What are oracles in crypto?

Leonard Reed in his very famous essay, ‘I, Pencil’ tells the story of the manufacture of a simple lead pencil. How the wood is harvested, the graphite mined, the rubber for the eraser acquired, and all the other ingredients mixed together to form the final product. The important part of that story is that no single mind could coordinate all that economic activity. What is important, is that prices coordinate human action and results in all the goods and services that are available for purchase. All of that happens through the logic of the price system. We don’t need to know ‘everything’, we just need to know prices.

But how do we know what prices are?

Market information needs to be communicated. As we know, communication at scale is beset with difficulty and trust issues can and do arise.

In the crypto-space we turn our attention to ‘oracles’. Oracles are data feeds that provide information to smart contracts. That information might be a price series, for example, or reveal a state of the world (for example, today is Monday, or it rained in the past hour). In traditional finance (CeFi) we would stock and futures exchanges (CEXs), central banks, and financial data providers like Thomson-Reuters and others serve as ‘oracles’, even though we don’t use the term in CeFi. Oracles in DeFi can included those things, but also include DEXs, cross-chain protocols like Chainlink, BAND and Tellor, among others. The challenge in DeFi, however, is just the same as in the CeFi the world; how can we be sure that the information being received is correct?

In small, isolated economies, word of mouth works to communicate prices. Gossip keeps merchants honest. In larger economies, merchants make use of advertising to communicate prices. But at this scale, the problem of false advertising arises. We need more than just word of mouth to keep people honest. Economies have evolved mechanisms that reveal information necessary for the conduct of trade and also mechanisms to ensure that information is truthful. Market exchanges have rules about conduct and very often publish prices, governments have consumer protection laws for the very same reason. These institutions exist to facilitate and promote the flow of information that underpins trade.

The problem with the digital economy

The digital economy faces a particularly acute information problem. The costs of producing and disseminating information has fallen dramatically over the past three decades. That has resulted in an explosion of digital information. Both truthful and untruthful information now pervades the digital economy. The value of truthful information must have risen – after all it is now relatively scarce. As such we should observe the emergence of information brokers that both provide truthful information and certify that information.

There is a trust problem associated with oracles in the digital world just as there is in the non-digital world. A single source of data can be compromised or corrupted (known as a ‘man in the middle’ attack). It represents a single source of failure. This is a manifestation of centralisation that the blockchain ethos tries to avoid.

Where oracles are becoming particularly important is on the internet-of-things. As we see more real-world goods and services being traded on blockchains, the need for trusted oracles will increase. In this application oracles will provide the data flows between the smart contracts that govern whatever trade is occurring.

When thinking about oracles it is important to understand what the data is being transmitted, the source of the data, and especially whether the data are coming from a centralised or decentralised source.