One thing even the harshest Bitcoin critics concede is the revolutionary, world-changing potential of blockchain technology. Despite the recent bear market, we have so far seen a steady stream of announcements for blockchain pilots and tokenization projects from a host of major players. Overall, investment in these technologies within the banking and financial services industry is expected to surge from USD $4.61 billion to USD $7.12 billion in 2024.
Implemented with an appropriate focus on security and resilience, blockchains show enormous promise to make all manner of financial processes more transparent, more efficient, and less risky. But let’s be honest - what we have seen so far is akin to the unveiling of concept cars on a showroom floor. Before these systems are “road-ready,” they will need to satisfy numerous important requirements related to everything from security and compliance to scalability.
To date, most blockchain experiments have avoided using Bitcoin as a technical foundation for experiments due to its restricted-by-design nature. Yet, it’s Bitcoin’s conservative approach, epitomized by architectural choices such as the Unspent Transaction Output (UTXO) model, that gives it the robustness that financial institutions require. Contrasted with the account model utilized by popular blockchains like Ethereum—you will see that Bitcoin’s design may ultimately position it as the ideal starting point for a road-ready financial infrastructure that is ready to disrupt the status quo.
UTXO Vs. Account: Transaction Models At A Glance
The account model operates much like a traditional bank account, with each new transaction transferring value from one account to another. If an account has insufficient balance, the transaction is deemed invalid. Accounts are also commonly controlled by smart contracts, which enable developers to bake in security, spending policies, and other special functions.
Bitcoin's UTXO model, on the other hand, operates more like a cash system. You can think of the UTXO itself as a bank note that can only be spent by the rightful holder. Once spent as an input into a transaction, the note is “destroyed.” Simultaneously, one or more new notes (new UTXOs) get created and distributed as outputs between you and any other transaction participant. At any given moment, ownership of the bitcoin can be calculated by totaling the value of outstanding UTXOs created but not spent.
This is not a trivial difference! While the account model might seem intuitive and simple, it is complex to support in a distributed system. This complexity creates risk and hinders the system’s ability to fulfill important technical requirements.
Reliability
Consider, it’s easy to verify settlement of a value transfer in cash. It’s harder to verify value transferred between bank accounts, because the latter depends on the status of each account and the order of pending transactions to be executed against them. In blockchain systems, the order of transactions is determined by a consensus process and needs to be resilient to rewrites and changes arising from disagreements.
In an account model, transaction validity is a run-time calculation with a computational (and, therefore, financial) cost. Ethereum, for example, suffers a ~2.3% failure rate among its confirmed transactions as cited by its creator, Vitalik Buterin. Because it’s harder to identify spurious transactions, it’s also harder to identify a nefarious actor submitting or propagating invalid requests.
In the UTXO approach, each transaction stands alone, with all information required to assess validity encapsulated in the payload. This makes it easier to audit, discard invalid transactions, and evict misbehaving peers. All of these factors improve the overall reliability of the system.
Scalability
Scaling blockchains while maintaining their decentralization benefits is incredibly challenging and a subject of ongoing research. If you do not care about decentralization benefits, you are far better off using a database! If you do, however, the primary approaches to scaling your system involve the ability to process multiple transactions simultaneously. This is easier to do with UTXO-based systems due to the self-contained verifiability of a UTXO transaction. Simpler approaches lead to more robust solutions, and indeed Bitcoin is advanced compared to its peers in the development and deployment of scaling solutions such as the Lightning Network, which batches multiple transactions between peers, and the Liquid Network, which allocates more blockspace in the form of a sidechain bridged to the main network.
Security
Blockchain security is critical. Compromised private keys or system vulnerabilities are common security failures that often result from exploited smart contracts. Account-based systems provide developers with more smart contract capabilities, which in turn are utilized to implement security features. Two examples are multisignature spending policies, which require multiple private keys to authorize a transaction, and atomic swaps, where two assets are traded and settled between counterparties in a single transaction, reducing fraud. The architecture of a UTXO-based system allows transactions of these types to execute natively, without the need for a smart contract. This means that the blockchain still supports rich security features while potential attack vectors are fewer and more costly to exploit.
Privacy
With the UTXO model, wallets generate a new address for each transaction, whereas the account model wallets feature a reusable address. This means that with an account model, the total account balance is visible to anyone, and there exist opportunities to front-run trades based on who is transacting by monitoring proposed-but-not-processed transactions.
UTXO-based blockchains can still align with regulatory compliance concerns while preserving a greater degree of financial privacy in an increasingly interconnected digital economy.
Programmability
The common critique is that the UTXO model and Bitcoin lack the sophisticated smart contract capabilities required for modern financial products. While account-based systems do offer richer programmability, they may not be the best option for executing large volumes of high-stakes financial transactions where system failures can lead to massive loss of funds. These are the conditions of modern financial systems; one has to assess which system is programmable enough while demonstrating a strong track record for dependable, issue-free performance.
Always robust, Bitcoin’s programmability has made incremental strides, most recently with the Taproot upgrade in 2021. Richer functionality on Bitcoin has further been facilitated by solutions like RGB, Taproot Assets and covenants and programmable assets on the Liquid Network, all of which utilize Bitcoin’s UTXO transaction model.
Built on and inheriting from Bitcoin's battle-tested codebase, the Liquid Network solution, offers finance-friendly features including faster, more confidential transactions and the ability to issue digital assets like tokenized securities, stablecoins, and debt instruments. Liquid utilizes no equity-like staking token and is governed and operated by a federation of independent businesses who each transact according to their own policies without needing to supervise their counterparties or rely on a trusted authority.
The UTXO Model: The Future Of Blockchain Integration
As the financial sector warms up to blockchain technology, the intrinsic merits of the UTXO model in terms of reliability, scalability, security and privacy are becoming especially relevant. Moreover, with the advent of Taproot and the emergence of second-layer solutions like Liquid, the narrative surrounding Bitcoin's capabilities to support smart contracts and complex financial operations is gradually shifting. Corporations and financial institutions eyeing blockchain integration would find it prudent to reevaluate the UTXO model as a viable option, harnessing Bitcoin's foundational principles to safely navigate the complexities of modern-day finance.
Note: an earlier version of this article was originally published in Forbes and can be read here.