Chainlink (LINK-USD): Moonshot Candidate With Risks

For the last decade, my focus has been investing my own money in stocks. I put a little money into Bitcoin and Ethereum in 2014/2015 out of curiosity, but I had not spent much time studying cryptocurrency.

In recent months, I decided to change course and go down multiple cryptocurrency rabbit holes in an attempt to find value in an industry that is – as of this writing – drowning in nearly 19,000 different cryptocurrencies.

In this article I explain what Chainlink (LINK-USD) is, why it has value in the blockchain ecosystem, and why its token, LINK, could be a great long-term bet. I also address some risks, of which there are many.

Crypto – A Quick Overview

In 2014, Ethereum (ETH-USD) was invented to expand upon Bitcoin blockchain technology to enable the creation of smart contracts by anybody.

The creation of Ethereum spawned new markets – DeFi, NFTs, etc. – that has led to a speculative frenzy in Ethereum’s token, ETH. As of this writing, ETH trades at ~$3,000 per coin and has a market capitalization of nearly $400B, making it nearly as big as Visa.

But like Bitcoin, Ethereum has its own limitations. For example, its transaction processing time is too slow to efficiently accommodate activity on its network. Slow processing time has led to high transaction fees, which has spawned multiple competitors to Ethereum. As it stands today, Ethereum and competitors are in a battle to develop a Layer 1 blockchain that processes transactions as fast as possible.

The more I learned about Ethereum and its competitors, the less certain I became about who could win the battle long term. Smart contract blockchain technology is progressing so rapidly, today’s leader could easily be an afterthought in a few years. Or, it could be that Ethereum and its alternatives will coexist in an ecosystem of interconnected blockchains.

However, none of these battles for Layer 1 supremacy matters when it comes to Chainlink.

Chainlink’s Role In Crypto

Unlike Ethereum, Chainlink is not a smart contract blockchain. Chainlink was invented to help make smart contracts smarter. Chainlink is built on Ethereum, but it is blockchain-agnostic and works with all blockchains.

Smart contracts are agreements written into code and executed by decentralized blockchain networks. However, smart contracts are limited in their capabilities because they have no way of importing data from the outside world.

What if you want to create a smart contract that is contingent on the price of the U.S. Dollar relative to the Japanese Yen next Thursday at 8 a.m.?

Without a trusted data feed containing the price of the U.S. Dollar and Japanese Yen from the real world into the smart contract, the contract would have no way of executing.

Chainlink has solved this by creating a decentralized network that provides trusted real-world data to smart contracts.

The company was founded in 2017. In the years since, Chainlink has become the leading provider of decentralized oracle networks (DONs).

An oracle – also known as a node – is a third-party-owned computer that acts as a bridge between a smart contract and real world data. Chainlink consists of multiple networks of these oracles, which comprise more than 900 Chainlink DONs as of this writing.

The job of these DONs is to procure real world data on behalf of a smart contract, verify that the data is accurate, and deliver the data to the smart contract.

The Chainlink ecosystem operates on financial incentives. The smart contract is paying a DON for off-chain data. The off-chain data providers are paid to provide the data, which the DON reviews for accuracy before sending it to the smart contract customer.

The point of the DONs is to provide a decentralized form of consensus that ensures that the data being retrieved off-chain is true. This guarantee of truthfulness is the value that Chainlink provides to smart contracts customers.

Chainlink co-founder and CEO Sergey Nazarov has said that much of the $100 billion DeFi industry was built on the pricing and market data feeds procured by Chainlink. To this point, oracle networks like Chainlink have largely been used to support DeFi. Nazarov has said that Chainlink has at least 60% market share in verticals like DeFi and gaming.

Moving forward, he expects global industries that use financial contracts to enter the smart contract ecosystem in the future. Nazarov has said he believes hundreds of trillions of dollars in assets could end up connecting with the blockchain to use smart contracts – assets like gold, real estate, stocks, derivatives, ad networks, and supply chains.

If this turns out to be true, the use of oracles connecting off-chain data to smart contracts could explode, which could lead to an ever-growing valuation for Chainlink if it remains a major player in this space.

But we don’t know if or when the use of smart contracts and blockchains by industries beyond DeFi and blockchain gaming will materialize. In the company’s risks section of its website, it notes that there is a risk these future markets may not materialize at all.

Today, Chainlink hosts more than 900 DONs. Nazarov said in March 2022 he expects this number to be in the thousands “soon.”

Additionally, Chainlink has developed solutions that may add value to its network, including VRF, Keepers, Proof of Reserves, and Cross-Chain Interoperability Protocol (CCIP).

Financial Incentives

The economic cornerstone of Chainlink is its token, LINK. Data is procured by smart contract developers through the purchase of LINK. And oracles and data providers are compensated in LINK.

For an oracle to participate in the Chainlink network, it must buy LINK and stake that LINK to the Chainlink network. Staking on Chainlink, however, looks different from staking on typical blockchains, where staking aims to prevent attacks on consensus. On Chainlink, staking is done to ensure the timely delivery of accurate data by DONs to smart contracts.

By staking LINK, an oracle is putting its own capital at risk in order to build trust and become an active participant in the Chainlink network. Misbehavior by an oracle could result in LINK slashing (i.e. financial penalties for bad behavior).

Critics and Competitors

As I noted previously, Nazarov has said at least 60% of the off-chain data used in DeFi and blockchain gaming is secured by Chainlink.

In 2021, total value of smart contracts secured by Chainlink peaked at $75 billion. Competitor Band Protocol boasts of having secured nearly $17 billion in 2021. The Chainlink website defines “total value secured” as: “Total U.S. Dollar value of crypto assets deposited into markets secured by Chainlink oracles.”

With DeFi being a primary user of off-chain data, it appears Chainlink, which had a first-mover advantage, is the most used oracle network.

But some critics have argued that Chainlink has some technical shortcomings. Eric Wall, CIO of Arcane Assets, heavily criticized the Chainlink 2.0 whitepaper by pointing out what he perceived as several technical holes in the document. A firm called Zeus Capital published a short case against Chainlink in 2020. Each of the points of the short case were rebutted by a Chainlink proponent.

Competitor API3 has argued that including decentralized oracles into the off-chain data collection process increases risks to data integrity. Instead, API3 has come up with an alternative solution that connects data providers directly to the blockchain with an oracle API wrapper that essentially makes it simple for any off-chain data provider to connect to the blockchain and provide data to smart contract clients directly.

The founder of Band Protocol has stated that he views Band Protocol as one of the fastest oracle networks available due to it being built on the Cosmos blockchain, which does not have the same congestion issues of Ethereum. Band Protocol touts its average transaction processing time at ~6 seconds.

I haven’t found an exact figure that shows how long it takes for Chainlink to process oracle requests, but Eric Schmidt, the former CEO of Google and now a strategic advisor to Chainlink, alluded to the slowness issue in December. He also noted that with all the money being poured into Web3, he believes processing times will improve.

Some Risks

Like other cryptos, LINK comes with its own unique form of tokenomics. Prior to selling its tokens in 2017, Chainlink decided that there would be no more than 1 billion tokens.

To be clear, there is no SEC filing that details Chainlink’s initial coin offering (ICO). There was an ICO details website link in the 1.0 Whitepaper published in 2017 – but this link today redirects us to the homepage of Chainlink’s current website where I could find no details about the ICO. Chainlink, however, does provide ICO details in its fact sheet, last updated on its website in 2020.

Per the Chainlink fact sheet, 30% of the LINK tokens – or 300 million LINK – would be retained by Chainlink for purposes of internal development. This is essential because Chainlink does not generate revenue. Chainlink does not collect fees from its network – Chainlink’s funding comes from selling its own LINK tokens.

Today, it looks like Chainlink owns 183 million LINK, based on stats provided by Etherscan, which is supposed to provide a live view into the largest wallet holders of various Ethereum-based tokens, including LINK:

Chainlink: Team Wallet 1	50M LINK
Chainlink: Team Wallet 2	50M LINK
Chainlink: Team Wallet 3	37.5M LINK
Chainlink: Team Wallet 4	37.5M LINK
Chainlink: Team Wallet 5	8M LINK
TOTAL	183M LINK

As of this edit, LINK is trading at $12, which is nearly 80% off its 52-week high.

Could there be a scenario where Chainlink operations need more cash than LINK redemptions would enable?

Yes, this could happen.

If LINK skyrockets to $200/token in six months, this is probably a non-issue. But what if LINK crashes to sub-$1 for an extended period of time? This could present a cash crunch to the LINK team.

One solution could be to print more tokens and sell them. As it stands today, LINK is a deflationary asset capped at 1 billion tokens. If Chainlink were to create more tokens, that could drive down the price of LINK.

Additionally, we do not have access to Chainlink’s financials. We don’t know what Chainlink executives are paid. We don’t know what Chainlink expenses look like.

I believe the issues I have posed above are examples of why the SEC is expected to crack down and regulate blockchain companies that were funded by ICOs. Without any required reporting rules or disclosures, it’s unclear to me as a potential token holder what I am getting.

However, it remains to be seen how/if Chainlink and other cryptocurrencies are regulated. Some have contended that LINK will never be viewed as a security or regulated because it is a “utility” token.

But Gary Gensler, head of the SEC, specifically called out utility tokens in a 2021 speech and his comments lead me to believe that utility tokens like LINK could face heavy regulatory scrutiny.

Chainlink has listed risks on its website, including regulatory risks.

Valuation

Chainlink issued its LINK token in 2017. ICOs from competitors Band Protocol, API3, and WINkLink came in 2019 and 2020. Today, Chainlink is the clear leader from a market cap perspective at ~$6 billion. The other three – BAND, API3, WINK – are trading at market caps of less than $300 million.

But what justifies the valuation of any of them, including Chainlink?

Chainlink is a company, but it does not have publicly traded stock. The company has no publicly reported financials or earnings reports.

The success of Chainlink as a business is dependent on creating a powerful network, which will presumably lead to an increase in the value of the LINK token, which will presumably be redeemed by Chainlink management at different points in the future to fund operations and development.

David Duong, Coinbase’s head of institutional research, recently stated the following about Chainlink and its valuation (italics below by me):

“Market saturation may limit the platform’s future growth prospects, potential dilution of LINK’s circulating supply is uncertain, and imbalances pertaining to dapp demand, node operator fees and operating costs contribute to selling pressure.”

It is impossible to value LINK with the limited data that we have available. Whiteboard Crypto attempted to value Chainlink using a lot of technical analysis, but I’ve never been a huge chart reader, and I don’t know how much value this has.

An investment in LINK is a highly speculative bet that Chainlink – and oracle networks in general – will play a major role in the future blockchain world as more and more industries come to rely on smart contracts for doing business.

Conclusion

There is a lot of uncertainty about what Chainlink should be worth, how viable the future of blockchain oracle networks is, and which oracle provider(s) today – if any – will be the big winner in the blockchain oracle network market in the future.

Given the uncertainty around all of these issues, it probably makes most sense to pick a basket of oracle networks, or simply just wait until the market shakes out, or buy an index of crypto assets – or avoid the industry altogether if you’re uncomfortable with the volatility and uncertainty.

Despite Chainlink’s large market cap compared to its rivals, all of these companies are still incredibly young, all could see massive upside, and all could conceivably be defeated by a new entrant given how quickly Web3 is evolving.

Haseeb Qureshi, managing partner of Dragonfly Capital, a venture capital firm that has been investing in crypto companies since 2017, probably said it best about crypto investing in general:

“If you’re a crypto investor, I don’t think your job is to pick out one sector that you think will be the future. The honest reality is that we don’t know. The future is still unwritten. As people show up and build, they’ll determine where the future [of crypto] is going.”