Oracles are lines of code that connect information in the real world to contracts and other agreements on a blockchain. They serve as a bridge between on-chain, which is every interaction that occurs on the blockchain, and off-chain data.
This connection allows smart contracts, or lines of code that initiate unstoppable commands, to execute transactions that rely on information not on the blockchain–for example, interest rates, temperatures, and third-party lists–with assurance the information hasn’t been tampered with. Tokens used to verify oracle data are worth more than $4 billion, according to data site CryptoSlate.
Why Do Blockchains Need Oracles?
Oracles themselves are not the source of real-world information, instead, they gather it from existing databases and communicate the data in a reliable way to the blockchain. The relationship between oracles and blockchains is reciprocal. Oracles can receive on-chain data to distribute to external applications like banking apps.
This provides potential new uses for enterprises, such as supply-chain tracking, which traces products from their source to consumers and bonds that rely on third-party interest rates. Existing systems can simply integrate with the decentralized network.
Blockchains and their public ledgers can be compared to a computer without an internet connection; such a device would be unable to search for and take in real-world data. A computer with no internet can only access what is stored on its local hard drives.
Similarly, a blockchain can only access the transactions recorded on its distributed ledger, which limits the number of applications that can be used without real-world information. Oracles provide this internet connection. They enable blockchains to find and access outside information for on-chain smart contracts.
The Problem With Centralized Oracles
While oracles solve one problem for blockchains, giving them access to real-world information, they create another in the form of centralization. Blockchains are decentralized and distributed networks that protect against single points of failure. For example, if a hacker gains access to your private crypto keys, they can only access your funds. But if that same hacker gains access to a centralized crypto exchange, they can access millions of accounts with one data breach.
Looking to benefit from blockchains connecting to the real world? Click here to check out our subscription newsletter for serious investors.
Simply put, a decentralized network of millions of computers requires millions of individual hacks, but a centralized system requires one breach for millions to be affected. If blockchains were to adopt centralized oracles, this would introduce a single-point vulnerability, which counteracts everything a decentralized network is built for.
To solve this problem, decentralized oracles were born.
How Decentralized Oracles Solve The Problem
Decentralized oracles solve the off-chain data problem by granting blockchains access to real-world information without introducing a single point of failure. They do this by using distributed data sources to avoid single points of vulnerability.
For example, decentralized exchanges that run on a shared protocol can provide price feeds for various assets like ether (ETH) and bitcoin (BTC) without a central authority. Decentralized exchanges allow individuals to swap assets directly with one another, via a shared, open ledger that no one owns, as is the case with centralized competitors like Coinbase or Kraken. The problem is that the decentralized exchanges have no way to access the current price of ether or bitcoin in terms of dollars. So, a decentralized oracle such as Chainlink can provide the exchange with a price feed.
But how does Chainlink offer this information without creating a centralized access point? It uses dozens of different data providers to create a single price feed. Therefore, if one of the data sources is compromised, the other 20 or so data providers are still protected and providing untampered information.
This is just one example of the way an oracle can be used. There are several other types of oracles based on the information they provide and how they collect it.
Oracle systems can be distinguished from each other by their data sources, the direction the information moves, and the way the data earns user-trust.
Data source refers to what data is being reported to the blockchain. While most data comes in a digital form, some systems collect physical data. These types of oracles are either software or hardware systems. For example, oracles can read radio frequency identification (RFID) chips, weather conditions, or healthcare data.
The direction of information highlights whether the blockchain is receiving data, or sending it. These are often referred to as inbound or outbound systems. For example, the Federal Reserve interest rate could be used in a smart contract transaction, or a wallet on-chain could reach a pre-determined amount, triggering a tax payment off-chain, in a banking application.
The trust mechanism illustrates whether the oracle is a decentralized or centralized system. Even though centralized systems can create single points of failure, many users prefer them to the more experimental alternatives.
Why Oracles Are Important for Blockchain
Cryptocurrency’s total market capitalization hovers around $1 trillion, however, according to McKinsey, the global financial system transacted over $5.76 trillion in a single year and is worth upwards of $487 trillion. The US residential real estate industry is estimated to be worth $43.4 trillion according to Zillow, and the U.S. healthcare system is estimated to be worth $4.1 trillion according to the Center for Medicare and Medicaid.
These figures highlight the size of the value that is available off-chain and demonstrates the importance of a bridge between centralized and decentralized systems. In order for these systems to access the power of smart contracts, they need decentralized oracles to ensure secure and immutable data on the blockchain to expand its real-world use cases.