What Are Decentralized Oracles?
Cryptocurrencies serve a wide range of purposes, but none of them would be possible without decentralized oracles. If we conceive our organs as separate pieces that each fulfill a specific function in our bodies, oracles are the nerves that allow them to work together. Decentralized applications, likewise, are organs of the blockchain world that would perish if kept apart indefinitely.
When Vitalik Buterin decided to establish Ethereum, he did so believing that Bitcoin's lack of scriptability was a severe constraint. While the smart contract ecosystem did succeed in creating a popular dApp hub, Buterin and his team overlooked the fact that Ethereum, like Bitcoin, had its own set of constraints.
Perhaps history repeats itself, but the blockchain business is experiencing the same interoperability challenges as the IT industry did decades ago. Because networks cannot communicate with one another, there is a lot of space for poor user experience and inefficiency. When we take a step back and consider how blockchains interact with the real world, we see that the situation is dire: blockchains cannot be directly connected to traditional systems, thus limiting their usability and acceptance.
The Oracle Problem is how experts refer to this constraint. Digital ledgers are isolated, much like a computer without an internet connection, because they have no mechanism to send or pull data from external systems established outside of blockchains. The oracle problem is far more critical than anyone can realize, given that the majority of smart contract use cases rely on interfacing with the actual world.
Blockchain developers established oracles to tackle this problem. We're not talking about any old oracles here. We're talking about decentralized oracles in this scenario!
What are decentralized oracles, and how do they work?
We discovered that some blockchain applications, particularly those that rely on smart contracts, necessitate connectivity to the outside world. Financial smart contracts, for example, require access to market data to determine settlements; a blockchain-based smart city would require smart contracts and IoT data to control rental agreements, and so on.
In these circumstances, there is no connectivity between a blockchain infrastructure and traditional IT infrastructure. To connect the two, we'll need a middleware service, a piece of software that connects on-chain and off-chain systems.
This piece of middleware is known as a blockchain oracle. Oracles are complicated by nature, yet they only serve one purpose: to connect blockchains and centralized systems.
The basic oracle functions
To establish a connection between on-chain and off-chain systems (note that in some circumstances, we also require oracles between blockchain networks themselves), all oracles must provide a specific set of features, the most significant of which are:
Listen is a feature that allows oracles to keep an eye on blockchain networks and respond to user requests for off-chain data.
Oracles include an extracted feature to get data from other systems.
The capacity to sign and share transactions on a blockchain to communicate data to a smart contract is broadcast.
An oracle must be able to service both on-chain and off-chain systems simultaneously to be valid. The one processes requests, gets data, and sends blockchain data to off-chain systems, while the other listens, makes connections, broadcasts data, and extracts information from networks.
If oracles are crucial for interoperability, why haven't they been established years ago? The issue, as always, originates from centralization.
Until 2017, the majority of oracles and oracle prototypes were centralized. Because deterministic transactions, or transactions that all nodes can validate, constitute the lifeblood of smart contracts, it was highly unreliable for networks like Ethereum to run these oracles.
A centralized oracle is analogous to an enterprise database, and if we employ it, blockchains will lose their decentralization once they interact with an off-chain system.
Developers have been working on decentralized oracles instead of bringing a middleware with the whole opposite ethos behind it since we don't want to undermine an essential blockchain feature by adding a middleware that has the complete opposite ethos.
The idea behind such an oracle is that it does not rely on a single source of information. Instead, we improve data quality and authenticity by developing them to aggregate data from various other sources.
Why are decentralized oracles so important?
A liquidation cascade in the lending protocol is not pleasant to learn about. Compound dating to November 2020 is an excellent illustration of why having many data sources is essential.
Users of Compound can borrow and lend crypto funds. Borrowing necessitates the provision of collateral, and if the borrower fails to provide sufficient collateral, the borrower's assets are liquidated. DAI is a popular stablecoin for loans.
Compound's pricing oracle at the time sourced prices purely from the market, and as the price rose, borrowers were left with undercollateralized loans that were promptly liquidated. On that day, the protocol had $88.4 million in liquidations. In addition, DeFi project dYdX had a setback but only lost $8 million.
As we can see, crypto investors lost $96.4 million due to a rookie error. The lending protocol would not have noticed DAI's price increase if Compound had utilized a decentralized oracle that collected data from different sources.
Blockchains would have a limited reach without oracles. Today's decentralized networks would be equivalent to a computer or smartphone without the internet. We can't imagine blockchain technology being beneficial to anyone outside of its existing group with that isolation level.
Decentralized oracles come to the rescue by establishing a secure and dependable link between on-chain and off-chain systems. They not only connect legacy and new ledger systems, but they also allow the connection to adhere to the underlying ethos of blockchain technology.
Oracles are more crucial than ever before, mainly since all DeFi initiatives rely on them to get price data, resolve settlements, and allow investors to trade assets without going via a traditional exchange. Some argue that DeFi wouldn't be worth $75 billion if it weren't for oracles. The fact that decentralized finance only became a thing after oracle providers like Chainlink matured are enough to convince us.