Cryptocurrencies are powered by blockchains, software that runs across a decentralized network of computers, enabling transaction data to be validated, recorded, and protected from attack. Platforms like Ethereum extend that functionality, allowing developers to build self-executing computer programs on the blockchain.
Those programs are called smart contracts, and they form the heart of decentralized finance (DeFi) applications, products that allow users to access financial services without going through a bank or other intermediary. And by eliminating the middleman, DeFi applications have the potential to make the financial system more accessible, less biased, and cheaper.
Ethereum is currently the largest DeFi ecosystem, with $175 billion locked (invested) in various DeFi products. And with a market value of $518 billion, it’s also the second-most-valuable cryptocurrency by a long shot. But while Ethereum still looks like a smart investment, it may offer less long-term upside than some smaller cryptocurrencies. For instance, Chainlink (CRYPTO:LINK) has a market value of just $13 billion, but it plays a critical role in DeFi. Here’s what you should know.
Making smart contracts more useful
Chainlink is a decentralized oracle network powered by LINK, a token built on the Ethereum blockchain. Oracles are entities (e.g., people and connected devices) that bring real-world (off-chain) data onto the blockchain. To illustrate why that matters, consider the following DeFi products.
Compound is an Ethereum-based DeFi protocol that allows users to earn interest by lending cryptocurrency. For instance, you now could earn an annualized 3.22% by supplying the cryptocurrency USD Coin to Compound. But the platform supports several other cryptocurrencies, and the interest rate on each asset is set algorithmically based on supply and demand. In other words, the Ethereum blockchain contains all the data needed to power the Compound protocol.
But some DeFi products require data from the real world. For instance, consider a DeFi platform that allows users to gamble on sporting events or purchase tokenized assets (e.g., artwork, real estate). Each of those smart contracts requires data not available on the blockchain — specifically, the outcome of the sporting event, and the current market value of the assets. Chainlink is the bridge that makes those smart contracts possible, and LINK is the token that makes the whole system work.
Specifically, the Chainlink platform allows oracles (providers of real-world data) to bid on requests from purchasers (buyers of real-world data). To take part in the network, oracles must first stake LINK tokens, a prerequisite that keeps them honest and ensures accuracy. Once the job is complete, purchasers compensate Chainlink oracles with LINK tokens.
Similarly, oracles can provide the same function in reverse, bringing on-chain data to real-world applications. For instance, imagine that you rent a vacation home and the rental agreement is a smart contract; once you make your payment on the blockchain, the system could signal an Internet of Things (IoT) device to unlock the door to your rental home.
The investment thesis
So what? As DeFi products become more popular, oracles should see increased demand. And Chainlink is the most popular oracle network, providing data to smart contracts collectively worth more than $75 billion across several different blockchains. That popularity should be a tailwind for the platform, and as more contracts are built to interact with Chainlink oracles, the smart contract operators will have to buy more LINK to compensate oracles for their service, sending the token price higher. That’s why this cryptocurrency looks like a smart long-term investment.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.