DeFi: governing decentralized financial systems

The first part of the article provides a brief overview of decentralized finance and describes the principles of end-user interaction with DeFi products, the main task of which is to create a fully autonomous, independent of centralized institutions blockchain ecosystem, which consists of decentralized applications (dApps) and smart contracts created primarily on the Ethereum platform. Together, they form a single infrastructure for the next-generation Web3 Internet. The main reason for the rapid growth in popularity of DeFi products is that they make financial transactions more accessible to users, both in terms of convenience and simplicity, and financial costs.

This part of the review focuses on one of the most important features of DeFi — decentralized governance through special algorithms (decentralized oracles) and governance tokens, which give their owners the right to participate in making the most important decisions by voting (unlike traditional financial organizations). In this respect, DeFi is fundamentally different from classical financial institutions.

Since there is a risk that the DeFi infrastructure will take a separate position and remain closed to itself, the creators of DeFi products have expanded the ecosystem by adding oracles that provide communication with the outside world. Thanks to this, decentralized financial systems enable combining various blockchain platforms and establishing interaction between them, which is sometimes very difficult to achieve in the traditional financial sector, because companies compete with each other, often sacrificing the convenience of consumers: cashbacks, promotions and bonuses create the illusion of discounts and it becomes obvious that these are nothing more than manipulations and psychological tricks of marketers, which are aimed at forcing the buyer to spend as much money as possible.

What are decentralized oracles?

At Mercuryo, we work with exchanges a lot and know better than anyone how important it is to always have the correct and up-to-date exchange rate, the accuracy of which has a direct impact on the entire cryptocurrency exchange process. Unfortunately, when working with centralized exchanges, we completely depend on the correct operation of this particular exchange.

Decentralized oracles are third-party providers that act as a bridge between data from the Internet and smart contracts. They take data from the outside world, convert it into a language understandable to blockchains, and transmit it to smart contracts. In other words, they link off-chain and on-chain data.

Smart contracts themselves remain closed and are unable to access external data sources, such as, for example, cryptocurrencies prices or results of sports matches. Thus, smart contracts can automatically determine the outcome of a transaction, receiving reliable information from blockchain oracles. This allows you to significantly expand the use of smart contracts.

This approach will significantly increase the functionality of the blockchain ecosystem and the transparency of DeFi when working with data from external sources, that is, from outside the blockchain.

How blockchain oracles work?

The work of a decentralized oracle would be easier to explain with an example.

Let’s say Alex and Betty made a bet using a smart contract that reserves players’ coins for the duration of the transaction. Alex assumed that the Italian driver would finish first. And Betty thinks the German car will win. As soon as the race is completed, the oracle receives data about the outcome of the race from a reliable source and transmits it to the smart contract.

The smart contract automatically checks the result. If Alex was right, then he gets both his and Betty’s coins. Otherwise, all coins are credited to Betty.

Oracles can work both ways: send data not only to the smart contract, but also to external sources. In addition, it is possible to create a network of oracles that will supply data from various sources. This solution is implemented in the ChainLink (LINK) platform.

ChainLink consists of a decentralized network of oracles that take data from several sources at once and compare them with each other. This improves the accuracy and reliability of the data received. For example, the rates of cryptocurrencies on different crypto exchanges may differ greatly. In this case, you need to bring the rates to a single average.

In addition, a network that provides only one oracle will be vulnerable to cyber attacks. If the data that the oracle sends to the smart contract turns out to be artificially modified, the program will run with invalid data. This will lead to an erroneous result, altering the outcome of the transaction.

Types of blockchain oracles

Depending on the conditions, there are several types of oracles:

• What is the data source: a program or a device?
• Does oracle send or receive data from external sources?
• Is it centralized or decentralized?

Software and hardware oracles

In the case of a software oracle, the main data provider is various web resources: servers, databases, and so on. Software oracles receive information from them, and then transmit it to the blockchain. This type of blockchain oracles is the most common, because it allows you to exchange information in real time and update it with minimal delays. This is very important when we are talking about quotes or results of matches.

Currently, hardware oracles are less commonly used in blockchain systems, but they can receive data from the physical world, for example, from scanners, sensors, and other devices, and then translate it into a language that smart contracts can understand. This is useful for tracking traffic, supply chains, and other types of tracking.

Incoming and outgoing oracles

Here everything is simple: incoming blockchain oracles accept information from external sources and transmit it to the smart contract, while outgoing ones do the opposite. It is clear with incoming oracles: smart contracts receive information about cryptocurrency rates or capitalization, for example. But in what cases are outgoing providers useful? They are useful when a smart contract distributes coins: for rewards, in a dispute, or at the end of any other transaction. Then it sends a command to the oracle to remove the lock.

Centralized and decentralized oracles

As the name suggests, decentralized oracles work independently and do not depend on any particular node. In other words, they don’t have a single point of failure. Centralized oracles are vulnerable to hacking, and if their operation is disrupted, they cannot guarantee the integrity and reliability of data.

Decentralized oracles are free of such risks because they use a network of nodes. This increases the reliability, reliability, and accuracy of information due to the fact that the smart contract verifies external data received from multiple oracles. However, this does not mean that the trust problem is completely eliminated: it is only distributed among the nodes.

Other types of data providers on the blockchain

There are less common additional types, such as consensus (or contract) and human oracles. Most providers allow data exchange between different blockchains. The consensus approach is designed to use a specific blockchain and is tightly tied to a smart contract. In this case, it is necessary to develop separate software for each smart contract. On the one hand, this complicates software development and increases its costs, but on the other hand, it allows developers to adapt the software to solve more narrow tasks.

The data provider can be a person who manually passes information to the algorithm. At the same time, a single oracle can analyze several sources at once to verify the authenticity of data and protect it from falsification.

Why blockchain oracles are important for the DeFi ecosystem

DeFi platforms offered a decentralized way to manage the economy, which allows the community to simultaneously improve traditional financial products, making them more fair, and expand the scope of blockchain technology. Oracles act as a cornerstone in this interaction, providing transparent and cyberthreat-resistant distributed systems without intermediaries.

The absence of intermediaries, in turn, reduces costs for companies, which allows you to significantly reduce the price of financial services, thereby making them more accessible to a wide range of users — such a future is possible for the global economy.

A brief overview of the leading protocols with oracles

We got to know oracles better and found out what they are and why they are so important for a decentralized market. It’s time to talk about the leading projects that have achieved the greatest recognition amid the DeFi boom.

1. Chainlink (LINK) — $1.19 billion, rank #10

ChainLink is one of the first blockchain projects to offer a decentralized network of oracles. The platform was founded in 2017 and is now one of the ten largest crypto projects by capitalization. The list of ChainLink partners is impressive: in addition to the largest crypto exchange Binance, such famous companies as Google, Microsoft and Intel cooperate with the project.

This only highlights ChainLink’s dominant position in the DeFi sector. The developers have created a transparent decentralized network in which any user can become a data provider (oracle), and receive a reward in LINK tokens.

The ChainLink solution is integrated by most of the DeFi protocols for delivering price data to DEX exchanges and crypto lending platforms, including Aave (LEND), Synthetix (SNX), Loopring (LRC), Ampleforth (AMPL), and others.

2. UMA (UMA) — $560 million, rank #32

This platform deservedly takes an honorable second place. UMA is an open source protocol that allows users to design and create derivative financial instruments themselves. Users can enter into contracts for the growth or fall of shares, for example. UMA oracles track asset prices on aggregators, and when the contract expires, it sends money to the winner.

In addition, the UMA platform allows users to issue their own ERC-20 tokens with a yield curve on the blockchain and create contracts for decentralized crypto futures, CFDs, swaps and other financial instruments.

3. Augur (REP) — $149 million, rank #70

The Augur project has developed one of the largest decentralized betting platforms. Unlike the UMA Protocol, Augur oracles transmit data not only from stock quotes, but also the results of sports competitions and many other world events.

Working with centralized bookmakers, users are forced to trust the company. In addition, they take a massive portion of the profits and can cut the betting coefficients. Decentralization eliminates these problems since the platform is managed by a smart contract. Therefore, the platform is able to decrease operational costs and fees.

4. Band Protocol (BAND) — $128 million, rank #77

Although the Band Protocol capitalization is significantly lower than that of the ChainLink projects (almost 10 times) and UMA (almost 5 times), this does not make the platform less useful for the decentralized finance market. Like ChainLink, Band Protocol offers a decentralized network of oracles that prevents unauthorized access to data for the purpose of forgery. This blockchain project has two key differences from the previous platform:

• First, Band Protocol offers cross-chain oracles that interact with smart contracts not only on the Ethereum (ETH) blockchain, but also Polkadot (DOT) and Cosmos (ATOM);
• Second, the developers have created a flexible system using WebAssembly, which allows you to create DeFi applications in a few minutes.

It should be added that Binance also supported the Band Protocol, and this project has great potential, given that it was able to achieve such results in just a year (the platform was launched in September 2019).

5. Aeternity (AE) — $37 million, rank #167

Aeternity is a high performance blockchain platform with smart contracts created in the Erlang programming language with dynamic typing. The Aeternity project is one of the industry’s pioneers: The company was established in 2016, and the mainnet was launched in 2018.

What makes Aeternity stand out from other projects with blockchain oracles? Aeternity is based on a proprietary blockchain, and is not built on top of another platform as a level 2 application. It is a scalable and high-performance sharding-supporting Turing-complete protocol. This enables creation of autonomous systems and removes the element of trust on the part of users. In addition, Aeternity allows users to tokenize both virtual and real assets: shares, cryptocurrencies and stablecoins, game items, real estate, certificates, and so on.