How Do Blockchain Oracles Work?

Blockchains and smart contracts can help perform a whole variety of tasks that are currently done using centralized technology. But in order to effectively do these tasks, vast amounts of data from the traditional web and APIs need to be inputted into blockchains, such as live streams of highly time-sensitive data. This could be on-chain and fiat price data for DEXs or stock prices for synthetics trading dApps. 

However, there is one key issue in bringing this off-chain data onto any blockchain: blockchains are designed to be secure, but isolated networks, similar to a computer before the internet was widespread. Essentially, blockchains have no fundamental connection to the off-chain world and the data housed within it. 

This isolation from the rest of the internet is referred to as the oracle problem. The oracle problem impacts almost every dApp and smart contract for the reasons stated above.

What are Blockchain Oracles?

Blockchain oracles solve the oracle problem by facilitating the secure transfer of data from any off-chain system to a blockchain. Because of this role, oracles must have both an on-chain and off-chain endpoint as well as a robust method of consensus to ensure that the inputted information is of a high quality. 

Decentralized oracles like Chainlink use a system of validator-operated nodes to fetch, validate and deliver data from multiple sources onto blockchains in a similar vein to a Proof-of-Stake blockchain. In exchange for providing these services, validators are compensated with the oracle’s token, which is LINK in the case of Chainlink. 

Centralized oracles also exist, with a relatively simple architecture that is controlled by a single entity that acts as the sole provider of information for the smart contracts that use the oracle. However, this centralization arguably defeats the purpose of using a blockchain in the first place, with the oracle acting as a single source of truth, and thus a central point of potential failure. As such, decentralized oracles are already much more widely adopted than their centralized counterparts and have a much clearer use case in the future.

Another interesting example of a platform that inherently depends on external data is the Ethereum-based prediction market Augur. In order to determine the payouts and proper odds for sports or an election, external information needs to be brought into the blockchain.

Why are Blockchain Oracles Necessary?

Simply speaking, the vast majority of the information currently accessible to us resides on the traditional web or on databases accessible by APIs rather than a blockchain. The vast majority of the streams of information being created in real-time right now also aren’t on a blockchain, which means that these archives and streams of data need to be brought onto a blockchain in order for dApps and smart contracts to be able to overcome the oracle problem.

dApps for insurance, lending, betting and trading all need oracle data to eliminate centralized points of failure. In a sense, blockchain oracles are to a future where the on-chain and off-chain words are interconnected what cross-chain bridges are to a multi-chain future: an absolutely integral infrastructural component that will rapidly scale in usage over time.

How Do Oracles Relate to DeFi?

Today, most applications of DeFi right now are dependent on oracles. For example, in order to create a decentralized money market protocol like AAVE or Compound on a blockchain, the protocol’s smart contract needs access to asset prices in order to calculate the collateral required for positions to stay healthy, which runs into the oracle problem. 

Stablecoins and synthetic assets also use oracle pricing data in a similar manner. A more interesting use case for oracles is in determining validator slashing through the use of server uptime data. 

Blockchain Oracle Applications

In addition to the whole range of DeFi-oriented applications in which overcoming the oracle problem is crucial, oracles are vital to bringing off-chain computation to the private sector. 

For instance, if a corporate legal firm deals with templated financial documentation and wishes to harness the computational power of a blockchain for legal automation, an oracle would be a must in terms of onboarding the regular flows of financial updates and documentation to any blockchain. 

An application of this nature would likely demand a first-party oracle solution or a centralized solution so as to eliminate the possibility of data tampering.

Top Blockchain Oracle Projects

Now that the basic concept and set of use cases for blockchain oracles makes some sense, here’s a list of the top oracle projects and how they differ from each other.

Chainlink 

Chainlink is an open source network of decentralized oracle networks built on Ethereum that was created in 2017. As of right now, it can be said to be the most well known oracle with a wide range of users and networks spanning the mainnets of Ethereum, BSC, xDAI, Arbitrum, and Avalanche among others. 

In terms of how decentralized Chainlink is, it has over 50 trusted validators who also run nodes for other blockchains. Chainlink put out a whitepaper for Chainlink 2.0 in April 2021, with some of the most interesting being the addition of Layer 2 focused scaling and off-chain networks built on top of Chainlink’s oracle. 

Off-chain networks are designed to direct most of the complicated computational tasks away from the smart contract’s platform’s main layer, which is important because of the Ethereum Network’s high gas fees stemming from the immense computational demand at present. 

For additional context as to the data that Chainlink provides chains with, a collection of Chainlink’s most popular feeds is available at https://data.chain.link/popular.

Band Protocol 

Band Protocol, created in 2019, is a decentralized cross-chain data oracle platform built on a custom Cosmos-SDK based blockchain. Given the timeframe of its existence, it has angled towards specialised on price data, specifically that of 28 fiat currencies, gold, silver and 154 tokens (including stablecoins) making it a key player in both the collateralized and algorithmic stablecoin space. 

For the precious metals and fiat currencies that Band Protocol tracks, foreign exchange rates and commodity prices are aggregated from Fixer, OXR, XE, and AlphaVantage and served via the on-chain oracle endpoint. For cryptocurrencies, Band Protocol aggregates spot prices from Brave New Coin, CoinGecko, CryptoCompare, and CoinMarketCap (which are all price aggregators) and a range of centralized exchanges. 

Looking forward, Band plans on leveraging its use of Cosmos to use the Inter-Blockchain Communication protocol to facilitate the transfer of data across chains, which has serious potential as an interoperable multi-chain future develops. 

API3 

API3 is an oracle platform built around cutting out middlemen by having off-chain data sources, and APIs run their own specialized oracles, which are searchable through API3’s core platform and are separated into 14 industry categories. 

Access to these oracles is handled in a similar manner to access to the underlying API, with a price structure based around oracle API calls. Naturally, this appeals most directly to firms seeking to onboard sensitive information to a blockchain while avoiding third parties. 

Another effect of this method is the scalability inherent to having a first party oracle for each API provider in the API3 network, especially as the data traffic that non-specialized oracle networks handle proliferates over time.

Where to Buy Chainlink, Band Protocol and API3

The tokens of oracle projects can be purchased on various trading platforms subject to their listing. Of the oracle projects’ tokens, Chainlink’s LINK is the most widely listed across Centralized Exchanges and can be purchased on Gemini and Coinbase in addition to most other Centralized Exchanges and DEXs. 

Band Protocol is a little less ubiquitous than Chainlink but is purchasable in its ERC-20 form through Coinbase, Voyager and most Cosmos DEXs. API3 can be purchased at Coinbase.

Are Blockchain Oracles Good Investments?

On balance, oracles are likely to be a good investment given that most DeFi protocols and hybrid applications of blockchains rely upon them in an infrastructural sense. The integration of oracles with cross-chain bridges and interoperability protocols  is also highly promising in delivering data in a chain-agnostic manner. Since many decentralized oracles use a system of validators, oracle tokens can be staked with a validator for passive returns. 

Irrespective of L1 or L2 dominance in the blockchain space, oracles will be important for the foreseeable future, at least until the majority of data needed by smart contracts and dApps begins life on-chain.