What is Chainlink (LINK) and How Does it Work?

2021/06/01 15:26:51

Chainlink is one of those projects that has defied the previous bearish markets with its strong fundamentals. In the last year alone, LINK has gone up in value by 1,336.96%, with a market cap surpassing $21 billion at its peak.

Source: KuCoin (Chainlink growth)

Chainlink brings decentralized oracles and off-chain computations for smart contract platforms and powers a significant portion of the $123.25 billion DeFi ecosystem. The Chainlink platform acts as a data layer for smart contracts. It allows them to communicate and fetch data from the outside world, such as BTC price feed from an exchange, data from a Web 2.0 API, or your account information from the bank.

Sounds interesting enough? This article discusses Chainlink and its ecosystem so the investors can understand the value and utility behind the LINK token. To fully understand Chainlink and its ecosystem, we first have to go through the long-standing “Oracle Problem” faced by blockchain platforms and how Chainlink solves that problem by bringing in decentralized oracles and off-chain computations.

The Oracle Problem

Blockchain platforms work in silos, just like a computer with no internet connectivity. They can't connect with the outside world to pull from or push data to any external system. This isolation property is a limitation, but also a strong security feature that makes these platforms very secure and reliable.

Source: Chainlink

Blockchains are limited by their consensus rules. These rules are based on simple true/false clauses that need to be validated using data solely generated within the blockchain, e.g., is the transaction signed by the private key? Does the public key hold enough funds for the transaction? Is the transaction format valid within the smart contract?

Smart contracts are bound by the consensus rules, and due to their narrow focus, they are “deterministic” because they can't rely on any external data. This deterministic behavior of the smart contracts also prevents Sybil attacks because the same piece of data is redundantly verified and validated by all the nodes on the network to achieve global consensus.

Bringing in external data that is not accessible to every node breaks the consensus and opens up governance, security, and reliability issues. It also introduces subjectivity, e.g., if a smart contract is pulling in data related to the price of a single bitcoin, the answers may vary depending on the data source being used. Then the question arises - which answer is correct and which data source isn't malicious?

This isolation and lack of ability to interact with external data is called the “Oracle Problem,” while the specialized infrastructure that bridges the blockchain (on-chain) to the outside world (off-chain) is called an “Oracle.”

In the early days, smart contracts relied on centralized oracles provided by third-party service providers to fetch the required data and still be deterministic within their execution environment. However, centralized oracles pose some severe threats to the system because a single entity has the power necessary to influence the smart contract through the oracle data feed.

Source: Chainlink (Centralized oracles are a single point of failure)

Centralized oracle nodes have proven to be a single point of failure, and they are exposed to common problems such as DDOS attacks, human errors, and downtime that can put user funds at risk. Chainlink solves all of these problems with its unique approach towards adding an external data layer to deterministic smart contracts.

Chainlink - the Decentralized Oracle Network

Chainlink is a decentralized oracle network connecting smart contracts with external data feeds such as off-chain data from third-party service providers, definitive financial truth, APIs, and even provably random numbers.

You can think of Chainlink as a middleware that translates and delivers real-world data to smart contracts in an on-chain supported format through a decentralized network of nodes. The Chainlink oracle network can be categorized into two different segments; node operators (data providers) and data purchasers.

Data purchasers are the smart contracts that request data from the node operators (data providers). When a purchaser requests the data, several node operators place a bid to deliver that data. During the bidding process, the node operators also commit a stake of their link tokens that are burned if the node operator misbehaves.

How does Chainlink Work?

Chainlink was launched on Ethereum mainnet in May 2019. One billion LINK tokens that power the Chainlink oracle network were minted in September 2017 in an ICO fundraising event where they raised $32 million from the backers.

To understand the mechanics of Chainlink's decentralized oracle network, let's break down the whole process from data request by a smart contract to data delivery.

The smart contract that requires specific data (e.g., price of BTC) puts out a data request to the Chainlink's protocol.
This request invokes an event, and the Chainlink's protocol generates another smart contract called “Chainlink Service Level Agreement (SLA) Contract.”
The Chainlink SLA contract creates three sub-contracts; a Reputation Contract, an Order-Matching Contract, and an Aggregating Contract.
The Reputation contract checks the track record of the oracle provider to verify the authenticity and disregards unreliable nodes.
The Order-Matching contract then broadcasts the data request to Chainlink's decentralized network of nodes (called node operators), takes their bids, and selects the right nodes that can fulfill the data request.
Finally, the aggregating contract accumulates all the data and compiles it into accurate results.

Source: Chainlink

Right after the data request is received from the smart contract, the “Chainlink Core” translates that request into a format that off-chain data sources can understand. Once the data is retrieved, the Chainlink Core converts that data back into the on-chain supported format and sends it to the aggregating contract.

The aggregating contract collects data from many different nodes and filters out “bad data.” If a smart contract requests “what is the current price of a bitcoin?'” the aggregator node collects all the answers from many different nodes, compares them together, and disregards the ones that deviate from the majority.

The LINK token

So, where does the LINK token fit in? The node operators place a bid for every data request, and smart contracts that request the data pay the bid amount in LINK tokens to the node operators for their work. Each node operator sets the price based on the demand of that particular data.

Node operators also deposit LINK tokens on the network as collateral to prevent malicious behavior. The reputation contract also considers each node operator's collateral size with other nodes on the network who have placed their bids for a particular data request. Node operators with much larger collateral are more likely to fulfill the data request and earn link tokens for their work.

LINK token is built on an ERC-677 token standard, and it inherits all the functionalities of an ERC-20 token. LINK tokens can be stored in any wallet that supports ERC-20 tokens. Due to their wider popularity and use case, LINK tokens are supported by almost every multi-currency wallet. You can buy LINK tokens on cryptocurrency exchanges like KuCoin, or acquire them by becoming a node operator.

Conclusion

Chainlink is one of those projects that provide a bridge between the on-chain and off-chain world. With Chainlink, smart contracts can take advantage of the massive potential by utilizing large amounts of data from the outside world without compromising on security and scalability.