The blockchain revolution in finance has so far been dominated by financial contracts denominated in cryptoassets. These assets are native to the blockchain. As a consequence contracts denominated in them can easily be settled by the consensus mechanism. Things become more complicated when people wish to contract in assets whose value is determined external to the blockchain. Since the vast majority of assets – stocks, bonds, commodities, etc – exist in the physical world, a solution to pricing them on the blockchain is required.
The obvious solution to this problem is to contractually employ a trusted source to supply pricing data, just like finance works now. The problem with this is that if one needs to fall back on such an arrangement for on-chain transactions, it renders the decentralised security of the blockchain pointless. The non-cooperative bargaining game to secure transactions globally and permissionlessly becomes theatre as anyone that wishes to break the contract need only compromise the trusted oracle. The employment of a trusted oracle therefore amounts to the recreation of traditional finance on the blockchain with an expensive non-cooperative bargaining game included as theatre. Naturally, all the benefits of cryptocurrency I alluded to in my previous post would be lost.
What is needed therefore is a system that can input pricing data on to the blockchain without a trusted third party. How is this achieved? You guessed it. Another system based on an open non-cooperative bargaining game. Much like incentives are created for miners or validators to come to consensus on the order of transactions on a blockchain, an incentive system that encourages people to come to a consensus on the correct price of an asset. Those that attempt to input incorrect prices face similar financial penalties to those that attempt to re-order transactions. Honest behaviour is rewarded, dishonest behaviour is punished.
So decentralised oracles systems are an essential foundational technology in bringing derivatives of real-world assets to the blockchain. These derivatives, known as synthetic assets (I’ll explore this more in the next post)