What the heck are centralized and decentralized oracles? — Simply Explained

Welcome back to simply explained. So far, we have learned in the previous blogs what blockchain, smart contracts and oracles are. Great! If you aren’t yet familiar with each term, just go ahead and quickly get through the older blog entries. Luckily, we have linked them individually for you, so you know where to look them up. Let’s get back to the topic.

What are the different types of oracles? What are centralized and decentralized oracles? What on earth is the oracle problem? We will debunk these questions and apply this to Decentralized Finance (DeFi) markets so stay with us. Let’s start with explaining all these terms.

Centralized vs decentralized Oracles

By now you know that in order to set up most smart contracts on Blockchain we need a connecting bridge — thus an oracle — that translates a needed information between the off-chain and on-chain world. There are different oracles which differentiate in terms of source and direction of information and degree of trustworthiness.

A centralized oracle is an entity that is operated by a single authority and the only provider of information for a smart contract. Therefore, it is one of the most secure oracles you can use. Note, however, that they’re not flawless and can be subject to hacking or corruption. What’s more, being a single provider of information leads to the problem that if the oracle fails there is no other source to fall back on.

Nonetheless, centralized oracles are cheaper since their architecture is by far simpler than their counterpart’s architecture. Also, keep in mind that since the architecture is simpler, the cost of its infrastructure and maintenance can be kept low. Therefore, this is definitely a point to consider when choosing between oracle types.

Now, we’ll have a look at the decentralized oracles. In contrary to the centralized oracles, decentralized ones do not rely on a single source of information. Instead, they collect data from multiple external sources that independently gather data which fortifies the authenticity of an information. Still, this obviously jeopardizes the information’s trustworthiness because the independent sources are reporting data uncoordinated with each other. Consequently, these oracles require higher investments in their architecture and its maintenance and are prone to various problems such as signaling and bribing. The decentralized oracle is only as good as its consensus algorithm.

Simply explained, centralized oracles are secure but rather slow while decentralized oracles are faster yet prone to manipulation.

The Oracle Problem

What seems like a paradox … is actually one? Let us tell you why.

You see, when smart contracts are being set up on Ethereum, a decentralized system, it needs off-chain data in order to execute most smart contracts. Ethereum itself can’t draw the information from the real world. It needs an oracle to do so which is just one source of information. As decentralized systems are only decentralized to the point of their weakest link, connecting an oracle with a single point of failure to the blockchain would arguably cause a complete loss of decentralization. Oracles are trying to solve that problem by setting up various consensus protocols or by making sure that the data is coming directly from a source such as the Blockchain Presence with its Sender Authentication model. As blockchain infrastructure improves more and more innovations and solutions are coming faster than ever.

When oracles fail…because some of them unfortunately do

So far, we’ve talked about all great things oracles can and can’t do and all the different kinds of oracles there are (hint: centralized vs. decentralized). Yet, oracles can sometimes fail in providing reliable data. There are several reasons, divided into technical and social dimensions. Shall, we dive in?

First of all, the technical dimensions. There are immense differences in the programming quality of oracles. So to speak, an oracle can be very poorly or very efficiently programmed. In addition, they can experience bugs, sabotage and/or malfunctions.

On the other hand, we have the social dimension. Unfortunately, this refers to cases in which the entity managing the oracle alters the data transfer for selfish purposes, even though the data source is reliable and the oracle well programmed. This could happen especially when the value of the smart contract is high.

Worth mentioning is that when an oracle functions incorrectly, it is impossible to find the nature of it. So, whether the failure belongs to the technical or social dimension is indistinguishable. That is why people in the field focus rather on the technical components than the social one. This is due to the fact, that the social component is naturally controversial and harder to spot and control.

Hopefully, this blog post helped you to get a better understanding of what exactly centralized and decentralized oracles are and what the oracle problem stands for. If you want to find out more about Oracles, smart contracts and the DeFi world, make sure to read our next blog post!