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Chapter 6:  dApps & Defi

Crypto Oracles: The Link Between Blockchain and Outside World Data

Interesting Fact:
Did you know that oracles serve as the equivalent of messengers in the world of cryptocurrencies?
9 minutes

In this section, we’re going to answer the questions of what is an oracle in crypto, and how important are they in the DeFi ecosystem!

At first glance, oracles in crypto can seem a sophisticated, and therefore, intimidating topic. In previous sections, I covered a bunch of blockchain-related subjects such as smart contracts, DeFi, and blockchains themselves. Crypto oracles are where all of them interlink.

You see, the world of blockchain tech relies on one, crucial aspect - information. Just like oracles were the ones who revealed seemingly unattainable information back in the old days, the modern-day crypto oracles do the very same - they keep things running by providing the latest data.

In this section, we’re going to take a deep dive into the concept and practical application of crypto oracles. I’ll give you a brief introduction of what they are, then I’ll look into how they are applied in practice, and, finally, what are their drawbacks. In the end, you’ll be well aware of what they do, what makes the best crypto oracles, and how they keep the bricks of the DeFi house together!

Without further ado, let’s get to it!

What Are Oracles in Crypto? (Beginner Friendly Animation)

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What Are Oracles in Crypto? (Beginner Friendly Animation)

What Are Oracles in Crypto? (Beginner Friendly Animation) What Are Oracles in Crypto? (Beginner Friendly Animation)

What is an Oracle in Crypto?

Let’s start from the very beginning - what is an oracle in crypto?

The technical definition sounds something like this: “Oracles are entities that provide real-world data, or information, to smart contracts on blockchain networks”. Okay, that doesn’t sound too complex. Why do we need them, though?

Oracles serve as a bridge between the blockchain and the outside world, allowing smart contracts to interact with external data sources in a decentralized (and secure!) manner. It’s thanks to them that smart contracts are able to be activated and execute actions based on verified, up-to-date, and reliable information. Best crypto oracles allow DeFi apps to run flawlessly, without the intervention and supervision of a third, centralized party.

Okay, suddenly, things got a bit more intricate. Let's take a look at it another way. Imagine a pawn shop. Someone brings in a gold watch that they want to sell. Now, to avoid being scammed, the pawn shop owner needs to be aware of how to recognize real and fake gold. Then, in order to accurately evaluate its price, the owner needs to be aware of the current price of gold, and how much particular gold watches go for. Based on their knowledge and experience, the pawn shop owner immediately scans the situation, and can come up with a fair offer.

Now, imagine if the pawn shop owner was on sick leave, and they had a random guy run the shop as a substitute. The substitute worker would have no clue about how to evaluate the gold watch. He would have to either Google things, or call the owner to consult with him. His decision would depend on an external source of information. You could say that… The substitute worker would need an oracle to accurately evaluate the deal.

Let’s turn this imaginary pawn shop into a DeFi application that runs automatically, thanks to smart contracts.

Smart contracts get activated when certain, predefined conditions are met. For example: “if a user pays X amount of coins, the user receives Y amount of different tokens”. If the amount is less than the required X, the smart contract is not activated; therefore, the user cannot receive anything.

But, in order for smart contracts to run smoothly, they need a constant reminder about the state of the ongoing deal, about the value of particular coins or other assets, or the simple fact that the user is solvent, and actually has the required amount of coins or tokens in their wallet. All of these variables substitute one word: information.

That’s where the crypto oracles come in. They verify all of this, and make sure that there’s no fishy business going on. And then, after all of this info gets verified, they trigger the payment, as the smart contract gets activated.

Different Types of Oracles in Crypto

By now, we have found out that the answer to the “what is an oracle in crypto?” question is that they function as a source of external, real-life information that smart contracts depend upon.

It would be easy to simply find a list with all the best crypto oracles named in it. But they differ in many ways, as there are several types of oracles in crypto. What are they?

Well, there are two main kinds, actually - software and hardware oracles.

What is an oracle in crypto: Software oracles.

A software oracle is what it sounds like. An oracle in the form of a specifically designed program to run as the bridge between the blockchain and off-chain data sources. These sources can be web-based databases, and they’re used for consistent tracking of a particular variable, such as the price of an asset, real-life events, or simply web services and their prices.

To tell it in layman’s terms, just like librarians help readers find a specific book within a large library, software oracles help smart contracts find the necessary information to validate and begin executing it themselves.

What is an oracle in crypto: Hardware oracles.

Moving on to hardware oracles. Once again, it’s all in the name. Unlike software oracles, hardware oracles aren’t simply computer programs. They are hardware devices. They operate in physically isolated environments, therefore, they are less accessible to hackers, or other actors guided by malicious intents. This aspect makes hardware oracles stronger and more resilient in terms of security. Their purpose remains the same - to securely transfer data into a blockchain.

So, to sum up, the key difference between hardware and software oracles is the level of security they provide to a blockchain.

Practical Use Cases of Oracles

Furthermore, let’s concentrate on something practical - let’s move on from the question “what is an oracle in crypto?”, and talk about what they do. Specifically, what are the practical use cases of crypto oracles? Let’s zoom in on a specific example - Chainlink, the decentralized blockchain oracle network. As of writing, it’s the most popular oracle in the entirety of DeFi. It’s also the perfect example of a software oracle.

Here’s what it does. Whenever traders engage in buying, selling, or trading coins and tokens, in order for trades to be executed, the smart contract needs to be updated with the latest information about the actual value of a particular coin. For example, whenever a trader is about to make a swap from ETH to the USDC stablecoin on a DEX, a decentralized exchange, the oracle is the mechanism behind precise and reliable price evaluations.

Besides, if you feel like your knowledge about stablecoins or DEXs needs updating, be sure to check dedicated sections to these topics covered in this Crypto 101 Handbook! Now, let’s cement it: oracles in crypto are the tools that keep the network fresh and up-to-date with constant updates about how much a particular coin is valued every moment.

What is an oracle in crypto: Supply chain management.

Furthermore, another crypto oracle use case is supply chain management. Think of an oracle as a GPS device. Just like it tracks the movement of a person, or a car, or a shipment, so does an oracle track the status of transactions of data, be it money, staking, swaps, or whatever, on the blockchain. Whenever a significant change takes place, the oracle gets updated, and sends out the signal to the blockchain.

In addition to these use cases, one more interesting example could be added: gaming. Think of it this way – as gamers continue playing games and climbing up the leaderboard, an oracle tracks the results and updates smart contracts on the blockchain with the latest achievements, progress, and stats.

Challenges and Risks

Now, no one’s perfect in this world. Oracles aren’t an exception, and even if you made a “best crypto oracles” list, you’d still find drawbacks with almost every one of them.

The main challenge that arises from using oracles is ensuring that the data they bring in is accurate and reliable. Instead of tampering with the oracles, attackers can manipulate the sources that oracles gather their data from. If the primary information point is compromised, the oracle will automatically transfer altered data to the blockchain.

What is an oracle in crypto:

Whenever an oracle relies on a single source of data, the risk gets high. This is where the term a Single Point of Failure (SPOF) comes in. It happens when there is a single point or entity that controls the oracle, and it gets compromised, thus hurting the trustless and decentralized nature of the blockchain.

A real-life SPOF example occurs when a power grid goes down because of a failure in a single power station. Just like a power grid, a blockchain network needs multiple sources of data to function properly. An SPOF oracle would mean that the network relied on a single point of informational input that got affected.

Wrapping Up

To conclude, oracles are like messengers of the crypto world, bridging the gap between the decentralized blockchain network and the traditional world of data and information. They enable smart contracts to access and use data from the outside world, making them a crucial component of the crypto ecosystem.

What is an oracle in crypto: Conclusion.

From DeFi to supply chain management and gaming, oracles have a wide range of use cases that are revolutionizing the way we interact with data in a fast, reliable, and decentralized manner.

However, with great power comes great responsibility. It's important to keep in mind the challenges and risks associated with oracles, and to implement measures to mitigate them. These challenges mainly consist of ensuring the accuracy and reliability of the data, avoiding the “Single Point of Failure” issue, and setting up enough barriers and protection from malicious manipulation.

So, whether you're a crypto enthusiast, a blockchain developer, or simply someone who's curious about the future of technology, being able to answer the question of “what is an oracle in crypto?” is essential.