The Oracle Problem In Decentralized Finance
Seeking Alpha Analyst Since 2020
- Decentralized finance platforms are vulnerable to oracle mishaps.
- Singular data sourcing systems are prone to feed manipulation.
- Investors lose millions of dollars each year due to blockchain oracle problems.
The rise of decentralized finance in the crypto industry has attracted many mainstream investors. This is because of the attractive guaranteed annual returns and the autonomy of decentralized platforms, which are deemed to be more secure than centralized platforms.
That said, every blockchain has a weakness. In decentralized platforms, oracles are particularly vulnerable, and this is because they rely on external services. They enable blockchains to pull information from the outside world.
This is achieved using web APIs and data feeds.
Oracles broaden the scope of smart contract operations. Without them, smart contracts would have limited use and would only be able to access data that is within their blockchain networks.
Delving a bit into their real-world use-cases, they are used in financial smart contracts to retrieve external market information. The data is, in turn, used to determine settlement rates. In insurance smart contracts, oracles cross-check external web data in order to make policy payout decisions.
When Oracles Fail
DeFi oracles are at the heart of the blockchain systems. Depending on their design, they provide varying reliability. Most are bound to fail due to their reliance on centralized data sources. Some oracle networks have attempted to mitigate such risks by creating systems that have a base recourse model.
QED Oracle has, for example, developed a decentralized oracle system that pulls data from numerous sources to get a consensus. The protocol, which has a recourse system, is designed to provide external collateral in the event of failure. Integrity is upheld using a post-execution process that resolves errors and undertakes loss restitution.
Millions of Dollars Lost Due to Centralized Oracle Systems
There have been instances where millions of dollars have been lost due to the exploitation of oracle systems relying on a singular source.
In November 2020, the Compound DeFi exchange platform lost approximately $90 million due to such problems. The primary contributing factor was its reliance on data derived from an unreliable CoinbasePRO feed.
The relayed DAI price from the feed was $1.3, while actual rates were at approximately $1. The sudden price change led to the liquidation of assets for platform users who had short the asset using heavily collateralized loans.
In another related incident in 2020, the bZx platform, which offers lending and margin trading, suffered an oracle price feed problem that led to over $500,000 in losses.
There has been a rise in oracle problems that have led to investors losing money due to unreliable oracles. Decentralized oracle systems that rely on multiple data sources have been found to be more reliable in mitigating centralization risks.
Analyst's Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.
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