The fatal flaw of the $500m decentralized finance industry

We’re at the forefront of a new financial system built on public blockchains with over $685M (USD)​ already locked up in decentralized finance (DeFi). These solutions are built on smart contracts, which are simple programs designed to automatically execute once a specified criterion is satisfied.

However, the data that decides this makes for a vulnerable Achilles heel that can put these funds at risk. ​How can we guarantee the security of immutable and permanent smart contracts that depend on data feeds and govern decentralized financial applications?

To answer this question, we must understand how decentralized applications use data and stop seeing data as simply an asset but as a primitive building block for the ecosystem of tomorrow.

What is DeFi and how does data play a critical role?

If you’ve looked into blockchain sometime during the past year, more than likely you’re wondering, “Why is everyone talking about DeFi.” DeFi is a movement aiming to rebuild the traditional financial system in a permissionless, transparent, open and censorship-resistant manner.

Think instant global transaction settlements. Think of peer-to-peer lending/borrowing. Think no more hefty fees from intermediaries.

A caveat to this is that blockchain networks cannot communicate or consume data external to their blockchain network. For example, decentralized applications (dApps) on Ethereum, by nature, aren’t able to tap into traditional stock prices or bitcoins price. This was until the introduction of data oracles — a technology that interfaces external data sources and APIs into compatible form to be used within a blockchain.

As users, we trust and interface with the front-end of technology applications every day but rarely do we consider what is going on in the backend — i.e. how the technology is programmed to behave.

In light of Synthetix, a platform that enables the creation of on-chain synthetic assets that track the value of assets in the real world, we saw a failure of ​a centralized point of data​. This lead to invalid trades that resulted in over $1 billion in profit in just less than an hour. We need to understand that oracles and sources of data are the absolute foundation of any technological application.

How can data be trusted in a decentralized manner?

Decentralized oracles are essential to the ecosystem as they are, by design, autonomous and trusted solution by incentivizing anyone and everyone to vote on behalf of data providers to earn data query fees. This mitigates the central point of failure issue within other oracle solutions as applications or users must choose their data provider.

Smart contracts can retrieve off-chain data through centralized or decentralized oracles.

The centralized option involves calling a random function from ‘trusted’ online sources. Although the fastest and cheapest method to feed data, users must place absolute trust that this data source will perpetually feed accurate data creating a single point of failure.

Decentralized oracles are a preferred option that aggregates multiple data sources to reduce the chance of collusion. Each data provider has its reputation and economic incentive to provide accurate data to the blockchain. Although there are differences in oracle design, some projects that facilitate this type of oracle include Band Protocol, Chainlink, and MakerDAO oracle.

Data is the lifeblood of the DeFi ecosystem

If there’s one takeaway from this piece, it’s that data is a critical component for any technology but it is especially vital for smart contracts.

With exponentially growing DeFi ecosystems and enterprise adoptions, data oracles will only become of greater importance whereby startups that supply reliable data with guaranteed accuracy such as Band Protocol and Chainlink will play a pivotal role in the next generation of smart contracts and reconstruction of the financial system we know today.