Ep. 139 – Smart Contracts & Oracles – insights from Chainlink

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Sergey Nazarov is the co-founder of Chainlink, a decentralised oracle network that provides reliable, tamper-proof inputs and outputs for complex smart contracts on any blockchain. In this podcast we discuss the fundamental opportunity blockchains along with smart contracts, connected to real world data via oracles, can provide in creating a level of hyper reliability for transactions to occur that hasn’t been possible up to now.

We also discussed how blockchain, smart contracts and oracles can create better insurance products and transform insurance cash flows into securitised tokenised assets.

 

What is blockchain?

Blockchains are tamper proof data structures that end up creating an immutable highly reliable record of smart contract state or contractual agreement between parties.

The way they do that is through the use of cryptography they prove that the data and the proof within a blockchain is actually reflective of what happened.

For Sergey the fact that you have a system of record and a system of executing transactions that’s hyper reliable is actually a very unique innovation in the history of contracts and in the history of how people interact with each other. Because traditionally what you would have had are multiple parties, within a transaction, keeping their version of what happened.

That means two important things. (1) that version of history, is their vision of history, whether it’s right or wrong. That version for example may have been corrupted or manipulated to their benefit. (2) It’s a version of history that they can’t easily present as a reliable proof of what happened to other parties, whether that’s the counterparty or whether that’s a regulator. This inability to prove what’s happening in a transaction or prove what the underlying value of an asset or prove what happened in an insurance kind of agreement is what leads to the big problems in the global financial system as was seen in the 2008 financial crisis.

The 2008 financial crisis was really a problem of proving that certain assets were in a certain state, and that certain people were in a certain state of solvency. Because everybody had their own version of history, and no one had a unified, single trustworthy version of history, the markets became dislocated and disconnected from reality.

Blockchain provides the ability for all parties in a transaction to have one single, hyper reliable form of history that everyone knows is true. And therefore, nobody even needs to keep their own copy.

 

Smart contracts

A smart contract is a tamper proof digital agreement that is represented on a blockchain. Blockchain provides a data structure, where the data about a transaction is hyper reliable. With smart contracts you now have a certain logic and conditions that gets executed, as coded into the contract. This is a hyper reliable system that sits outside the control of any of the people in the contract.

Sergey believes that smart contracts should instead be named tamper proof digital agreements. Smart contracts take standard digital agreements and provide a level of unique guarantee that digital agreements can’t provide because they’re not secured cryptographically on a blockchain.

 

Trust in a brand vs cryptography

The relationship and the brand of an insurance company or financial institution is there to assure you of solvency and of reputational loss if the contract is mishandled, misrepresented or not executed properly.  Reputation brand is essentially a mechanism to guarantee reliability.

The internet has created a paradigm shift by being able to reliably guarantee a relationship between a user and the outcomes they expect from an internet based agreement. In those situations, people abandon brand and relationship and simply go towards the quality they can get at the best price.

In addition, publicised failures from recognised brands like WireCard and Enron to name a few, will simply demonstrate that the guarantee of a brand doesn’t mean safety in a relationship with a certain type of contractual agreement.

Mathematically guaranteed internet based alternatives gives people guarantees not based on conversations with other people, but based on firm, mathematically guaranteed outcomes.

What a smart contract does, is it forces that agreement to function in a certain way, regardless of the entity with om the agreement was made. It enables to abstract away the risk that an entity won’t be solvent, or that an entity will fail to follow through on the commitments in the agreement. Parties to a smart contract can verify that the agreement will execute the way it was promised regardless of whatever the entity decides to do. If that’s the level of reliability, you’re now able to achieve from a digital agreement from a tamper proof digital agreement slash smart contract, then the value that a brand presents in creating that same guarantee is deeply lessened.

 

The role of Oracles

Smart contracts are the representation of a contractual agreement in a blockchain based data structure.  In order to achieve their hyper reliability, they are purposefully limited in their interaction with the outside world.

Even though they’re called smart contracts, they cannot actually connect to an external system. So, the only thing that a smart contract can know is the data that’s within a blockchain based system. The only data that’s inherently within a blockchain based system out of the box, is ownership of tokens and private key signatures.

Blockchains are a hyper reliable walled garden, for contractual state that are completely disconnected from the outside world.  Oracles are the gateway for the outside world. Decentralised oracle’s are the technology that provides data to smart contracts. What oracles do is expand the two types of data that a smart contract can be about, private keys and tokens to, hundreds, thousands and millions of data points from the real world. This has enabled the appearance of decentralised finance and decentralised insurance to appear.

Chainlink provides the most widely used decentralised oracle mechanism, the most widely used decentralised oracle network that essentially provides data into these smart contracts. Whilst at the same time, does it in a highly validated, highly reliable form, so that the data meets the high reliability standards of the contracts. A universally connected smart contract is a smart contract that’s connected to the real world in a reliable manner from end to end – from the data that controls the contract, to the contract’s execution on chain, to the contracts execution of a payment outcome somewhere else.

 

Ensuring hyper reliability

Essentially, it boils down to the verification of outcomes, of transactional events, of real world events in the case of an oracle, multiple times by multiple independent agents, independent computing systems also known as nodes.

In tandem with that, you have cryptographic proof, which proves the provenance of the data, which came from multiple sources. It provides an immutable guarantee of being proven by many nodes. In the case of Bitcoin and Ethereum this is from thousands of nodes.

With oracles you have the same logic. You have decentralised computation to create definitive truth, whether that’s for proving the state of the weather, the state of an asset’s price, or the state of a good’s location. With that definite truth, that something has happened in the real world, you can automate the execution of a system and/or relationship in a highly efficient way.

That is the real promise of the combination of Oracle’s and smart contracts that you can prove that something happened and that there’s a system that based on that proof can now act

 

Adoption drivers of smart contracts in the insurance industry and enterprises in general

The insurance industry seems to have a certain kind of fast follower strategy.

However, just like FinTechs made their way into the global financial system and started eating into the market share of traditional banks and financial institutions. We’re now seeing a growing tide of InsureTechs that are using technology to generate better and easier to access insurance products.

In Sergey’s point of view this is the kind of underpinning force that will drive adoption of smart contracts in the insurance industry. What he thinks will happen is that either smaller, more innovative insurers are going to launch new hyper reliable insurance policies, driven by data, such as parametric insurance and/or that insurance cash flows will become securitized.

Smart contracts are the format in which parametric insurance can actually deliver on its guarantees. Smart contracts together with oracle’s enable parametric insurance to prove that something has happened, guarantees the policyholder of a certain outcome while enabling insurance providers to eliminate claims management.

InsureTechs like Arbol and Etherisc are essentially combining oracle’s and smart contracts to make innovative new insurance products that actually enable them to go into geographies where they don’t even need a legal relationship with users. They can just have a relationship with users on the basis of technology and the users can trust that policy not because there’s a big brand and logo there. But because the technology and its guarantee are so highly reliable that the insurance policy will be acted upon immediately when an insured event occurs.

InsureTechs are building out an increasingly easily consumable, hyper reliable insurance products, built on blockchains and smart contracts as a competitive advantage to guarantee that hyper reliability.

Traditional, larger insurers will essentially continue with their fast follower strategy and will seek to build their own systems depending on their technological readiness and capacity to adapt to blockchain and smart contracts.

The second event that Sergey predicts may happen is that insurance cash flows will become securitized. In his opinion the first people that are going to do that are going to become unbelievable successful.

The way this would work is that you make hyper reliable insurance products that can be adopted by users globally without having to rely on a logo. You take the guaranteed cash flows from those insurance products and you turn them into securitized tokenised assets. This can be done either in the traditional financial world or in the decentralised financial markets. This already exists in the refactoring industry for global invoices and for trade finance. Sergey believes the same thing is going to happen within the insurance industry and that it can be underpinned by blockchain and smart contracts to provide both better insurance products but also the format through which to prove to the market that the insurance cash flows are turned into securitized tokenised assets.

 

Chainlink enabling enterprises

There’re a few key decisions that enterprises need to think through when they approach smart contracts and blockchains and oracles.

The first key decision is, do they want to be an issuer? Or, do they want to be a participant?

If you want to be an issuer, somebody who issues or generates or creates smart contracts, you essentially make new financial products, new insurance products, new global trade relationships, through smart contracts. You are the party that’s driving that innovation, you’re the party that’s building the contract.

Once the enterprise has decided to become the issuer they need to create a blockchain team. They need to generate an internal competency around how to reinvent certain categories of agreements. They need a go to market strategy to educate their customer base. Numerous Insuretechs like Arbol and Nexus Mutual are good examples of companies who have done that.

To build this you’re going to need contract developers, smart contract developers and oracles to connect to real world data. What Chainlink can enable you to do is to get the data that you need into those smart contracts in a validated form. Chainlink can actually connect your internal systems to those contracts as well.

If you become an issuer or a creator Chainlink will enable you to do two things:

  1. Architect out contracts that are properly connected to real world data
  2. Be the abstraction layer that enables enterprise existing systems to interact with various types of blockchains

If the enterprise doesn’t choose to become an issuer but instead a participant they are still going to still need to interact with contracts. They’re going to find themselves in a similar position that people experienced when email came about is that everybody’s going to start asking you for your email address to exchange information. At that point enterprises who didn’t want to become issuers and didn’t want to move quickly won’t have a choice. They’re going to have to participate in the environment that has the contractual agreement that their counterparty wants.

In that participant category, what Chainlink will offer that abstraction layer, that’ll enable them to basically e-sign, interact with, agree to confirm their relationship to multiple smart contracts on multiple different chains.

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