Smart contracts automate agreements on the blockchain. They evaluate information, and if certain conditions are met, they execute. However, this presents a problem – blockchains don’t really have a good way to access external data. The difficulty of connecting off-chain data with on-chain data is one of the great challenges facing smart contracts.
Chainlink attempts to solve this problem by providing a decentralized oracle service. In short, an oracle is a piece of software that translates external data to a language that smart contracts can understand (and vice versa). So, how does Chainlink work and who uses Chainlink? Well, let’s find out.
What is Chainlink?
Chainlink is a blockchain-based decentralized oracle network that allows smart contracts to connect to external data sources. These can include APIs, internal systems, or other types of external data feeds. LINK is an ERC-20 token that’s used to pay for this oracle service on the network.
How Does Chainlink Work?
Chainlink uses a network of nodes in an attempt to make the data provided to smart contracts as trustworthy and reliable as possible. Let’s say a smart contract requires real-world data, and it puts out a request for it. The Chainlink protocol registers this event and forwards it to Chainlink nodes to take their “bids” on the request.
What makes this process powerful is how Chainlink can validate data from multiple sources. Due to an internal reputation system, Chainlink can determine with relatively high accuracy which sources are trustworthy. This can greatly increase the accuracy of the results and protect smart contracts from all sorts of attacks.
The smart contracts that request the data then pay Chainlink node operators in LINK in exchange for their service. The prices are set by the node operators based on the market conditions for that data.
Node operators also stake on the network to ensure long-term commitment to the project. Similar to Bitcoin’s cryptoeconomic model, Chainlink node operators are incentivized to act in a trustworthy manner instead of being malicious.
Chainlink Use Cases: Who Uses Chainlink?
By providing strong security and reliability guarantees on par with the blockchain, more advanced smart contracts are being created using Chainlink oracles. The main ones include:
Decentralized Finance (DeFi)
Many traditional financial products like loans, payments, derivatives, asset equity, and more are being built on the blockchain using smart contracts to increase their security and transparency and reduce barriers to entry. These DeFi applications use Chainlink to price assets, access interest rates, verify collateralization, and more, which enable these products to perform functions like issue a loan at fair market value, automate the issuance of dividends, and settle an options contract.
Insurance
Smart contracts are also being leveraged to create parametric insurance contracts on the blockchain. Chainlink is currently being used in production to provide weather data to the Arbol crop insurance market, enabling farmers all over the world to obtain parametric crop insurance simply with an Internet connection, which is settled in a fair and timely manner according to the amount of rainfall, temperature, or other evaluators the policy is set to (e.g. if it rains more than x amount this year, pay out y settlement).
Gaming
Developers are also beginning to launch smart contract-based gaming applications on the blockchain that often incorporate non-fungible tokens (NFT) as scarce digital collectibles. One of the key building blocks of many blockchain games is a source of randomness to generate random in-game scenarios or determine the lucky winner of prizes. Chainlink provides a randomness solution called VRF, which generates randomness and delivers it to the smart contract in a manner where users can prove it is fair and unbiased, as neither the players, game creators, or external entities can tamper with or manipulate the randomness to their advantage.
Traditional Systems
Another key use case of Chainlink is providing traditional systems like data providers, IoT networks, websites, and enterprises a way to make their data and services available to any blockchain network. Since the Chainlink Network is blockchain-agnostic, Chainlink oracles serve as an integration gateway for connecting current digital and data infrastructure to any/all blockchain networks.
These are just some of the many capabilities Chainlink provides to allow smart contracts to interact with external data and systems with a high degree of security and reliability. The end result is the ability for blockchain-based smart contract applications to enable extensively more use cases across a more diverse set of markets.
If blockchains are decentralized computers and smart contracts are decentralized applications, then Chainlink can be thought of like a decentralized Internet that finally allows smart contracts to interact with the outside world while maintaining blockchain technology’s fundamental guarantees around security, transparency, and trust.
What is LINK Used For?
Chainlink node operators can stake LINK as a way to offer a bid to the intended buyer of the data. The node operator that "wins" the bid must provide the information to the smart contract making the request. All payouts for node operators happen in the form of LINK tokens.
This approach incentivizes node operators to keep accumulating. Why? Owning more tokens means access to bigger and bigger data contracts. If a node operator decides to break the rules, they’ll have their LINK tokens removed as a result.
Closing Thoughts
And that is all for an introduction to how does Chainlink work. Its technology has proven to be one of the most important pillars of the DeFi and broader crypto ecosystem. While that does introduce risks onto ETHereum DeFi, trusted external data sources are one of the most important building blocks for a healthy on-chain ecosystem of products.
