Understanding UTXOs - The Gold Coin Analogy
The UTXO is a fundamental technological unit within the Bitcoin blockchain, and it can be understood by way of analogy to a Gold Coin.
A “UTXO” is one of the fundamental building blocks of both Bitcoin and on-chain analysis. It is also one of the least understood. The UTXO term is an abbreviation of Unspent Transaction Output, and these are the base unit that keeps track of coin ownership within the Bitcoin protocol**.**
While this name accurately describes what a UTXO is, many new on-chain audiences find this concept very mysterious.
This piece aims to theorize the Gold Coin Analogy to simplify the explanation of a UTXO, and lay the foundation for more sophisticated on-chain metrics (e.g. Realized Cap, Coin-days Destroyed, and Realized Profit/Loss).
Although a unit of bitcoin is divisible, we should not think of bitcoin amounts like a dividable liquid, but instead as discrete quantities, like GOLD Coins.
Considering this analogy between UTXO and GOLD Coins where 1 BTC = 1-oz of gold:
- When one receives 1.5 bitcoin to an address, the owner now owns discrete 1.5 bitcoin held in a UTXO. Using our analogy, this is the equivalent of “receiving a 1.5-oz GOLD Coin”.
- To spend 0.2-oz of the gold coin at a shop, the owner cannot simply break off a piece of the coin and pay only that piece. Instead, they must “Melt the entire 1.5-oz amount” by putting it into a Transaction (analogy is a “Melting Pot”).
- This process destroys the original 1.5-oz gold coin (the UTXO is destroyed), and mints a new set of gold coins with new denominations (UTXO creation) In this case, the transaction will create::
- one 0.2-oz gold coin —> paid to the shop owner
- one 1.299-oz gold coin —> returned to the original owner as change
- a small fee of 0.001-oz —> paid to the operator of the mint for their services (analogy is the Bitcoin miners)
- Total value is 0.2 + 1.299 + 0.001 = 1.5-oz
- With the transaction, the network can divide and “Mint” the gold coin into any set of arbitrary denominations of “New Coins” (analogy is newly created UTXOs) and send it to as many different addresses as is required.
- Bitcoin miners, who are the equivalent to operators of the melting and forging equipment, take a small fee for their services (the transaction fee).
Now we will explore the reason why the creating (minting) and destroying (melting) process for UTXOs (gold coins) is so important to understand for on-chain analysis. We can learn a lot about investor behaviour based on the history of UTXOs by studying the time and price at which they are created, and destroyed. Some examples insights we can gather:
- If a UTXO was purchased 10-years ago, and has never been spent it, it becomes increasingly likely that the coin is lost, or may be in a secure safe storage vault.
- When a very large amount of UTXOs that were purchased many years ago are destroyed in a short period of time, it may indicate that long-term believers are selling their investment.
- We use the market price to assign a value to each UTXO at the date it was created, and then revalue it when it is destroyed. From this we can calculate how much profit, or loss the owner made on their investment.
- We can identify the spending behaviour of large financial entities (like exchanges and miners) due to their very specific patterns of managing their UTXOs. This allows us to observe coin inflows and outflows associated with these entities.
These examples highlight a number of on-chain metric categories that we can use to understand the sentiment, momentum and health of the network.
- Supply Distribution - the study of owners, and how many coins they have.
- Network Health - the study of transactions, UTXO creation/destruction, and network activity.
- Lifespan - the study of coin age in the supply and the balance between newer (inexperienced), and smart money (experienced) investors.
- Profit/Loss - the study of investor gains and losses, which provides insight into market sentiment, and bull/bear cycles.
The following table summarizes the equivalent concepts in this analogy