What is Chainlink - DeFi Oracle Network Explained

What is Chainlink? DeFi Oracle Network Explained

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Chainlink is one of the most popular blockchain projects at the moment, with the LINK token being among the top ten largest cryptocurrencies out there. Chainlink’s market capitalization has surged thanks to an increased interest in Decentralized Finance (DeFi), which has been the fastest-growing sector of the crypto industry.

In a nutshell, Chainlink is a decentralized oracle service that collects and filters external data and redirects it to smart contracts on Ethereum and other blockchain networks. It helps various blockchains connect with the real world. In the present article, we’ll discuss all the intricacies of Chainlink to see whether it is a project worthy of consideration. This will help you make an informed decision in the case you want to add LINK to your portfolio or maybe stake the token.

What is Chainlink?

Chainlink is like a group of well-versed individuals who are always trying to distinguish the best-quality information that is closest to the truth. These individuals are called oracles, which represent nodes in the Chainlink network. The oracles feed data from the outside world into the smart contracts of blockchains. While Chainlink is not a DeFi project per se, it helps many DeFi applications to explore relevant data from the real world. This is why LINK surged along with the DeFi boom, but we’ll discuss its price performance a bit later.

In order to become an oracle and provide data to blockchains, nodes should stake a certain amount of LINK. They are rewarded for their effort with LINK tokens, but they can face penalties in the case they provide inaccurate data.

The blockchain-based oracle network enables smart contracts to leverage real-world data by connecting to external sources, which may include APIs and other types of data feed from the outside world. If you’re still not familiar with the smart contract, it represents a blockchain-powered online agreement programmed to execute or settle when certain predetermined conditions are met. In other words, smart contracts can replace third-parties like banks, judges or notaries to handle various agreements between two or more parties. Smart contracts have been used in various use cases, from handling sales to creating new digital assets.

However, one of the most important issues of smart contracts is that they have to rely on data coming from the outside world in order to settle based on the terms, and the information might not always be accurate. For example, smart contracts used to tokenize company shares may need access to APIs providing real-time market prices.

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A centralized oracle is problematic because it is the only one that provides access to external information to a smart contract. But what if this single source is ill-intentioned or simply fails to provide accurate data? In this case, the smart contract will be triggered on erroneous terms. This is a serious problem that Chainlink tries to solve, and it seems that it does a great job so far. 

Smart contracts are used to automate agreements on blockchains. Evaluating information is one of the most important processes because the predetermined conditions that trigger the execution of smart contracts rely on the accuracy of external data. Traditionally, connecting to off-chain data was a big challenge for most blockchains since they are digital and closed networks.

However, Chainlink manages to address this problem by providing a decentralized network of multiple oracles, which reduces the risk of manipulation, as there is no single point of failure. Each oracle represents a piece of software that translates real-world data to a language readable by smart contracts and vice versa.

Chainlink - Smart Contract Network
Source: Chainlink – Smart Contract Network

Now let’s see what makes Chainlink unique in comparison to other blockchain oracles.

How Does Chainlink Work?

Chainlink relies on a decentralized network of nodes, which makes the data provided to smart contracts way more reliable and trustworthy. Here is how the service operates: when a smart contract needs some external data, it places a request for it on the network. The Chainlink protocol then registers this event and transmits it to the nodes, which are free to take their “bids” on the request.

In this way, Chainlink can collect data from multiple sources. It employs a proprietary reputation system that figures out whether the sources represented by nodes are reliable. This approach ensures that the information reaching smart contracts is accurate and is not manipulated by bad actors. 

LINK plays an important role in the ecosystem. The smart contracts asking for external data pay node operators in LINK in exchange for their effort. The prices are decided by node operators considering the current market conditions for that specific data.

Besides this stream of income, node operators also stake LINK on Chainlink to demonstrate their long-term dedication to the ecosystem. To rule out malicious behavior, Chainlink penalizes nodes that provide inaccurate data.

To enable smooth communication between nodes and external data sources, Chainlink has split its execution process into three distinguishable steps as follows:

  • Oracle Selection – Initially, network users draft a so-called service-level agreement (SLA), which defines a series of demanded data requirements. The internal software then takes the SLA and matches the requirements with oracles available to provide the data. Once the conditions are set, the user submits the SLA and puts his LINK tokens in an Order-Matching contract, which awaits bids from oracles.
  • Data Reporting – During this step, oracles connect with off-chain sources and get external data as requested in the SLA. The information is then processed by oracles and sent to smart contracts running on Chainlink.
  • Result Aggregation – This final step is about checking the results of the data collected by oracles and sending it to a so-called Aggregation contract, which verifies the accuracy of the information and returns a weighted score to the user. Note that the score is based on the collected data that is merged into a single result.

The last operation is the distribution of LINK. Nodes that provided accurate data become eligible to receive LINK as a reward. On the other side, nodes that had sent incorrect data lose LINK. The distribution process is taking place automatically.

Architecture

The Chainlink network revolves around three types of smart contracts as follows:

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  • Aggregating Contracts – Contracts collect data from oracles and send the most accurate results to the smart contracts that require them.
  • Order-Matching Contract – Matches a smart contract’s SLA with the best oracles.
  • Reputation Contract – Verifies the oracle’s authenticity and integrity by monitoring its track record. The main parameters influencing an oracle’s reputation are the total number of completed requests, average response time, and amount of staked LINK.

It’s worth mentioning that Chainlink also connects with oracles that do not operate on its proprietary blockchain, and that may collect external data requested by the contracts independently.

Speaking about Chainlink nodes, they consist of two elements:

  • Chainlink Core – Component that reads the submitted SLAs and redirects assignments to the Chainlink Adapter.
  • Chainlink Adapter – Connection point between nodes and off-chain data. The adapter is capable of reading and processing data and writing to the blockchain.

A Bit of History

Chainlink is a relatively new project, compared to other large blockchains, such as Ethereum, Litecoin, and Ripple. It was launched in the summer of 2017 by a company known as SmartContract. Co-founders Steve Ellis and Sergey Nazarov released the white paper in September of the same year.

The project held an initial coin offering (ICO), raising about $32 million by selling over a third of the 1 billion supply of LINK. Another third was put aside to incentivize oracles and less than a third was allocated to SmartContract to be used for the development of the project.

The token showed some bullish attempts in 2019 and then skyrocketed last year. We’ll discuss the price performance in detail a bit later.

Chainlink and DeFi

There is a strong connection between Chainlink and many DeFi projects, which requires off-chain data to conduct their operations. DeFi has become very popular last year, and the sector has seen a growing interest in top-notch oracle solutions. Most DeFi projects rely on smart contracts, which require accurate information to run properly.

DeFi platforms that rely on centralized oracle services are exposed to major vulnerabilities, including data manipulations and attacks. Incidents like these have already been reported during the last few years.

While Chainlink might not address all the issues related to data accuracy, it is the most advanced oracle platform at the moment and can greatly reduce oracle manipulation risks. This is why popular DeFi projects like Aave and Synthetix use Chainlink’s technology.

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Chainlink is a decentralized, global network of oracle nodes, and it apparently has no single point of failure. Still, even platforms like Chainlink are prone to attacks. For example, in September of last year, the network experienced a “spam attack” in which the attacker stole up to 700 ETH from node operator wallets. While the incident was addressed immediately, it shows us that all systems have some vulnerability that can be exploited by bad actors.

Pros and Cons of Chainlink

While Chainlink is the most advanced and popular oracle platform at the moment, it still has room for improvement.

Pros: Here are the main advantages of the network:

  • Chainlink empowers smart contracts by making sure they receive reliable data to execute based on the predetermined conditions.
  • Chainlink actually addresses one of the most important problems in the blockchain space – the oracle problem. It tries to solve it and it’s almost there.
  • The project is trusted by a long list of reputable entities, including Oracle – the $115 billion tech giant itself, Google, and SWIFT, among others.
  • Chainlink is the first platform that implemented a practical solution for the oracle program. Thus, it is years ahead of competitors.

Cons: On the other side, here are some cons of Chainlink and its token:

  • Chainlink still doesn’t have a clear roadmap that would set long-term goals.
  • The DeFi space is developing very fast, and it’s not clear whether Chainlink can scale its network infinitely to address the rapid increase in transactions. Such a rapid surge in demand can potentially cause malfunctions and even system failure.
  • Even though LINK has a use case within the ecosystem, its price is very volatile and the recent surge might have been also driven by investors’ fear of missing out (FOMO), which is valid for the entire DeFi space.

Tokenomics

LINK has a maximum total supply of 1 billion tokens. As mentioned, 35% of the tokens were sold during the ICO about four years ago. Also, the company behind the project had put aside about 300 million tokens to use for the development.

Unlike many other cryptocurrencies, such as Ethereum, LINK’s supply is capped at 1 billion and cannot increase. The current circulating supply is over 401 million as of mid-January, according to Coinmarketcap data.

It’s worth mentioning that LINK doesn’t reside on a proprietary blockchain developed by the Chainlink team. Instead, it is an Ethereum-based token created using the ERC-667 standard, which is a version of the popular ERC-20 standard. In other words, you can store your LINK in any wallet that supports Ethereum tokens, including MetaMask and Trust Wallet.

What is LINK Used For?

As explained earlier, Chainlink node operators can choose to stake the native token in order to secure a return. Those who stake LINK are eligible to offer bids to users who require off-chain data. The node operators selected by the protocol have to provide the information to the smart contract making the request through the SLA. For their effort, node operators receive LINK as reward. However, if they break the rules, they will lose a portion or all of their LINK tokens.

Node operators are interested to accumulate more LINK tokens because this gives them access to bigger data contracts and thus bigger rewards.

LINK Performance

LINK has been one of the most successful tokens in 2020. It surged over 570% for the year, starting the New Year at over $12.2. In 2020, it peaked at about $19.3 in August, as the DeFi market went to the moon thanks to projects like Compound, Aave, Synthetix, and Kyber Network. In the first weeks of 2021 alone, LINK surged another 100% to update the record high at over $23.6. At the time of writing, LINK is the ninth-largest cryptocurrency by market cap. Here is the token’s performance (blue) compared to Bitcoin:

Coinbase LINK/USD Price Chart
Source: TradingView – Coinbase LINK/USD Price Chart

The price surge has been fueled by several factors, including the growing interest in DeFi projects, investors’ FOMO, and the impressive rally of the crypto market led by Bitcoin, which updated the record high and jumped to over $40,000, attracting more institutional investors to invest in the emerging industry.

Besides this, Chainlink partnered with several reputable companies and organizations, which also contributed to the price boom. For example, in 2020, the project partnered with Hedera Hashgraph, Matic network, and Nexo, which is a crypto lender having over 800,000 users. It was also mentioned in a Google blog post praising its technology. The Chainlink ecosystem also includes big names like Paxos, BitGo, Crypto.com, Huobi, Tezos, Polkadot, and Intel.

Source: Chainlink – DeFi Ecosystem

The Final Note

Chainlink has already proved that it is one of the most important blockchain projects given its functionality and support from the blockchain community. It is definitely here to stay and may continue to show impressive performance in 2021, even though it’s not clear what the next major milestones are.

Ethereum transformed the blockchain space by bringing the concept of the smart contract, but Chainlink goes further by empowering smart contracts with relevant and accurate off-chain data. 



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