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Oracle's Role in DeFi: Bringing Real-World Data to DApps

April 24, 2024

The problem of insufficient interoperability between networks has been plaguing the DeFi industry for some time. Networks cannot exist in a vacuum and need to connect with each other, the rest of the crypto ecosystem, and sometimes even the world beyond to perform effectively. Oracles can assist in building such connections by linking blockchains' smart contracts and external data together. 

Oracles are third-party data services that help closed systems, such as blockchain networks, communicate with the rest of the world. They fetch information from different sources and then supply the gathered data to dependent entities, thus allowing the execution of actions and processes connected to specific circumstances. The most widespread example of such action is the completion of limit orders. 

Oracle Classification

Oracles are typically classified in regard to the level of their centralization, the source of data they transfer, and the direction of that transfer. Firstly, oracles can be centralized or decentralized. Centralized oracles are operated by a single entity, which chooses what data sources to aggregate. Such an approach creates serious security risks since these oracles are more likely to be attacked, censored, or compromised otherwise. Decentralized oracles are designed to prevent such risks. By using multiple data sources and dividing trust among many members of so-called DONs (decentralized oracle networks), they provide a higher level of security and more seamless operation. 

Secondly, oracles are divided into software and hardware. While the first obtains data from various digital sources (websites, databases, APIs, etc.), the second gathers data from the real world through sensors, scanners, or other devices. In addition, there is a rare case of human-powered oracles that receive data from people.

Thirdly, oracles can be inbound (importing off-chain data into blockchains) or outbound (importing blockchains' data off-chain), the first being more typical. This means that even though the focus is usually on transferring information to blockchains, the opposite is also possible, as the communication between oracles and blockchains' smart contracts is two-way. 

DeFi Use Cases

When it comes to DeFi, the primary use case for oracles is delivering accurate information for various apps, be it for trading, lending, or other services. One prominent example is indeed trading. Most trading software and apps depend heavily on oracles since the latter supply them with price rates, thus enabling them to execute trades based on ever-changing market conditions promptly. The quickness and correctness of data received influence the efficiency of trading strategies, allowing traders to take advantage of arbitrage opportunities.

Another example is DeFi lending platforms, which also rely heavily on oracles for data supply. With the help of oracles, they can manage loans effectively and ensure that all of them are sufficiently collateralized, thus mitigating default risks. As a result, borrowers can access affordable loans without needing much collateral or none at all. 

Potential Developments

Developers are constantly improving and customizing oracles, just like any other technology or tool in the DeFi industry. The primary objective of developers is to maintain the accuracy and reliability of the data provided by oracles. As was mentioned above, to address the risk of data being compromised or manipulated, there has been a move towards employing DONs as they provide better security. For instance, suppose one of the decentralized oracles fails to function as intended or tries to feed faulty data. In that case, a smart contract relying on those oracles will still function, supported by the rest of the network.

Another way to ensure data integrity is to expand the range of data sources and services. An increased number of sources would enable oracles to access more diverse data types and support a broader array of DeFi applications. Scoring can also be beneficial. Some DONs are implementing reputation systems to rank data providers based on their past performance and reliability. Such an approach incentivizes data providers to maintain high standards and improves overall data quality.

The second popular development direction that ensures oracles' efficiency and the security and privacy of oracle-transmitted data is the use of zero-knowledge technology, namely ZK proofs. They enable oracles to prove data accuracy without revealing the data itself, which is particularly crucial when dealing with sensitive information, as it allows for its validation without compromising confidentiality. Moreover, ZK-powered oracles can enhance transaction speeds and decrease expenses while maintaining the accuracy and authenticity of the data.

The third trend in oracle development is cross-chain compatibility. As the DeFi space advances, cross-chain compatibility becomes indispensable for promoting interoperability and supporting more complex use cases. This necessitates the development of novel technologies and strategies to guarantee that data can be transmitted securely and efficiently across different chains. Therefore, oracles are increasingly designed to work across multiple blockchains, thus allowing for seamless data transfer and network interoperability, which are essential for prompting the creation of more efficient cross-chain applications.

Hybrid smart contracts are the fourth trend in the blockchain industry. They are a combination of on-chain code with data and computation sourced from outside blockchains and are facilitated by DONs. Hybrid contracts enable developers to create more sophisticated and versatile apps by leveraging additional capabilities provided by oracles, including scalability and confidentiality.

Final Thoughts

Oracles are a fundamental component of DeFi's development. They empower the creation of more intricate and sophisticated applications and services that cater to the evolving needs of the crypto community. By improving the speed, security, scalability, and adaptability of blockchain oracles, the crypto industry can unleash the crypto's full potential and build the next wave of decentralized solutions that are more efficient, reliable, and trustless.

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