Institutional adoption sparks excitement as new launches storm DeFi
Blockchain oracles & DeFi use: Is hype or substance driving the market?
The rise of oracle tokens and their role in the DeFi market
Along with an explosion of interest in decentralized finance, or DeFi, one of the biggest, albeit quieter, crypto success stories of 2020 is that of the blockchain oracle. Generally, a blockchain oracle is a service that allows smart contracts — i.e., blockchain-based programmable contracts — to access data that’s not stored on a blockchain. This data could be an asset’s price, election results, supply chain information or even which team won a football game.
While there is considerable optimism about how smart contracts will transform many industries, without a reliable source of off-chain data, their utility is severely limited. In cryptographic circles, this problem is hardly a new one. However, its successful resolution is crucial if blockchain and smart contract technology are to have the kind of impact that many believe they’re capable of.
In this article, OKX Insights looks at the rise of blockchain oracle services and the rapidly growing market capitalizations of the platforms providing them. While there is certainly demand for decentralized oracle services, we consider whether it’s actual usage or simply speculation that’s driving the surging prices of oracle platforms’ tokens — namely Chainlink’s LINK, BandChain’s BAND, Nest Protocol’s NEST and Tellor’s TRB.
The year of the oracle?
With a combined market capitalization now approaching $6 billion, cryptocurrencies native to oracle service applications are among the most talked about in the industry today. Having pumped over 600% over the last 12 months, market-leader Chainlink’s LINK token is currently occupying the fifth spot in terms of market cap on crypto comparison site CoinGecko.
Oracle protocol competitors launched more recently have experienced similar buzz. NEST, BAND and TRB have risen by around 90%, 170% and 240%, respectively, in the last 30 days alone. With what seems like almost any project that claims to have solved the blockchain oracle problem seeing meteoric price rises, it’s clear that the idea of blockchain oracles appeals to the crypto-investing public.
A brief history of the oracle problem
Long before the birth of cryptocurrency, the utility of smart contracts was clear to some. Writing in 1996, visionary cryptographer and legal scholar Nick Szabo coined the term. He defined smart contracts as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”
Like Szabo, Bitcoin’s (BTC) creator recognized the role smart contracts could play in a future decentralized economy. In 2010, cryptographer and early Bitcoin developer Gavin Andresen spotted functions encoded into Bitcoin that were then inactive. When Andresen asked Satoshi Nakamoto about said functions, they replied:
“The design supports a tremendous variety of possible transaction types that I designed years ago. Escrow transactions, bonded contracts, third party arbitration, multi-party signature, etc. If Bitcoin catches on in a big way, these are things we’ll want to explore in the future, but they all had to be designed at the beginning to make sure they would be possible later.”
A few years later, another early Bitcoin developer emphasized the future importance of smart contracts. Speaking at Bitcoin 2012 London, Mike Hearn gave several examples in which programmable money could increase efficiency and decrease risk across a variety of processes. They included the automatic settling of a will, the selling of a vehicle without either an intermediary or the seller even being physically present, and, much to the crowd’s delight, a future financial system in which smart contracts replaced trusted third-parties — namely banks.
While Hearn’s inheritance example certainly used an oracle of sorts (in the event of the grandfather’s passing, a smart contract would reference a national register of deaths), many of the nuances that would dominate later discussion were left unaddressed. They would, however, come to the fore around the launch of Ethereum in 2015.
The Ethereum white paper acknowledged the need for oracles in delivering non-blockchain data to blockchain applications. However, it ceded that “a trusted source is still needed” to provide information not native to any blockchain.
As expounded in the articles of prominent developers at the time — as well as Ethereum’s co-founder, Vitalik Buterin — relying on such a source of information would be fraught with security issues. Among the concerns were the potential for a single oracle to act maliciously for financial gain or the fact that decentralized applications would cease to function should the data source drop its service.
The discussion gave rise to several early efforts at solving the oracle problem. Reality.eth, Orisi and Counterparty were among them — as was an early iteration of Chainlink, although the proposed solution of parent company SmartContract.com relied on centralized data sources to provide data to blockchain applications until a few years later.
In 2017, SmartContract.com began working on a decentralized oracle service to act as a bridge between blockchains and the world outside them. The company raised $32 million in its initial coin offering in September 2017 to fund the development of what would become Chainlink. Built on the Ethereum network, the Chainlink mainnet went live in June 2019. Its subsequent success inspired other oracle projects, including the aforementioned BandChain, Nest Protocol and Tellor.
Solving the oracle problem is a big deal
Much of the potential of smart contract platforms like Ethereum relies on the availability of trustworthy data from the outside world. A price-predictions market, for example, is of little use if price inputs do not reflect reality.
Ethereum and its aim to support a range of decentralized applications attracted immense speculation in 2017. Investors piled into the market, inspired by promises of a future in which smart contracts would allow for intermediary-free ride-sharing services, automated insurance products and immutable supply-chain data. The price of Ether (ETH) on Jan. 14, 2017 was just $9.70. Exactly one year later, it peaked at around $1,470 per coin.
Adding fuel to this price rise, and at least in part related to investors’ belief in Ethereum’s future utility, was the boom in fundraising via initial coin offerings — generally referred to as the 2017 ICO bubble. If Ethereum was going to be home to the decentralized applications of the future, the development of such platforms needed funding. In exchange for funding a given platform — often with ETH, which further drove up demand for the coin — investors received that platform’s tokens. Many ICOs were arguably driven mainly by investors’ speculation on a token’s price going up as the platform in question developed over time.
As the interest in ICOs peaked in 2017, investors poured money into just about any project with a buzzword-heavy white paper and some grand decentralized vision of tomorrow. As it turned out, many of those projects had failed by as early as the following year.
As John Adler, a former developer at Ethereum-focused software company ConsenSys, highlighted in September 2018, adequate scaling technology is needed to make a smart contract-enabled blockchain usable — only with reliable oracle services would such a platform find true utility. Without a trustworthy source of off-chain data, a smart contract’s use would be limited to applications requiring only information present on the particular blockchain on which the application was built.
With Ethereum struggling to function at scale, provide a solution to the oracle problem and having been heavily inflated by ICO speculation, Ether’s price crashed 94% over the 11 months following its January 2017 high. Clearly, the platform’s fundamental value did not match the inflated market price of ETH. However, the rise itself demonstrated that the market saw great value in what Ethereum set out to achieve, even if it wasn’t ready to deliver it in 2017.
It’s clear that trusted oracles, capable of providing a source of tamper-free, reliable data, will be part of the evolution of cryptocurrency. With a series of projects now purporting to provide just that, smart contract technology appears to have taken another step toward the real-world uses that inspired much of the speculation of 2017.
Oracles quick to find a use case
Oracle-related cryptocurrencies are not the only projects to receive a massive influx of capital in recent months. The use of DeFi applications, built on smart contract-enabled blockchains, is also growing. At the beginning of 2020, there was just $681 million locked in so-called DeFi apps. Fast-forward eight months and the combined total, according to DeFi Pulse, hit an all-time high of about $6.8 billion.
The rise of oracle tokens and the use of DeFi are, of course, linked. DeFi relies on price data from various markets. Not being available on the blockchains themselves, this price data must be sourced from elsewhere. Some decentralized financial applications have taken on the oracle problem themselves, and others have outsourced the task to dedicated oracle “middleware” providers like Chainlink and others.
This early application of decentralized oracles is certainly contributing to the recent price performance of the so-called oracle tokens, such as LINK, BAND, TRB and others. LINK, for example, is used to both pay off-chain data feeds, as well as serving as collateral for those providing data to ensure the quality of information and reliability of the feeds. If a project wants to use Chainlink’s oracles, it needs access to LINK tokens.
Similarly, BandChain uses its own native token, BAND, as collateral, as a means of payment and as part of its governance model. Tellor’s Tribute Token, TRB, is also used to pay data providers and is staked by miners, providing the basis for its own security model. Increased use of such services should, therefore, see the prices of the protocols’ native tokens rise.
Does utility match the market caps?
While DeFi provides the dominant use case for blockchain oracle services today, the market capitalizations of the two niches suggest that prices are not based on current use alone. Chainlink, for example, has seen its own market cap rise to over $7.4 billion in its relatively short existence, peaking earlier this month — a figure greater than the almost $7 billion locked in DeFi smart contracts today.
A closer look at the Chainlink network shows that there is clear demand for its oracle services. Chainlink Oracle Reputation details recent node activity on the network, highlighting which data feeds are live as well as the jobs they have completed.
While some Chainlink nodes are certainly active, the available data feeds from those nodes that have completed jobs during the last seven days exclusively provide asset prices. This suggests that use outside of DeFi is currently almost nonexistent and that the actual usage of LINK tokens for nonspeculative ends still very much relies on the use of DeFi applications.
Meanwhile, analysis of the BandChain network suggests that actual network use is an even less significant factor in its own token’s recent price run. Of the 79 total data sources currently live, almost all deal with asset prices. While there do appear to be feeds for both weather and flight data, there is very little network activity relating to any data sources, including price feeds, at this early phase of the project. Evidently, speculation on the future use — or price — of BAND is outpacing actual utility at the moment.
The chart below showing LINK’s price over time is eerily reminiscent of many cryptocurrencies from late-2017. While fundamental developments and usage certainly had a part to play in the previous bull run, the rapid appreciation of prices at the end of 2017 was the product of pure speculation.
Today, oracle services are seeing a similar rise. Just as the ICO boom gave a real-world use case to ETH, DeFi provides utility to oracle services. However, with the market capitalization of the oracle projects comfortably exceeding the combined value locked in DeFi smart contracts, speculation appears to have overtaken actual usage.
DeFi risks are oracle risks
Attracted by elaborate lending and borrowing strategies that generate profits for those savvy and wealthy enough to deploy them effectively, the number of DeFi users continues to grow. Much of the sector’s recent expansion can be attributed to so-called “yield farming.”
As mentioned, DeFi currently provides the dominant use case for oracle services like Chainlink. Until another application of smart contract technology garners the same level of interest, the continued use of oracle services demands the continued use of DeFi.
That’s not to say there won’t be future demand from other industries. When Chainlink’s founder, Sergey Nazarov, spoke at ETH Denver this year, he mentioned applications like decentralized insurance that oracles will one day provide data for. However, with most of the presentation firmly focused on DeFi — and almost all current data feeds providing the prices of different assets — it’s clear where Chainlink’s dominant market is today.
While the growth of funds locked in DeFi applications is certainly good news for oracle services, the sector is not without risk. Discarding the fact that it’s possible for inexperienced users to suffer heavy losses, the smart contracts themselves provide a lucrative target for hackers. Potentially locking up millions of dollars each, there’s a clear incentive to find vulnerabilities in the code.
This isn’t just a theoretical attack vector. DeFi smart contracts have been exploited before, and the risks are substantial enough for the co-founder of Ethereum to warn users. Speaking on Laura Shin’s Unchained podcast in July, Buterin advised against users underestimating the dangers. He went on to comment on the future of yield farming:
“It’s a short-term thing. And once the enticements disappear, you could easily see the yield rates would drop back down very close to zero percent.”
More recently still, Buterin tweeted similar concerns:
Along with potentially diminishing returns and the risk of smart contract exploitation, DeFi could become the target of regulators. As DeFi is still in its infancy and presents a radical new set of risks, financial regulators will certainly be mulling over ways to protect investors. An overzealous clampdown on the sector could see interest drop significantly — as was the case with ICOs following regulatory scrutiny. This too would temporarily damage the value proposition of those oracles finding utility serving DeFi applications.
A 2017 rerun? Partnerships, listings, hype
Much of the current excitement surrounding oracle services appears to be driven by high-profile announcements. At the time of writing, Chainlink has reportedly partnered with 258 different entities that work in a range of industries — from video games to real estate. Included in the list are household names like Google Cloud, SWIFT and Intel, along with several Korean banks and Deutsche Telekom’s IT subsidiary, T-Systems.
Perhaps most notable among those reportedly interested in Chainlink is China’s recently launched Blockchain Services Network, or BSN. Announced via press release in late June, the deal may see Chainlink oracles provide data to members of the BSN. Those founding the service include China’s State Information Center, China Mobile, China UnionPay and Red Date Technologies.
Historically, news regarding China’s relationship with blockchain has given rise to both uncertainty and optimism in the cryptocurrency industry. A recent example comes from 2019. Chinese President Xi Jinping announcing support of blockchain technology caused the combined crypto market capitalization to increase by more than 23% in a matter of days. News that the Chinese blockchain industry now appears interested in Chainlink seems a likely contributor to the rise of blockchain oracle prices.
Although less impressive, developments in other blockchain oracle services also appear to be driving speculation. The Sequoia Capital-backed Band Protocol — the company behind BandChain — saw the price of its BAND token pump following its listing as an initial exchange offering on Binance in 2019 and its addition to Coinbase Pro in August 2020. Coinbase also added pricing data for NEST in July, lending further credence to the belief that oracle services are, or will be, vital to the blockchain ecosystem.
Being fueled in part by a growing list of high-profile partnerships, it’s not just the LINK price chart that has similarities with Ether’s 2017 run. The February 2017 launch of the Enterprise Ethereum Alliance and subsequent membership announcements seemed to kickstart a wave of speculation on its future use that, combined with the asset’s use in ICO funding, helped take ETH to its all-time high.
LINK’s own price has experienced similar gains surrounding announcements. On June 13, 2019 — the day Chainlink tweeted the addition of Google Cloud as an ecosystem partner — the LINK price increased by more than 65%, rising from $1.13 to $1.87 in a few hours.
Scaling issues and Ethereum oracles
The scaling issues that limited Ethereum’s use in 2017 are still relevant today. Gas prices — i.e., fees for transacting on the Ethereum network — are currently rising. According to Ethgasstation.info, Chainlink itself is now the eighth-largest user of gas on Ethereum. Users of Chainlink’s oracle services have reportedly spent almost $1 million on transaction fees in August alone.
If Chainlink’s high-profile partnerships do result in greater usage of the network, increased gas demands will send Ethereum fees even higher. Until a solution to the scaling problem is implemented, obtaining data from Ethereum-based decentralized oracles may become prohibitively expensive and may, ultimately, limit adoption.
Scaling is one of the most pressing topics in the cryptocurrency industry. The Ethereum network’s much-anticipated upgrade to Ethereum 2.0 will address the issue. However, as Buterin mentioned on Unchained, sharding — a breakthrough that aims to radically increase the Ethereum network’s total transaction capacity — is not part of Phase 0 of the upgrade. Instead, it’s expected in a later phase of the network overhaul.
That said, there are other efforts to scale the network in the works. Second-layer, or so-called Layer 2, technologies like Optimistic Rollups and ZK-Rollups move some transaction data off-chain. In explaining the concepts earlier this year, Buterin optimistically stated that these improvements should allow Ethereum to process more than 1,000 transactions per second, even before sharding goes live. A serious increase from the 15 transactions per second currently possible, such implementations should allow the network to support a greater number of smart contracts without leading to transaction fee spikes. This will also increase the fundamental value of those oracles serving them.
Competition in the blockchain oracle space
The explosion of interest in DeFi this year has not only provided a use case for Chainlink, it has also inspired the creation of other oracle services. Increasingly, developers are looking for their own solutions to the blockchain oracle problem.
In the same month, OKX also launched its own oracle. Based on the OPF standard, the service aims to add another source of reliable price data for use by Compound and other DeFi applications.
In addressing whether consensus oracle systems like Chainlink, BandChain and others can compete with industry heavyweights providing similar data, the team behind OKX’s oracle commented:
“Different data types will come from different data sources, and as such, a wide variety of oracle types and providers will emerge. These oracles will vary in trustworthiness — a gauge of their data accuracy as well as their uptime.
“OKX’s oracle will be the most trustworthy for OKX market data. This means that no other oracle can guarantee that it knows the prices of our many markets better than we do. Services like Chainlink might continue to exist as a method to aggregate less reliable data oracles as well as to provide backup in case of service interruptions. In addition, data types with unclear sources of truth may also be served by consensus oracle systems like Chainlink (e.g., how many dogs live in NYC today?).”
Blockchain oracles: A lot of hype but huge potential
It’s clear that blockchain oracle services, in some shape or form, have a future. Without external data, the utility of smart contracts is limited to those applications relying on on-chain data alone. The growing DeFi sector has already given a use case to existing oracle platforms. Future adoption of smart contract technology should, eventually, create huge demand for oracle services from other industries, too.
In an email exchange with OKX Insights, Tellor’s co-founder, Michael Zemrose, reasoned that the market is only just beginning to understand the role oracles will play in the proliferation of smart contract technology:
“I think 2020 was the year most people first learned about oracles and their importance in smart contract security as a key part of crypto infrastructure. It makes sense that the market understands that value.”
However, there are clearly issues with current solutions. Rising Ethereum gas prices and the inherent risks of DeFi itself may leave oracles struggling for a use case until either scaling is achieved or additional applications for oracle services gain momentum. Admittedly, Band Protocol recently launched its BandChain on the Cosmos blockchain, specifically to “sidestep congestion concerns” on Ethereum, according to the project’s CEO. This will protect it from increasing gas prices but not from a suddenly contracting DeFi market.
The largest DeFi projects, such as Compound and Maker, have also been developing their own solutions to the oracle problem. Meanwhile, huge industry names like OKX and Coinbase now provide their data directly to decentralized applications via Compound’s Open Price Feed. Given the considerably lower price for data, those projects currently providing fundamental value to blockchain “middleware” providers may simply choose to go with a cheaper option.
As alluded to by the OKX Oracle team quoted above, there are limitations to the kind of data crypto exchanges can provide. While their price feeds increase the security and reliability of DeFi applications, nonfinancial data is unavailable to them. Efforts like Chainlink’s, which aim to simplify using nonfinancial data with blockchain systems, may have the edge when the use of smart contracts expands into other industries.
By lowering the technical barrier of entry for using smart contract technology, such projects make it easier for developers to create innovative, non-DeFi applications without taking on the oracle problem themselves. This may well usher in a wave of smart contract adoption across myriad industries, providing a fresh market for oracle services that reduce reliance on centralized data reference points.
Oracles, in some shape or form, will certainly enable the expansion of the cryptocurrency industry into exciting new areas. However, the rapid growth in prices of oracle protocol tokens such as LINK, BAND and TRB suggests that it’s an expectation of future utility rather than present usage, which is currently inspiring investment.
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