How blockchain oracles will help shape Web3's future narrative

Authored by Sally Gu, researcher @OKX Ventures

TL; DR

Blockchain oracles were in the crypto spotlight in 2023, but what long-term potential does the technology have?

OKX Ventures' view is that as long as off-chain data remains valuable, middleware such as oracles will continue to play an important role in the Web3 narrative. This applies specifically to the following areas:

• With the continued development of the Web3 ecosystem, it’s possible the increase in decentralized apps (DApps) and protocols will drive greater demand for accessing data sources and application programming interfaces (APIs) through oracles. In the future, DApps, especially decentralized exchanges (DEXs), are likely to integrate more than one oracle (usually one as the main data source and one or two as cross-validated backups) to obtain off-chain metadata. Doing so can avoid the price feeding delay or manipulation caused by oracle attacks that may cause unbearable losses to the protocol — for example, the 2022 Venus attack.
• When it comes to potential trading opportunities, though traditional DeFi mainly focuses on price/data feed functions, it is difficult to say who will break the monopoly position of Chainlink in the short term. However, there may be room for second place competition across the remaining circa 10% of the market. More significantly, there have been notable innovative protocols and narratives emerging in various sub-segments of oracle, such as layer 2, credit, Non-Fungible Tokens (NFT), Decentralized Identifiers (DID), and others.
• Based on the observation of DEXs and layer 1, it seems impossible for oracle’s future to be monopolized by one player in the long term, particularly when we consider the incremental market demand plus the presence of layer 2 and zero-knowledge rollups, as well as emerging segmented scenarios. There’s still great potential for market development, such as the deep integration of artificial intelligence (AI) and machine learning (ML) technology with off-chain computing, non-standard on-chain asset valuation, and other blockchain scenarios.

In the following article, we provide a comprehensive breakdown of the concepts, classifications, application scenarios, and trading opportunities of oracle.

Oracles in the spotlight

Vitalik Buterin has previously warned about certain limitations with oracles, but believes a more effective trust mechanism for oracle protocols will emerge in the future. In the text, he also proposed two solutions to the limitations seen:

• Price oracle: There are two sides to price oracle: one, a decentralized oracle for not-quite-cryptoeconomic systems, and two, a validator voting-based oracle.
  • The latter mainly relies on emergency recovery strategies instead of layer 1 consensus to recover. For example, a price oracle relies on the trust assumption that voting participants may be colluded or corrupted by bribery. Users can receive attack warnings in advance and exit any system that depends on the oracle. Such oracles can intentionally delay rewards for a long time, so if the protocol fails, participants won't be rewarded.
  • The proposal for the price oracle is mainly based on the previously proposed schelling coin/point mechanism, which adopts a kind of reverse prisoner's dilemma game theory concept.
  • Generally speaking, the core idea is still to maintain the simplicity of the chain and avoid the chain’s hard fork caused by a single oracle failure.
• More complicated is the Truth oracle, which is adopted to report facts that are more subjective than prices.
  • Truth oracle is similar to a decentralized court system built on not-quite-cryptoeconomic Decentralized Autonomous Organizations (DAOs).
  • The idea of the Rocket Pool Oracle DAO where nodes form a DAO logically also conform to Ethereum's expectations for oracle’s future evolution.
  • However, Buterin suggests in his article that he favors the first validator-based solution based on a complex game theory more.

Data overview

Looking at the overall data in the oracle space, Chainlink still holds a dominant position in the market. Despite being a core middleware in the entire DeFi field, oracles haven't received much attention. This is partly due to most protocol tokens lacking practical use cases, and partly because retail users lack recognition and motivation to learn about them.

• It's worth noting that projects such as Band and UMA, which rank lower in the vertical, have also performed well historically.
• Additionally, protocols like Gelato offering automation, cross-chain, and off-chain computation services have great potential, as they possess strong fundamentals and are prepared to add more token utilities.
• As more developers join and DApps emerge in the next cycle, the demand for calling oracle data sources and application programming interfaces (APIs) is unlikely to shrink. There is a large amount of untapped market potential that could drive sector growth.

With the above in mind, we believe that oracle, and particularly its vertical segments, deserves closer attention from crypto players and is worth considering in the medium to long term.

Interpreting oracle

1.1 Concept

Oracle is commonly regarded as a bridge connecting on-chain and off-chain data. In short, oracle is a middleware that provides trustworthy off-chain data services for blockchain projects.

The main reason we need oracles is that the current trust generated by the blockchain itself is not enough to support all the demands from upper-layer applications. As a result, we need oracles to inject more trust:

• Currently, the amount of off-chain and on-chain data is not equal. Off-chain data in the real world has rich data types and huge volume, while pure on-chain data is insufficient to support independent development completely detached from the off-chain. At this stage, most protocols cannot survive without integrating oracles.
• This is also why many people argue that oracle is actually a ‘necessary evil’ for the blockchain world. When the depth of on-chain data surpasses that of off-chain, we will no longer need to rely on oracles or similar relay/third-party agents. This is also the fundamental factor why many DEX and DeFi protocols are so persistent in developing oracle-less and crypto-native on-chain solutions. Blockchain is a closed ‘black box’ that cannot directly connect to the Internet. As a result, smart contracts cannot access deterministic information from the Internet or the real world, such as stock prices, exchange rates, or the final results of presidential elections. Additionally, due to the consensus mechanism, trusted third parties are required to verify data. Therefore, the oracle plays a role more like a broker that matches trust between on-chain and off-chain.

It is important to note that the main issue addressed by the oracle is not how to acquire information from the real world. In fact, anyone can upload off-chain data to the blockchain. The real challenge is how to enable the blockchain to trust information/data from the real world. Even if we upload off-chain data to the blockchain, it won't be trusted unless honest nodes are involved.

Trust is generated through communication, not just connection. Therefore, the intrinsic value of the oracle depends on its ability to bridge the communication channel between on-chain and off-chain, which is its ability to inject trust into data from the real world off the chain through forwarding, verifying, and filtering. Therefore, the key to determining the quality of an oracle is to figure out to what extent it is trustworthy.

1.2 Classification

Oracle can be classified into two types based on its form: software oracle and hardware oracle. Additionally, centralized and decentralized oracles also exist.

• Software oracle: Provides API/software development kit and other services to assist protocol access and transmission of third-party server data, such as commodity prices, weather indices, and flight numbers.
• Hardware oracle: Widely used in Internet of Things, commonly seen as electronic sensors and data collectors, for example. Based on their data source, oracles also can be categorized into centralized and decentralized types.
• Centralized oracle: Usually only integrates a single trusted third-party such as government departments, official institutions, or reputable companies. Centralized oracles are integrated to provide data. One advantage is that it separates data from the operating system of untrusted local devices, preventing data tampering and loss. However, the disadvantage is that centralized data brings the risks of a single point of failure.
• Decentralized oracle: Decentralized oracles are those with a distributed consensus mechanism, also known as a consensus oracle. It obtains data from multiple external sources rather than a single one, making it more reliable and trustless.

Centralization vs decentralization

A centralized oracle has the advantages of efficiency and feasibility. Decentralized oracles, on the other hand, are more reliable and secure due to their discrete multi-nodes and cross-referencing processes.

When efficiency is not the main objective, centralized solutions are not the most desirable. Obviously, the information provided by a single node is likely to be biased and arbitrary. In this case, authority comes from dictatorship rather than its credibility.

Due to the requirement and concern for trust risk management, most DeFi applications basically adopt third-party decentralized oracles such as Chainlink instead of independently developing a simple centralized oracle, or running nodes to transfer data to the chain. It’s important to remember here that projects or individuals cannot gain community trust even if they upload data to the chain themselves.

1.3 Application scenarios

Chainlink 2.0's whitepaper introduced the concept of the Decentralized Oracle Network (DON) for the first time in 2021. DON is a network maintained by a group of Chainlink nodes that allows Chainlink to provide external data to blockchains through trustless off-chain computations. To achieve its vision, Chainlink has launched a series of products and services such as Verifiable Random Function (VRF), Keepers, and Cross-Chain Interoperability Protocol (CCIP), which further opens up the use of oracles in Web3 applications.

In the graphic below, we’ve listed several use cases of oracles in different scenarios, such as DeFi, NFT, GameFi, social, DAO, and cross-chain:

1.4 Mapping

We believe that three dimensions can be used to categorize the direction of oracles based on specific functions, data providers, and data processing methods.

1. Based on specific functions, alongside common DeFi oracles, there common types of oracles: credit oracles, NFT oracles, and identity (DID) oracles.
2. Based on data sources, oracles can be divided into three types: first-party oracles, third-party oracles, and multi-party oracles.
3. Based on data processing methods, oracles can be categorized into five types: game theory-based oracles, reputation-based oracles, staking-based oracles, cryptography-based oracles, and aggregation-based oracles.

Growth opportunities

2.1 POVs

A. Traditional DeFi oracles focusing on price/data feeding services

It is difficult to tell in the short term who will break Chainlink's monopoly (with a market share of 80-90%). However, there may still be room for competitors to capture the remaining 10% market share.

• One potential opportunity is on protocols with consensus mechanism innovation. Buterin has proposed two solutions and we may see theoretical implementation projects in the future, such as:
  • Game theory as the core, combined with Proof-of-Stake / Proof-of-Work
  • DAO committee/decentralized court form
• Another opportunity is on protocols with superior cost-effectiveness, for example, the price feeding or random number generation services are much cheaper than others. For instance, RedStone, Ontropy, and a few novel oracle providers claim their price feeding can be 80 to 100 times cheaper than legacy solutions like Chainlink. Generally, DeFi or gaming projects will only consider replacing Chainlink or other service providers when they can significantly reduce the cost of data calling.

B. Emerging oracles for specific scenarios

There are potential opportunities in several segments such as layer 2, credit, NFT, and DID:

• The layer 2 oracle is mainly a native solution for the Optimism / ZK ecosystems, with low latency and security being core concerns, while low cost of data feeds is relatively less important.
  • It is important to consider the expansion of Chainlink on non-Ethereum virtual machine chains, as the competition could become much fiercer if Chainlink already dominates the data feed on a particular chain.
  • Layer 2 oracles are mainly designed to meet the demands of high-frequency trading on derivative exchanges (layer 2 can provide higher transactions per second to support on-chain decentralized derivative trading), similar to other oracle protocols like Pyth and Pragma (Empiric), which offer more accurate data feeds or stronger data integration processes (such as on-chain first-party data integration and validation, eliminating the need for off-chain nodes).
  • Assuming that tokenomics are well designed with added utility, we can expect that the token price of typical oracle protocols will have a relatively stable and satisfying performance. Utility is key, as Chainlink's tokenomics design has in the past been criticized for lacking utility. As a result, liquidity staking and yield farming protocols like LinkPool were introduced, which activated liquidity to some extent.
• Credit oracle, in light of on-chain credit expansion theory, is likely to take off in the next cycle.

  • The development and stability of on-chain credit rating systems are necessary for creating on-chain insurance and recovery mechanisms, therefore, it plays a crucial role in the growth and evolution of the entire DeFi ecosystem. In the previous mapping, we provided several examples of credit oracles, such as CreDA, Cred Protocol, LedgerScore, Spectral, Credora: Infrastructure for Institutional Credit, and more.

  • With credit oracle, we think it’s important to prioritize the differences in verifying on-chain data and incorporating comparable products (such as the extent of coverage, cleansing capabilities, and accuracy of on-chain credit rating data). Also, having a robust financial engineering background or actuarial skills would be advantageous for the team.

  • We also noticed that the entire project of integrating off-chain credit systems onto the chain will be more complex than expected:

    • On one hand, it can be challenging for a singular project to establish a direct connection with a nation's social credit system. One crucial aspect revolves around whether off-chain economic activities can truly validate on-chain credit abilities. Nevertheless, companies like Spectral Finance with strong business development capabilities, and that directly cooperate with large credit rating agencies in the United States, can be considered a good solution.
    • On the other hand, integrating off-chain public credit data onto the chain itself is not difficult (even traditional cloud teams from Big Tech theoretically have the ability to develop and implement related functions).

NFT oracle is mainly divided into two approaches:

• One is Time-Weighted Average Price (TWAP) which can also be completed with moving averages.

  • Currently, it’s not possible to implement the Volume Weighted Average Price (VWAP) due to the lack of trading volume, and considering that NFTs are illiquid and non-fungible, it’s tough to expect the implementation of NFT VWAP in the short term.
  • Traditional DeFi oracles such as Chainlink and DIA currently provide NFT TWAP price feeding services, and many will directly adopt Chainlink's TWAP solution.
  • After communicating with relevant technical teams, we believe that most NFT TWAP price feeding functions are still in the early stages. This means there’s space for optimization in the integration method, but overall, the development prospects in this direction are not great.

• The other approach is to use AI/ML combined with off-chain computation for valuation and pricing, which we believe is more promising, relatively.

  • In the later stage, some horizontal integration can be carried out to transform it into a full-stack application combining NFT data analysis, marketplace, and valuation (the entry point for NFT spot trading and a liquidity activation scheme), which is a good potential scenario.
  • However, such solutions are basically black boxes because the algorithms are not open source, making it difficult to obtain trust in cooperation agreements (such as Upshot and Banksea). Although they’ve achieved good results in financing, their profitability relies on other derivative businesses, such as wallet data analysis and market integration service fees.
  • Nabu's open-source ML technology may be a transparent solution, but its profitability in the future is still uncertain. However, if similar protocols can be converted into an open-source ML model DAO with token issuance, similar to the commercialization approach of Forta/Go+, there is great potential for development prospects.

• DID Oracle is a protocol service that collects user off-chain data and integrates it into the blockchain for the purposes of identity verification and social graphing. It’s well recognized that this sub-field has significant long-term value potential.

  • Chainlink's CanDID (DECO) team relies on highly optimized multi-party computation and zero-knowledge proof technology to build a decentralized on-chain identity infrastructure. Similar zkDID projects such as legalDAO and Intuition are also providing similar solutions through the design of DAO committee-type identity verification services.
  • However, most of the currently seen identity oracles are mostly centralized with low barriers (although most intend to transition to a decentralized form in the future, it is difficult to verify their feasibility without actual implementation).
  • It is crucial to give attention to the verification process, which includes assessing node quality and the reliability of verification. And, it’s imperative to take into account the storage method employed and the way in which the storage is executed.

2.2 Cases

Following the growth viewpoint outlined above, we’ve selected one case for each specific direction, which is analyzed in the following table.

The final word

To sum up, OKX Ventures believes that as blockchain technology continues to develop, oracles will continue to play an indispensable and important role in the crypto ecosystem by the next cycle. There’s still great potential for development and enormous market space to be explored, such as the deep integration of AI/ML technology with off-chain computing, non-standard on-chain asset valuation, and other blockchain scenarios. Looking ahead we’ll closely track innovative protocols and trading opportunities in the oracle space.

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