Making Sense of Price Oracles in DeFi

Huobi DeFi Labs, the latest venture of the Chinese cryptocurrency exchange Huobi, is the platform for Defi research, investment, and ecosystem building. The Chinese venture portfolio for the Defi Industry with a focus on lending, decentralized exchanges, and derivatives markets, has issued its first research report “Price Oracle: a Must-Have Infrastructure”. It makes a strong case for the adoption and usage of oracle projects and suggests that price oracles are an integral part of the decentralized financial services infrastructure.

Blockchains cannot communicate with events taking place outside of the network, while application layers facilitating dispute settlement, liquidation, and risk management could not be possible without off-chain information. Oracles are the messenger of the off-chain events in the blockchain infrastructure. 

According to the research, the DeFi sector has notable differences from the traditional finance industry such as:

Lack of viable options to conduct proper risk management; 

Time in the on-chain world is discrete rather than continuous, measured on a block by block basis;

Existing automated market makers rely on arbitrageurs to ensure that prices on AMM DEXs do not deviate from the actual market prices;

Liquidity providers are not compensated enough for having market exposure on volatile assets.

The report reviews the period of May-September 2020, in which Chainlink and Nest Protocol (another oracle project) appear among the TOP25 Ethereum gas fees consumers. In October, those two projects appeared to be among the Top ETH consumers, spending collectively almost $2.5 Million worth of $ETH at the time of writing. Similarly, while the Google search index of keyword “blockchain oracle” was close to zero, we noticed a spike in the search terms during the summer, with a trend that seems to continue during the autumn. The low Google search index implies further growth potential since oracles remain a core blockchain infrastructure, which seems yet undiscovered. 

There are two types of oracles — centralized and decentralized ones. 

Centralized

Among the notable centralized oracles is the Coinbase Price Oracle, which takes Coinbase Pro’s API as the data source, and later excludes data points with significant deviation. DeFi projects that are requesting data fees can make calls to Coinbase Price Oracle with public key verification enabled. 

While centralized exchanges are more practical to be used, there is only a little adoption, mainly due to the security concerns. A typical attack could be orchestrated by an attacker by controlling the oracle data sources, and then broadcast malicious information to a smart contract that relies on the data, thus contaminating the decentralized trading environment. 

Decentralized 

Decentralized oracles are widely accepted by DeFi platforms such as lending services, derivatives, and some DEXs, which all need a reliable oracle to access price data. 

Ethereum Ecosystem: 

The Ethereum ecosystem is featuring mainly four Decentralized Oracle Projects: Chainlink, Band Protocol, Tellor and Nest Protocol. 

Chainlink provides feeds for 55 trading pairs, including 30 fiat pairs. At least $2.5B are locked values in crypto assets, which are referencing to Chainlink price oracles. 

Band Protocol beyond cryptocurrencies can also connect to trusted data sources such as weather, lottery, or even unemployment rate through traditional Web APIs with customised oracle script. 

Tellos takes the old fashion Proof of Work Method combined with the staking concept to maintain data quality. Users can request data by adding the Tellor token as a tip. 

In general, the decentralized oracles, the price generation process is created as follows:

Off-chain data upload > On-chain validating > Feed Data 

Of course, Ethereum decentralized oracles are likely to fail to update due to the Ethereum network congestions and extreme market conditions, like the one on Black Thursday. 

Polkadot Ecosystem: 

Kylin Network aims to Build a Cross-chain Platform Powering the Data Economy, which aims to be the Data Infrastructure for DeFi and Web 3.0 Powered by Polkadot. The Open API and SDK of Kylin Network offers any applications and blockchains (such as parachains and parathreads) instantaneous but transparent, reliable and valid on/off-chain market data and social data sources by leveraging the power of Polkadot/Substrate Framework on open networks. 

Kylin Network represents extensibility and a synergetic increase to the off-chain workers’ capability as it will provide not only access, management, insights, coordination to a greater array of data sources, but bolster validity and decentralization of the data sources themselves.

Kylin has chosen Polkadot, due to the weaknesses of Ethereum, especially high transaction costs, and low scalability. Thus, an implementation based on the Polkadot network and its cross-chain interoperability is a better solution for the blockchain ecosystem.

Kylin has received a grant from the Web3 Foundation. According to Polkadot, the grant program's aim is to  steward the Web 3.0 ecosystem and carefully manage Web3 Foundation resources. "We provide grants that we believe will return the highest impact on the Web 3.0 ecosystem over the long term". 

Kylin is one of the few grant winners in its most competitive grant wave to date, Wave 8. Via Polkadot, Kylin can theoretically allows work on any chain in existence and potentially any new chain in the future via Polkadot's novel bridge-chaining interoperability features.

The project is among the oracles projects that have not yet launched a token, though it’s for granted that it is expected in the near future since tokenomics it’s an integral part for the safeguarding of the network. 

Harmony Ecosystem 

Both Chainlink and Band Protocol are building decentralized oracles on Harmony. The project has solidified its edge as one of the most cutting edge blockchains for security and scalability through sharding by dividing not only the network nodes but also the blockchain state into shards — scaling linearly in all three aspects of machines, transactions, and storage. 

Furthermore, Harmony has innovated on the battle-tested Practical Byzantine Fault Tolerance (PBFT) for fast consensus of block transactions to a Fast BFT (FBFT) which leads to low transaction fees and 1-block-time finality in Harmony Mainnet. To date, the network has produced over 20M+ blocks without any issues.

A small team in the Harmony community has already started building an application choosing to utilize Band Oracles on Harmony. Until then, here’s a system diagram as a teaser…😀

Comparison of Decentralized Oracles 

Price delay and price deviation are two key risk factors presented in all oracle infrastructure. Huobi DeFiLabs researchers conclude that network congestion or a lack of price feed can cause price delay causing price deviations. These two risk factors can influence the performance of other DeFi platforms on these oracles. Unfortunately, there is no way to eliminate price delay and price deviations due to the fact that the off-chain world runs on continuous time, but the on-chain world runs discreetly by block. In fact, the transfer of asset experience from off-chain to on-chain will produce three different prices with small deviations: exchange quotations, oracle theoretical feed prices, and on-chain quotations (true price generated by Oracles).

Similarly, in a recent report that dates back to August 2020, OKEx academy suggested that despite the hype, blockchain oracles could offer huge potential. Without external data, the utility of smart contracts is limited to those applications relying on on-chain data alone. Future adoption of smart contract technology should, eventually, create huge demand for oracle services from other industries, too.

In an interview with OKEx Insights, Michael Zemrose, Tellor’s co-founder, reasoned that the market is only just beginning: 

“I think 2020 was the year most people first learned about oracles and their importance in smart contract security as a key part of the crypto infrastructure. It makes sense that the market understands that value.”

In a similar note, Kylin’s Network CEO, Dylan Dewdney, noted: 

“The market always evolves and turns on fundamental problems getting solved. Connecting to the real world to the blockchain is a fundamental problem and has become an acute need as crypto is on the precipice of mainstream adoption. The stakes are high for both crypto in general and for decentralized oracle solutions specifically, because they genuinely need the other for the next evolution to occur: a blockchain world.”