What is a DeFi oracle?
An oracle is an intermediary service that enriches on-chain smart contracts with outside data. The blockchain accepts the oracle and trusts the information that comes from it, further using it to execute on-chain algorithms.
Oracles serve as third-party information sources that are integrated to the smart contract technology based on blockchain. Through oracles, smart contracts have access to actual updated information that blockchain requires to operate. Generally, this information includes current prices for various assets. It’s important to know that oracles are not data sources on their own, they are intermediary services that bring together information and smart contracts, executing data verification.
At present, most projects operating within the decentralized finance ecosystem use oracles to feed their systems with relevant information. To understand how popular oracles are, it’s enough to say that only three out of ten leading Dapps don’t use oracles, while the rest of them strongly rely on oracles that work in a centralized or partially centralized manner as there are practically no oracles providing external data without centralized authority.
Blockchain-based system depend on oracles as they are not designed to store and update on-chain data. To operate properly, blockchains need to use relevant information that would be updated once there’s any change. On-chain systems access the data that is generally stored on large cryptocurrency exchanges — be it Gemini, Binance, or any similar exchange, with one condition that it must have specialized programming structures enabling the use of oracle layers.
What types of oracles are there?
There are different types of oracles depending on where the information comes from, where it goes and how trustworthy it is.
In technical terms, information can come from either software or hardware. Based on this, there are software and hardware oracles. The first ones take data from the real world and transform it to digital variables further delivered to computer protocols. The information is gathered via scanners and sensors that read the data and conduct it to the smart contracts. Oracles of the second type operate by receiving information from the Internet, searching for it on online platforms, websites and thus transporting most relevant data to the algorithms. Blockchain-based systems generally receive information from online exchanges.
Information can be directed inwards our outwards, therefore dividing oracles to inbound and outbound ones. The first ones support the system in sending data from third-party sources to smart contracts, while the second ones do the opposite — they allow computer protocols to transmit information to outside sources.
There are also centralized and decentralized oracles. Oracles that operate on a centralized basis function as a separate entity transmitting information from a third-party origin to the system with a relatively firm security level. Yet, as it is a centralized oracle — meaning having only one accountable source — it is still not secure enough compared to decentralized systems. The same pain point is applicable to traditional finance and all networks it underpins — they have an intermediary that can cause harm to the security of the whole system as being an easy entry point, these intermediaries can be corrupted or hacked with hacker data being uploaded or original data being stolen.
Oracles operating in a decentralized manner use various third-party sources with the aim to enhance the trustworthiness of the information brought to the smart contracts. These oracles rely on the principles of game theory (also called Schelling points), where all members provide information without any communication and conspiracy, and then it is decided whether the data provided is applicable to be used as a solution to a raised problem.
What is the purpose of a decentralized oracle within the DeFi ecosystem?
Oracles serve as mediators providing reliability and credibility within the ecosystem.
Companies operating within decentralized finance mainly use decentralized data bridges as centralized ones can’t be used with DeFi products and applications. Working as financial instruments, Dapps rely on the blockchain technology entirely, mostly Ethereum one.
The most popular metric for DeFi space is TVL — total value locked — is the total amount of value stored in multiple smart contracts of the Dapps across the space. Usually this is the balance composed of all ETH, BTC and all other tokens running on Ethereum blockchain stored on the smart contracts of all Dapps. The TVL reading has recently escalated to over $7 billion in the second half of 2020, being somewhat $675 million when 2020 started. This head-over-hills jump indicates how much oracles mean for the DeFi space. Their importance is also reflected by the extraordinary growth of tokenized return-on-equity since the beginning of the year in relation to the investments in largest blockchain oracles, such as Chainlink and Band Protocol. Even Bitcoin doesn’t provide such returns as for now.
So-called mixed DeFi protocols have started to gain an exceptional popularity recently, the ones that work in a decentralized fashion, but reduce volatility. They function by applying traditional financial tools, mainly those backed by US dollar, to digital assets.
What are the main challenges for oracles within the DeFi space?
Whatever good oracles make for DeFi projects, there are precise problems related to their use that still have to be addressed.
The main problem with oracles in the DeFi space is a trust issue that emerges when centralized external systems get integrated with decentralized smart contracts and on-chain protocols. Oracles play an important part in the functioning of the smart contracts because these algorithms rely in their operation on the data carried in by the oracles. Thus, oracles have a certain power over the smart contract technology. In this regard, it is essential for the proper functioning of decentralized applications and algorithms that oracles provide credible data with minimum delays possible.
In a more general way, oracles can be divided into two groups: those with low latency and low security and those with high latency and high security. Decentralized oracles are often characterized with high speed. Interestingly, most oracles running applications in the DeFi space are centralized or partially centralized due to high susceptibility of their decentralized fellows to hacker attacks as they work on the basis of game theory principles.
The game theory underpinning the operation of decentralized oracles means that various information sources participate in the process of data collection without any integration or interdependence among them. As there’s no connection among these multiple informers, these data providers transmit as credible information as they can relying on other sources to act in the same fashion. This process has its own pain points such as probable conspiracy among information sources and other malicious actions including bribery. If the system gets hacked with a cyberattack, also known as machine-in-the-middle attack, and the hacker alters the original system arrangements, there’s no retribution instrument in force. Even a slightest change in the network can cause serious damage to the everyday operation of the decentralized applications backed by the hacked oracle.
Centralized oracles are featured with high latency and high security, which means they operate slower, but offer higher data protection options. In comparison to decentralized ones, centralized oracles are steadier in their interaction with independent system elements. They offer voting options and additional layer of security to avoid hacker attacks and any consequences if such attacks take place. Yet, enforced security measures require longer periods of data processing and transmitting, up to weeks, which is the primary reason for many Dapps to refuse to use them as an information feeding instrument. Protected enough from game-theory driven cyberattacks, centralized oracles are vulnerable to hacker attacks thorough the central node, which lowers the security level of the DeFi application using it.
How do decentralized applications solve oracle-related problems?
Strong security built on game theory elements and dispute options shape probable solutions to the oracle-related issues.
As high-tech and complex blockchain oracles are, they still have room for growth, and the oracle-related error that took place within the Synthetix ecosystem is a good example. When the Synthetix oracle was attacked, it resulted in 37 million tokens lost. This is one of many proofs that blockchain oracles are not secured enough, and these lapses can lead to abnormal price behavior and large amounts of assets being stolen. The main reason why oracles — both centralized and decentralized — are subject to such attacks is that they are not an integral part of the on-chain consensus mechanism, therefore the high security measures blockchains benefit from don’t work for oracles.
The leading developers of blockchain oracles are Chainlink, Compound, Band Protocol and others. The first one is known for its close cooperation with digital titans Google, Binance, Matic, Dapps Inc and many others. Apart from that, there are ongoing negotiations with SWIFT — The Society for worldwide Interbank Financial Telecommunication. The prospects are huge for sure.
What are the biggest names in DeFi operating on blockchain oracles?
Open-source yield farming platforms, MakerDAO and Compound being the most popular, operate on Ethereum blockchain and use oracles to feed their networks with outside data.
MakerDAO is considered to be one of the largest open-source yield farming protocols within the DeFi space. Maker’s token DAI is a cryptocurrency-backed stablecoin which is paired with USD. MakerDAO is one of the biggest adopters of blockchain oracles that feed the platform with real-time prices for various assets. The oracles on the Maker platform regularly transfer data updates to the aggregating contract that establishes an average price further stated on the platform.
Compound is an algorithm-based decentralized protocol that enables users to earn profits from interest rates. The platform is also lending digital assets against collaterals. Compound is another example of a famous DeFi platform which functioning includes the use of oracles to collect data on price. The data is then sent to the platform managed by platform runners — COMP holders.