Think of a thriving financial ecosystem not controlled by big banks and financial institutions. They don’t exist. Transactions happen without intermediaries, powered by self-executing smart contracts, where Oracles fuel live streaming data.
That’s the brave new world of DeFi—where traditional finance (TradFi) is reimagined on top of the blockchain. Therefore, the growth of Oracles is a subset of blockchain growth.
The Concept of Oracles in Blockchain
Oracles form the foundation of blockchain technology and DeFi in building a decentralized, trustless, and permissionless network. To make this possible, It needs to deal with real-world entities to conduct traditional financial operations.
The dynamic fluctuations of data, such as real-time asset prices and exchange rates, are made possible by oracles. Smart contracts cannot function without this navigational information.
Sergey Nazarov, the founder of Chainlink, considers them a bridge between on-chain smart contracts and off-chain data sources.
This complex world of digital assets and automated contracts depends on a critical component—the oracle. They occupy a crucial position in DeFi applications, retrieving and validating real-world data before smart contracts utilize it.
Types of Oracles And Functionalities
Below are the following types of oracles based on their functionalities:
1. Software And Hardware Oracles
Software oracles gather data from external sources, including servers and web pages. Any real-time data, such as exchange rates or stock prices, fall under this category.
Hardware oracles extract data from the real world and then provide it to smart contracts. These oracles convert the gathered data into machine-readable values.
2. Inbound And Outbound Oracles
As the name implies, inbound oracles take data from internal sources, whereas outbound oracles take data from external sources.
3. Centralized And Decentralized Oracles
Centralized oracles fetch data from pre-determined and controlled sources, like APIs. On the other hand, the decentralized oracles function gathers data through multiple nodes depending on the cryptographic scheme.
4. Man-in-the-Loop Oracles
These experts in a given field can vet information from various sources, research it, and confirm its integrity before eventually transferring it to smart contracts.
5. Hybrid Oracles
Hybrid oracles combine centralized and decentralized oracles, balancing security and efficiency.
How Oracles Work
Blockchain oracles perform the crucial function of supplying data to smart contracts. Let’s unfold the process in a bit of detail:
1. It receives data from external sources, such as online data feeds, sensors, APIs, IoT devices, human input, or third-party data providers.
2. Next, it verifies the authenticity of the data. This is a crucial stage to avoid smart contracts executing the contract on inaccurate data.
3. Following data verification, oracle sends it to smart contracts to execute the contract, and other automated agreements are implemented. Ethereum nodes can directly use the data.
Oracles in DeFi: Why They Matter
Oracles are the invisible force powering DeFi. What the Internet means for computers, oracles mean it for DeFi. Whatever the use case, whether it’s lending, decentralized insurance products, algorithmic stablecoins, derivative products, or any other product, the execution relies on oracles as a bridge between external entities and blockchain natives.
Oracles: Real Word Examples
Below are some popular oracle-related platforms:
- Chainlink, developed by Sergey Nazarov, is a multi-chain oracle that provides “reliable, tamper-proof inputs and outputs for intelligent contracts. It offers various asset prices, price feeds, sports data, weather-related data, etc. Leading DeFi protocols like Aave, Kyber Network, Synthetix, and many others use Chainlink.
- Witnet works on a consensus-based algorithm for analyzing nodes’ responses. Nodes in Witnet earn or lose reputation based on whether they fulfill the data request correctly or incorrectly.
- Band Protocol, a cross-chain data oracle based on community-curated data sources, powers dApps for integrating price and event feeds, bridging the gap between the decentralized and natural worlds. Integration with Google Cloud has been a significant achievement.
- DIA is a popular open-source platform for creating oracles for sourcing data from an array of off-chain and on-chain exchanges, supplying and sharing creditworthy data to build DeFi solutions.
Blockchain Oracles: Potential Risks And Challenges
Though oracles are crucial to the growth of the DeFi ecosystem, they also pose material risks for the users of DeFi. These risks are particularly significant in the case of external data sources, as using them increases the attack surface that bad actors can exploit to their advantage.
Another problem is handling concentration risks caused by the dominance of the Chainlink protocol. S & P Global, in a report, says, “At a DeFi protocol level, data concentration is a notable risk for third-party oracle networks as they are designed to aggregate data from multiple nodes.
Apart from risks, oracles also suffer from the following challenges, that includes:
- How to ensure the security and reliability of third-party data as they are vulnerable to manipulation.
- How to consistently ensure data meets the rules and logic of smart contracts. Any potential irregularity in data can compromise the entire blockchain’s integrity.
- How do you maintain the speed of data feed? If the data feed is slow, the execution of smart contracts will be slower.
For example, in the supply chain industry, the problem occurs from information filtration when the producing company tries to prevent unwanted information.
This can lead to incomplete data entering the innovative contracts system, causing delays, inaccuracies, and inefficiencies in the supply chain oracle module.
How Oracles Are Shaping the Future of DeFi
The success of DeFi depends on the efficiency of smart contracts. Currently, a significant challenge blockchain developers face is the scalability of smart contracts protocol, and the reason is that the efficiency of on-chain oracle platforms built on top of the Ethereum protocol is not enough to deal with the scale of modern-day scale of financial transaction volume.
Furthermore, they’re not easily accessible and lack transparency and decentralization in the true sense, seriously impacting the growth of the DeFi-based Web3 financial order. However, various oracle protocols are working to address these challenges.
Teller, for example, ascertains the integrity of data using a network of staked miners, which is then transmitted for use in smart contracts.
Interoperability is a big challenge as various protocols need different data feeds. Band protocol enables developers to write custom oracle scripts to meet their particular business needs.
Overall, the future of the DeFi ecosystem will depend on how oracles evolve in the future and address the existing limitations of scalability, reliability, security, speed, and accuracy of the data.
As the DeFi-based Web3 landscape evolves, the role of oracles will become increasingly crucial to ensure the efficiency and accuracy of smart contracts. Various oracle-based platforms are already trying to ensure data integrity; we can expect more platforms to play a significant role in the future of DeFi.
For more information on our DeFi solutions, do get in touch with our web3 solutions team.