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Concepts: Decentralized Autonomous Organizations (DAOs)

Gunnar Jaerv
Gunnar Jaerv 1 September 2021

DAOs are organizations where decisions emerge through consensus or formal votes, but without any centralized structure.

There are various ways to participate, but ownership of a token is a common method.

DAOs operate using smart contracts to establish rules which are then technically inviolable; no person or group is in charge of enforcing them. Instead, they’re written into the code on which the whole organization operates. Within these rulesets, members get voting rights, often including avenues for readjusting the rules, in a manner similar to constitutional amendments — or EIPs. Many DAOs operate using a proposal-and-vote mechanism where any member can propose an amendment which is then voted on, and built into the smart contract if it wins.

There’s always a delicate balance to be struck in an organization or group, between allowing anyone to have a voice and anyone to join on the one hand, and being vulnerable to bad actors and spam on the other. Many DAOs solve this by having a pre-vote sorting system in which proposals need a certain amount of support to be voted on by the whole organization. This isn’t a new idea. You’ll find something similar in the EIP protocols, as well as the proposal-and-seconding method in Robert’s Rules of Order.

Since they’re built on blockchains, DAOs are secure, private, and transparent; anyone can audit their treasuries and transactions, immutably recorded and available to all.

3 steps to a DAO

DAOs typically launch in three major stages:

Smart contract creation

A developer or group creates the smart contract that underlies The DAO. After launch, these rules can be changed, but only through the governance rules of The DAO itself, which is necessarily more cumbersome, so the first iteration of the smart contract needs to be robust and extensively tested.

Funding

After smart contracts have been created, a DAO will seek funding and members. Typically, tokens are sold prior to the launch of the project, redeemable for the project’s own currency upon launch, and usually also conferring voting rights on purchasers. As such they may seem closer to traditional stock in a company than to securities. A landmark 2017 case established that tokens in a DAO known simply as “The DAO” (see below) were securities and subject to SEC regulation, but this organization was dedicated to investment and other DAOs may be treated differently by regulators, particularly in different jurisdictions.

Deployment

Once The DAO is set up, its smart contract is deployed to the blockchain — in many cases, this will be Ethereum; other past contenders included GENIOS, while projects like Polkadot and Cardano are both capable of supporting DAOs, and governed by them. From here, The DAO is in the hands of its members, who will decide its future. The development team now have no more say over it than any other member — exactly as is the case with public blockchains like Ethereum itself.

Why DAO?

DAOs offer several advantages over traditional organizational structures:

Trustless

As with other blockchain-based tools and systems, DAOs can operate without trust between the transacting parties or in a third-party intermediary. A traditional organization centralizes trust in its leadership team; DAOs require only that the code be trusted.

Innovative

DAO memberships consider and vote on suggestions and ideas based on merit, without the tendency to hierarchy inherent in traditional organizations, in which those lower down the ladder dare not speak up or challenge leaders’ ideas. Thus, DAOs allow for greater innovation and agility than traditional organizations. In their relationships with other organizations, however, DAOs may suffer from a reduced ability to trade on the personal brand of leaders.

Adaptable

DAOs allow investors to pool funds (and risks) to support or invest in startups and new decentralized projects, quickly and easily creating funding pools that concentrate capital where a majority of investors think it should go.

Principal-agent solution

The principal-agent problem, in which the principal and agent have differing or contradictory motivations and incentives, plagues traditional organizations. When those who make decisions on your behalf act in their interests rather than yours, problems can arise, and the agent need not be distant. CEOs sometimes do not act in the best interests of the board, for instance.

In other cases, the agent may take risks knowing that they will receive the reward if they are successful, but the principal will pay if they are not; thus, compared with the principal, their risk-reward calculus is skewed.

DAOs dissolve the principal-agent problem by dissolving the relationship. Everyone scrutinizes, considers and votes on problems, questions, and opportunities. The DAO’s actions or even its code then reflects the result of this decision, without the need for agents, and the incentives of all the group are aligned.

The Đ DAO: lessons from history

DAO is a type of organization; The DAO, sometimes stylized “Đ”, was a specific organization that provides some insight into ways DAOs can go wrong and pitfalls that must be considered to ensure the future success of successive DAOs.

What was The DAO?

The DAO was an early version of modern DAOs, something like the Wright Flyer of decentralized autonomous organizations. It was launched in 2016, designed to be an independent autonomous venture capital fund, and its founders hoped that it would be used to direct capital to other DAO-structured organizations. Its token owners could derive profits from the organization’s investments either as dividends or through token price appreciation.

Funding and launching The DAO

The DAO funded itself through crowdfunding on Ethereum, its chosen substrate (and at the time, nearly the only available choice). It raised $150 million in ETH, in what was at the time a record-breaking crowdfunding campaign.

The organization formally launched on April 30, 2016, when Ethereum engineer Christoph Jentzsh released the open-source code for an investment organization based on Ethereum. Investors bought DAO tokens by moving ETH to smart contracts created by the new organization.

Issues with The DAO

Just a few days into the token sale, some developers noted that The DAO’s smart contracts were vulnerable, and bugs in the code might allow bad actors to drain funds from these smart contracts.

A governance proposal was set forth to address the security flaw, but while it was being considered, an attacker took advantage of the flaw and stole over $60 million in ETH from The DAO’s wallet.

This was of concern not only because of the sum lost, but because of the sums that could be at stake. At the time of the theft, about 14% of all circulating ETH was invested in The DAO, meaning the hack was a significant blow to both the idea of DAOs and the idea of general-purpose blockchains. The Ethereum network, then just a year old, embarked on a debate about what to do. Founder Vitalik Buterin proposed a soft fork blacklisting the attacker’s address and preventing them from moving funds.

Following this, the hackers themselves entered the debate, claiming that their appropriation of The DAO’s funds was legal under the terms of the smart contracts and threatening legal action against any attempt to recover the funds. Simultaneously, the hackers proffered bribes to some Ethereum miners in an attempt to block the soft fork. Eventually a hard fork was adopted, leading to the creation of Ethereum Classic (ETC) and the current Ethereum network.

The future of DAOs

DAOs are increasingly being used as governance bodies for meta-blockchain projects like Pokladot and Cardano. They’re an ideal tool for the job, especially when the project operates on a PoS consensus algorithm, and they are likely to become more rather than less popular for the purpose as blockchain-based services, financial and otherwise, integrate more closely with the rest of the economy.

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