The demand for cryptocurrencies has been growing at substantially higher rates in recent years, thereby sparking interest in various fundamental aspects of how they work. UTXO is also one of the common terms you must have noticed while navigating information about cryptocurrencies such as Bitcoin. When you send or receive Bitcoin, you would see the term ‘Unspent Transaction Output,’ and it might leave you puzzled. What does it mean? Do you get a receipt for the failed transactions where money was not spent? No, there is absolutely no reason to make up any false assumptions regarding UTXO. The following discussion will help you obtain a comprehensive introductory guide to the UTXO model.
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What is UTXO?
The first aspect in any discussion on UTXO would draw attention to its definition. It is one of the crucial concepts in the domain of blockchain. Interestingly, the concept is quite simple to understand. It is basically the result of transactions that a user receives and could spend in the future. They are basically the unspent output of transactions, and it is important to note that users could spend the UTXOs only once.
As a result, the UTXOs do not have the status of being unspent anymore, thereby implying that they could not be used again in the future. Basically, the UTXO is an indivisible native chunk of native tokens under the control of private keys of owners. In some other words, it is also an accounting or balance model used for blockchain networks.
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Blockchain as a State Machine
In order to understand the significance of UTXOs, it is important to reflect back on the basics of blockchain. Before trying to understand the different accounting or balance models, it is essential to understand how blockchains are basically state machines. Systems are stateful only when tailored for remembering the preceding user interactions or events, where the information remembered is the system’s state.
Therefore, blockchains definitely qualify as stateful systems with their primary objective of documenting past events as well as user interactions. The addition of every new block in the blockchain creates a state transition process that depends on the state transition logic outlined in the concerned protocol.
All the blockchain networks follow this approach of state transition with the addition of new blocks. Generally, each new block records the set of transactions and user interactions broadcasted to the network after verification. Subsequently, the blockchain updates the balances of the parties involved in the transaction upon the transition of the system to the new state. So, the state transition is the foundation of accounting/balance models such as UTXOs.
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Working of UTXO
Now that you know about the way transactions happen on blockchain networks and the role of accounting/balance models, it is important to dive deeper into an understanding of UTXOs. They are indivisible native tokens on blockchains that you have to use for transactions. Blockchain records ownership of UTXOs while the network takes care of tracking available UTXOs. The number of Bitcoins in the ownership of a user could include different UTXO coins. As a matter of fact, they are not restricted only to Bitcoin as UTXOs find applications in many other blockchains such as NEO, Litecoin, and others.
The UTXO model implies that new transactions use outputs from previous transactions, while the new transactions generate new outputs in the form of UTXOs, which you could use in the future. You can get a clear impression of ‘what is UTXO’ only with the help of a practical example.
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Practical Example for Understanding UTXOs
With the basics of the UTXO model quite clear for you by now, it is clearly evident that UTXOs offer an efficient instrument for the organization of a blockchain’s ledger. One of the primary objectives of UTXOs focuses on ensuring safeguards from the double-spending problems. After spending a UTXO, one or multiple UTXOs are generated from the transaction.
The newly created UTXOs then go to the appropriate wallets. You can also think of UTXOs as another variant of blockchain protocol with prominent references in the original Bitcoin whitepaper. The original Bitcoin documentation assumes UTXOs as the benchmark for verifying the availability of funds required for executing requested transactions. Here is a practical analogy to help you get a better understanding of how the UTXO set works.
You can think of UTXO coins as single fiat currency bills. For example, if you have $55 in cash, then you could have more than one currency bill as you couldn’t get a fifty-five dollar bill. So, even if you may have $55 in your wallet, you would have a combination of different bills or ‘UTXOs’ in your wallet. You can have different combinations such as eleven $5 bills, fifty-five $1 bills, five $10 bills, and one $5 bill or two $20 bills and three $5 bills. There are many other combinations you can think of, and ultimately you would end up with the same $55 in cash.
Even if you have different bills, you have the same amount of cash in every scenario. The same concept applies clearly to the case of UTXO. Just like the $55 in cash in your wallet, you can see a single balance in your crypto wallet. However, you could have one or multiple UTXOs in your wallet, and they could vary in size. The sum of all the UTXOs in the wallet amount to the total balance of the wallet.
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The “Pay for Coffee” Example
Imagine that you are in a coffee shop, and you buy a cup of coffee for $4.50. Now, it is clear that you could not provide the exact amount of money when paying with cash. You have $55 in your wallet, and you could pay a $5 bill to get two quarters in return. If you pay a $10 bill, you will get a $5 bill and two quarters in return. If you pay a $20 bill, then you could get three $5 bills and two quarters in return. The same concept of change money, when applied to the blockchain, gives rise to UTXOs.
When you send cryptocurrencies, you have the same currency and change model like with fiat currency. For example, you have a total of 700 Bitcoins in your wallet. Now, the balance in your wallet will be available in the form of three UTXOs, with distinct values. One UTXO could be in the amount of 300 Bitcoin, while the second one can be 140 Bitcoin and the third can be 260 Bitcoin.
Now, think of a scenario where you have to send 100 Bitcoins to a specific address. In this case, you have to send one whole UTXO to complete the transaction. You could not just tear a $20 bill in half to pay for an item worth $10 by handing one half. Similarly, you could not tear UTXOs in half for completing a crypto transaction. You have to send the complete UTXO and receive the change in return.
For example, if you want to send 100 Bitcoins to a friend, you could send your UTXO worth 140 Bitcoins. Your friend would receive the single UTXO of 100 Bitcoins. On the other hand, you would receive a smaller UTXO of 40 Bitcoins. The amount of UTXOs you receive can depend on the size of the ones you sent in the transaction to your friend.
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Are UTXOs and Fiat Currency Bills the Same?
Another prominent concern you may have in discussions regarding the UTXO model is largely evident in the differences between UTXOs and fiat currency bills. Are they essentially the same things, just on different platforms? The practical examples presented above for highlighting the fundamental working of UTXOs definitely show analogies between them and fiat currency bills. However, there are certain glitches in the fundamental examples, which can shed further light on the UTXO set.
First of all, the examples have not taken the transaction fees into account. You need to pay the transaction fees on every blockchain network for executing a trade. So, users sending cryptocurrency to a different address would get the new UTXO, which is equal to the value of the original minus the amount of cryptocurrency sent alongside the transaction fees. The transaction fees could vary on different blockchains.
The next notable glitch in the fundamental example for UTXO model refers to the fixed value of fiat bills. Basically, fiat bills are limited in supply and depend on the government’s decision to print them. You will find a pre-determined value for every fiat currency bill. However, you cannot say the same for UTXOs as they could come in any type of amount.
As a result, the unspent transaction output model can also lead to some promising benefits. The foremost advantage you can come across, in this case, would refer to better flexibility in comparison to fiat currency. You could have almost 1000 Bitcoins in a single UTXO rather than thousands of fiat currency bills required in cash.
What about Flexibility with the UTXO Model?
The foremost factor about UTXO is that blockchain developers get the opportunity to write code for optimizing the way for packing small denominations of cryptocurrency. Therefore, developers get the opportunity to add their insights for maintaining the data weight of the blockchain in manageable proportions. The collaboration between the developers alongside their expertise has quite a crucial role in defining effective UTXO set management. Improved levels of efficiency in generating UTXOs could lead to reduced data weight alongside ensuring optimal processing speeds.
UTXOs definitely presents a lot of flexibility in comparison to fiat currency while also playing a crucial role in blockchain functionality. However, it also has a formidable limitation in comparison to fiat currency. The number and quantity of UTXOs in every individual’s digital wallet must be documented. Therefore, the possibility of assembling or disassembling UTXO coins only comes at times when you participate in public blockchain transactions. If you do not send or receive any crypto funds, you cannot modify the quantity and amount of UTXOs in your wallet.
Value of UTXO Model
The most crucial highlight of any discussion on UTXO would obviously point towards the value it offers.
Language Agnostic Smart Contracts
The UTXO-based smart contracts have emerged as a major breakthrough in the blockchain ecosystem. Such smart contracts are completely independent of language and could allow all UTXOs to develop unique consensus mechanisms.
Support for Decentralized Exchanges and Atomic Swap
The second important advantage of UTXOs directly refers to their support for decentralized exchanges. The UTXO model could support atomic swaps, thereby enabling peer-to-peer crypto trades without the intervention of any third party or middlemen. You don’t have to worry about any centralized accounts, escrow services, or proxy tokens with atomic swaps. As a result, the atomic swap feature of UTXOs offers a better facility for direct cryptocurrency trades between user wallets.
Another significant benefit associated with UTXO coins refers to scalability. Since you have the option for processing different UTXOs at one instance, you get the facility or parallel transaction processing. As a result, you can clearly note how the model can reduce the computation load on the blockchain network.
Privacy and Security
The next key-value advantage associated with UTXOs is the facility of privacy. With new addresses used for every UTXO transaction, it is practically impossible to track the transactions. The additional advantage with UTXOs in this case also becomes evident in the link between inputs and outputs for transactions. Although there are some rare exceptions, UTXOs can enable easier authentication of all transaction sequences while addressing concerns of double-spending.
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UTXOs are a fundamental aspect of developing blockchain platforms due to their significance in accounting capabilities. They serve as the bookkeeping mechanisms for blockchains and are integral for all types of transactions, including crypto trades. The basic mechanism of UTXOs is quite similar to the cash and change you generally use in daily life.
UTXOs bring the same functionality in the world of cryptocurrencies while adding the advantages of privacy, security, customization, and scalability. The UTXO model also presents prolific advantages for blockchains by empowering optimization of computational load. However, UTXOs also have their own share of setbacks in terms of complexities in their implementation. Learn more about UTXOs in detail and understand their true potential.
*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!