks such as SWIFT, Visa, or Mastercard.

But when it comes to “on-chain” transactions, the throughput must be limited. This can result in periods of high transaction fees at times—several tens of euros versus a few tens of cents under normal conditions.

(A price of around 500 satoshis per byte translates to a $30 fee for a typical transaction)

Fees have recently become erratic due to the trend of inscribing shitcoins and jpegs. This DDos attack is literally about turning transactions into casino tokens.

This results in a premature rise in fees which leads us to talk about “utxo consolidation”. It is crucial to understand what a UTXO is to avoid unpleasant surprises if you’re used to making small transactions to your wallet.

Each time you receive BTC, you get a package of “satoshis”. 1 bitcoin = 100,000,000 satoshis.

In the jargon, these packages are called UTXOs. Essentially, they are a piece of code that mathematically links (asymmetric cryptography) a quantity of bitcoins to a bitcoin address.

If you receive two transactions, one of 0.01 BTC and one of 0.02 BTC, your wallet will simply display a balance of 0.03 BTC. But under the hood, your wallet contains two separate UTXOs.

However, wallets often have an option to view these UTXOs separately.

Bitcoin UTXO

The transaction fee is the same regardless of the amounts transferred. The rate is the same whether you send 0.01 BTC or 10,000 BTC. What matters is the amount of data added to the blockchain.

However, a transaction can include multiple UTXOs. Wallets are sometimes required to combine several UTXOs to reach the amount you wish to transfer.

A wallet containing 10 UTXOs of 0.1 BTC will have to consume them all to send 1 BTC. And the more UTXOs a transaction contains, the more expensive it will be in fees.

Example with two transactions assuming the fees are about 80 satoshis per byte. (We’re talking about virtual bytes [vbytes] since the SegWit soft fork)

– A transaction using only one UTXO currently costs 10,700 sats, or ~$4.60.
– A transaction of 80 UTXOs costs 635,000 sats, or ~$275.

Use the site mempool.space/fr/ to monitor the evolution of transaction fees:

“Someday we will look back and say, ‘Remember when we could send an on-chain bitcoin transaction for just 1 sat/vByte?’. Let’s enjoy it while it lasts.”

In short, if transaction fees were to increase significantly in the future, some UTXOs would no longer be worth spending because of the excessive transaction fees.

Let’s repeat it once more. Transaction fees can cost more than the value of a UTXO…

This is why it’s wise to take advantage of periods of low fees to consolidate several small UTXOs into one larger one to save on significant fees later on. Especially since it is certain that fees will increase as the number of users rises.

To avoid this pitfall of unusable UTXOs, it’s best to avoid withdrawing too small amounts from exchanges to your wallet.

Best Practices

If possible, you should not transfer amounts smaller than 0.01 bitcoin (~400 euros) to your wallet. Picking up large UTXOs ensures much more flexibility in case of perpetual increases in transaction fees.

If you own less than 0.01 BTC, it’s better to leave them on your exchange to avoid subsequent fees. Wait until you have accumulated at least 0.01 BTC, or possibly 0.02 BTC.

Having small UTXOs will eventually cause significant problems for their owners. If you have made the mistake of amassing a multitude of small UTXOs, take advantage of periods of low fees to consolidate them.

To consolidate, proceed as follows:

1) Create a new address in your wallet.
2) Send several small UTXOs to this address to combine them into one of a more significant amount.

But be careful. Each UTXO can be tracked and traced… Consolidation always results in a loss of anonymity.

Imagine that you received a UTXO from an exchange. If you consolidate it with others, the exchange will deduce that they all belong to you.

In short, it’s important to know what a UTXO is. Prefer to use a wallet that allows you to label them according to their origin (Sparrow, Trezor, Wasabi, etc) to avoid consolidating ‘telling’ UTXOs.

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Nicolas T. avatar
Nicolas T.

Bitcoin, geopolitical, economic and energy journalist.

DISCLAIMER

The views, thoughts, and opinions expressed in this article belong solely to the author, and should not be taken as investment advice. Do your own research before taking any investment decisions.