Exploring DeFi Oracles, and Their Roles in Decentralized Finance

Decentralized finance (defi) applications are emerging at an unprecedented rate. There’s no doubt the future of the legacy banking system is gradually thinning out of the scene. As of the end of 2021, the total value locked in defi sits at $200 billion — a number that invariably competes with the gross domestic product (GDP) of myriad nation-states.

As it seems, people are growing tired of having to walk long miles to book an appointment with a banker in a bid to access financial services. They have taken up a much better alternative with decentralized finance — an open, trustless and permissionless sector that allows anyone anywhere in the world to borrow, lend, save and trade digital assets with just a strong internet connection and a crypto wallet.

What are DeFi Oracles?

Oracles are third-party services enabling smart contracts within the blockchain technology to access external, real-time data. They send external data from outside their ecosystem to a blockchain. This data can range from price charts to weather readings to voting aggregates to mortality rates. After the data has been sent, a smart contract on the supposed blockchain uses the data to validate its conclusion. The need for oracles arises as a result of blockchain not having on-chain on their ecosystem.

For instance, a group of farmers who live in unpredictable and unfavorable weather conditions might be keen for insurance in case a flood or drought affects their harvests. That’s to say, if a farmer faces any of such conditions, a sum of monetary funds needs to be paid to cover up for the losses. In this case, a weather oracle will have to send a cumulative data, let’s say there were about ten flooding incidents in a year, to the blockchain’s smart contract whose work is to ascertain whether the affected farmer is to be paid or not.

Since blockchain do not have on-chain data on their ecosystem, businesses and companies running within different spheres of decentralized finance rely greatly on oracles for their real-time, on-chain data. Matter-of-factly, over the years, eight out of ten DeFi applications have sourced their important data from centralized, semi-centralized or decentralized oracles, especially decentralized oracles due to its fast sweeps.

What Are The Types of Oracles?

Oracles are categorized in relation to the source of the data, the direction of the data and the extent of trust.

In regards to the source of data, the oracles can either be hardware or software. Hardware oracles gather information from the external world and convert it into digital computations inputted into the smart contract. Major examples include sensors, lasers and barcode scanners that directly and indirectly gather data. On the other hand, software oracles collect data from online sources and websites and provide the bulk of up-to-date data to the smart contract. They are mostly used in cryptocurrency exchanges.

Based on the direction of the data, oracles can either be inbound or outbound. Just as the term ‘inbound’ supposes, inbound oracles allow the technology to access outside data sources to send to smart contracts. In reverse, outbound oracles allow smart contracts to send information to external data sources.

When we talk about the degree of trust, oracles can either be centralized or decentralized. For centralized oracles, data is provided from an outside data source to a smart contract through a single entity that holds custodial authority of the data, oftentimes drawing out strict regulatory features. Because it comes from a single storage block, there’s a single point of failure. And this makes it a bit insecure and susceptible to attacks. In contrast, decentralized oracles rely on data from myriad external sources to pan out the correctness — and curb the inaccuracies — of the data made available to the smart contract. Using its Schelling game theory in which every user can provide information without opinion debate or collusion, these oracles can verify whether the data points inputted into the software are credible and valid.

The Silver Bullet

As all growing models, oracles have their own fair share of problems, ranging from trust conflict and latency. Since information is directly brought to smart contracts, there’s no doubt that oracles hold a kind of custodial power in functionality of smart contracts. Therefore, decentralized finance applications, protocols and the likes need to hold onto oracles with verifiable data and little-or-no latency.

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