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If we have DFI in our balance, will it automatically

convert it to UTXO for transaction fees? ( say, in the above example, when we are converting from DBTC to DUSD)

or do we have to convert DFI to UTXO ourselves manually?

what is the program / design logic for separating DFI from UTXO, if it confuses the end user and adds an additional step ?

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One simplified answer is, that the UTXO principle is coming from Bitcoin. Defichain is as per concept cashflow oriented. E.g. in Liquidity Mining would require decent amount of UTXO transactions each block to cover this. By having to types of DFI: UTXO and Token both can be covered. The Transaction between accounts and the tokenized processes like Liquidity Mining.

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