Chainlink is a decentralized oracle service provider that connects blockchains with other blockchains or real world systems. Co-founder Sergey Nazarov describes the protocol as a digital highway, a public good – of which everyone owns a part – that connects various on-chain and off-chain entities, and therefore investors.
Today’s article discusses Chainlink and the way it solves the oracle problem. You will learn more about how Chainlink’s decentralized oracle network works, what it’s used for, and how it powers a $54 billion DeFi industry.
What Is Chainlink?
Chainlink is a decentralized oracle service provider that acts as a bridge between worlds in the blockchain industry. Chainlink uses oracle nodes to connect various systems and trustlessly transfer authenticatable data without the need for 3rd-parties.
Let’s say you have borrowed funds on Aave. You took out a loan for Ethereum and your liquidation level is at $900. If Ethereum at any point drops to $900, the protocol will liquidate your position and take your collateral. But how does Aave track Ethereum’s price in real time? Or even better, how do their smart contracts automatically execute liquidations at that given price point?
Aave needs a price oracle like Chainlink to track Ethereum’s market movement. The price oracle consists of multiple data providers who report on ETH’s price. The average of this set of data points is then sent to Aave and reported as Ethereum’s live price.
Most cryptocurrency protocols today are decentralized thanks to exclusively utilizing smart contracts. But these smart contracts only execute certain tasks once certain requirements are met. They do not generate or track external information - like the price of another crypto asset. For smart contracts to facilitate decentralized financial instruments such as lending, token swaps, and yield farming, they need the help of oracles.
How Does Chainlink Work?
Chainlink works on the premise of decentralized oracles. Oracles act as intermediaries that report certain data sets and convert them into a format understandable by blockchain networks. The purpose of an oracle is to connect two systems – one on-chain, the other off-chain – and deliver data between the two in a transparent, trustless, reliable, and decentralized way.
Such an environment forces the oracle to simultaneously perform three functions: listen, extract, and broadcast.
Listen is a function in which the oracle listens to a blockchain for incoming information. That information might be a user’s request for an external data point such as the weather in New York, the price of Apple’s stocks, the result of last night’s football game, etc.
Extract is a function oracles use to fetch data from external systems – those outside blockchain networks. The oracle can fetch data from Bloomberg’s terminal, the Times magazine, or a bank.
Broadcast is a function that allows oracles to sign and share transactions on a blockchain for the purpose of delivering data to a smart contract. This is the part where a smart contract receives external information with the help of an oracle – one that it can’t access.
Requesting Oracle Services: The 5 Important Smart Contracts
These three functions take place within the scope of five individual smart contracts that the requester (smart contract) and data provider (oracle) sign together.
The first contract is a request contract. This is the smart contract requiring external data filing a request to the oracle.
The second contract is a service level agreement contract. Before fetching external data, Chainlink registers the request contract as an event on its protocol and produces a matching Service Level Agreement (SLA) contract for it on the blockchain.
The SLA contract contains three sub-contracts that fulfill the following functions:
- Reputation contract: verifies the integrity, legitimacy, and track record of an oracle provider (e.g. ETH/USDT price oracle). The contract discards unreliable oracles and selects provably-reputable oracles.
- Order Matching contract: connects Chainlink nodes and their bids with the data requestee (smart contract). Selects the necessary number and type of nodes.
- Aggregating contract: checks aggregated data collected from all chosen nodes and verifies the results.
But how does the protocol ensure that data providers (nodes) act in good faith? This is where the LINK token steps in.
LINK is the protocol’s native utility token. It symbolizes the network’s value and serves as a mechanism for rewarding and punishing nodes.
A smart contract that requires very sensitive information might want to ensure its accuracy by requesting nodes that stake a certain number of LINK. If the node acts maliciously or unintentionally ships bad information, Chainlink will slash the node’s tokens. That might mean losing anything from a few hundred to a few thousand dollars worth of LINK.
When it comes to protocols that have liquidation mechanisms in place, having such a process is more than necessary. Slashing is an important way to prevent malicious actors from bombarding the network with bad data. On the other hand, it rewards those that provide accurate data and act in good faith.
Chainlink and DeFi
Decentralized Finance (DeFi) is a sector that grants crypto investors access to decentralized financial instruments. Such instruments include lending, yield farming, token swapping, etc. A majority of these instruments are only available in the legacy financial system via banks (e.g. taking out a loan) so it's important to bring them to crypto investors as well.
But DeFi protocols are closed off systems that can’t request external information found outside of their native blockchain network. A protocol on Ethereum can’t directly request data from one on Solana and vice-a-versa. Naturally, the DeFi sector needs a decentralized oracle network such as Chainlink.
These protocols often require sensitive data such as cryptocurrency prices, volatility metrics, interest rates, liquidity, etc. Moreover, such data is often found externally on the blockchain. For example, you need to go to Binance, Coinbase or any other centralized exchange to check the price of Ethereum.
Chainlink is a powerful layer of technology that acts as the pillar of the ongoing DeFi movement. It has the potential to, at a future moment, act as a bridge between worlds and connect crypto’s highly decentralized blockchains with financial institutions, banks, and regulators.
Oracles facilitate decentralized and trustless communication in a sector that must enforce decentralization in each part of its ecosystem. Chainlink’s oracle network allows anyone to be a data provider and sign agreements with smart contracts for the purpose of delivering accurate information.
Chainlink’s success depends on the adoption of its network and the incentives it can provide to node operators. By being blockchain-agnostic, it can function on all blockchain networks and essentially monopolize the oracle market. But all of this depends on the security and incentives of a network as innovative as Chainlink.
If you want to read more about Chainlink and decentralized oracles, I recommend reading the following articles: