A Decentralized Autonomous Organization (DAO) is an entity without a central direction. Decisions are made bottom-up, under the direction of a community organized around a specific set of rules applied on a blockchain.
DAOs are web-native organizations, collectively owned and managed by their members. They have integrated treasuries that can only be accessed with the approval of their members. Decisions are made through proposals on which the group votes for a fixed period.
A DAO works without hierarchical management and can have a large number of objectives. Freelance networks where contracts pool funds to pay for software subscriptions, charities where members approve donations, and group-owned venture capital firms are all possible with these organizations.
Before proceeding, it is important to distinguish a DAO, an organization born on the Internet, from The DAO, one of the first such organizations ever created. The DAO was a project founded in 2016 that ultimately failed and led to a dramatic split from the Ethereum network .
How does a DAO work?
As mentioned above, a DAO is an organization where decisions are made from the bottom up; a collective of members owns the organization. There are several ways to participate in a decentralized autonomous organization, usually through the possession of a token.
DAOs work using smart contracts, which are basically pieces of code that automatically run when a set of criteria are met. Smart contracts are deployed on many blockchains today, although Ethereum was the first to use them.
These smart contracts establish the rules of the DAO. People with a stake in a decentralized autonomous organization then obtain voting rights and can influence the functioning of the organization by deciding or creating new governance proposals.
This model prevents decentralized autonomous organizations from being inundated with proposals: A proposal will only be adopted if the majority of stakeholders approve it. How this majority is determined varies from DAO to DAO and is specified in smart contracts.
Decentralized Autonomous Organizations are fully autonomous and transparent. As they are built on open-source blockchains, anyone can view their code. Anyone can also check their integrated treasuries, as the blockchain records all financial transactions.
How is a DAO launched?
In general, the launch of a decentralized autonomous organization takes place in three main stages
- Creation of the smart contract : First, a developer or a group of developers must create the smart contract behind the DAO. After launch, they can only change the rules established by these contracts through the governance system. This means they need to test contracts thoroughly to make sure they don’t overlook any important details.
- Funding : After creating the smart contracts, the DAO needs to figure out a way to receive funding and set up governance. Most often, tokens are sold to raise funds; these tokens give holders voting rights.
- Deployment : Once everything is in place, the DAO must be deployed on the blockchain. From this moment, the stakeholders decide the future of the organization. The creators of the organization – those who wrote the smart contracts – no longer influence the project, nor do other stakeholders.
Why do we need DAOs?
As born-on-the-internet organizations, DAOs have several advantages over traditional organizations. A significant advantage is the lack of necessary trust between two parties. While a traditional organization requires a great deal of trust in the people supporting it — especially on behalf of investors — with DAOs, only the code needs to be trusted.
This code is easier to trust because it is publicly available and can be thoroughly tested before launch. Every action taken by a DAO after its launch must be approved by the community and is completely transparent and verifiable.
Such an organization has no hierarchical structure. Yet, it can still perform tasks and grow while being controlled by stakeholders via its native token. The lack of hierarchy means that any stakeholder can come up with an innovative idea that the whole group will review and improve. Internal conflicts are often easily resolved through the voting system, according to the rules pre-written in the smart contract.
By allowing investors to pool their funds, DAOs also give them the opportunity to invest in startups and early-stage decentralized projects, while sharing any risks or rewards that may arise.
The principal-agent dilemma
The main advantage of DAOs is that they offer a solution to the principal-agent dilemma. This dilemma is a conflict of priorities between a person or group (the principal) and those who make decisions and act on their behalf (the agent).
The problem can arise in certain situations, especially in the relationship between stakeholders and a CEO. The agent (the CEO) may work in a way that is not in line with the priorities and objectives determined by the principal (the stakeholders) and instead act in his own interest.
Another typical example of the principal-agent dilemma occurs when the agent takes excessive risks because the principal bears the burden. For example, a trader may use extreme leverage to attempt to earn a performance bonus, knowing that the organization will cover any downside.
DAOs solve the principal-agent dilemma through community governance. Stakeholders are not forced to join a DAO and only do so after understanding the rules that govern it. They do not need to trust an agent acting on their behalf and instead work within a group whose incentives are aligned.
The interests of token holders are aligned because the nature of a DAO incentivizes them not to be malicious. Since they have a stake in the network, they will want to see it succeed. To act against him would be to act against their personal interests.
What is “The DAO”?
“The DAO” was an early iteration of modern decentralized autonomous organizations. Launched in 2016, it was designed to be an automated organization that acted as a form of venture capital fund.
Those who owned DAO tokens could benefit from the organization’s investments by reaping dividends or benefiting from the appreciation in the price of the tokens. The DAO was initially considered a breakthrough project and raised $150 million in Ether (ETH), one of the biggest crowdfunding efforts of the time.
The DAO was launched on April 30, 2016, after Ethereum protocol engineer Christoph Jentzsch released the open-source code of an Ethereum-based investment body. Investors bought DAO tokens by transferring Ether to its smart contracts.
A few days after the token sale began, some developers raised concerns that a bug in the DAO’s smart contracts could allow malicious actors to drain its funds. While a governance proposal was put in place to fix the bug, an attacker took the opportunity to siphon off over million worth of ETH from The DAO’s wallet.
At the time, around 14% of all ETH in circulation was invested in DAO. This hack was a blow to DAOs in general and to the then year-old Ethereum network. A debate within the Ethereum community ensued, with everyone trying to figure out what to do. Initially, Ethereum co-founder Vitalik Buterin proposed a soft fork that would blacklist the attacker’s address and prevent him from moving the funds.
The attacker or someone impersonating him then responded to this proposal, claiming that the funds had been obtained “legally” according to the rules of the smart contract. They said they were ready to take legal action against anyone who tried to seize the funds.
The hacker even threatened to bribe ETH miners with some of the stolen funds to thwart a soft fork attempt. In the ensuing debate, it was decided that a hard fork would be the solution. This hard fork was implemented to go back in the history of the Ethereum network, before the DAO hack, and reallocate the stolen funds to a smart contract for investors to withdraw them. Those who disagreed with this decision rejected the hard fork and supported an earlier version of the network, known as Ethereum Classic (ETC).
Disadvantages of DAOs
Decentralized autonomous organizations are not perfect. It is an extremely new technology that has drawn a lot of criticism due to persistent concerns about its legality, security, and structure.
DAOs can be distributed in multiple jurisdictions and have no legal framework. Any legal issues that may arise will likely require those involved to deal with many regional laws in a complicated legal battle.
In July 2017, for example, the United States Securities and Exchange Commission released a report in which it determined that The DAO sold securities as tokens on the Ethereum blockchain without permission, thereby violating parts of the law. on securities in the country.
Decentralized autonomous organizations have gained traction over the past few years and are now fully integrated into many blockchain projects. The decentralized finance (DeFi) space uses DAOs to enable applications to become fully decentralized, for example.
For some, the Bitcoin (BTC) network is the oldest example of DAO there is. The network grows through a community agreement, even though most network participants have never met. It also lacks an organized governance mechanism, but miners and nodes must signal their support.
However, Bitcoin is not considered a DAO by today’s standards. Under current metrics, Dash would be the first true DAO, as the project has a governance mechanism that allows stakeholders to vote on the use of its treasury.
Other more advanced DAOs, including decentralized networks built on the Ethereum blockchain, are responsible for launching cryptocurrency-backed stablecoins. In some cases, the organizations that originally launched these DAOs gradually cede control of the project to one day become irrelevant. Token holders can actively vote on governance proposals to hire new contributors, add new tokens as collateral to their coins, or adjust other settings.
In 2020, a DeFi lending protocol launched its own governance token and distributed it through a liquidity mining process. Essentially, anyone who interacted with the protocol received tokens as a reward. Other projects have since replicated and adapted the model.
The future of DAOs
Today, the list of DAOs is long. Over time, it has become a clear concept that has grown in popularity. Some projects are still looking to achieve full decentralization through the DAO model, but it should be noted that they are only a few years old and have yet to achieve their final goals and objectives.
As born-on-the-internet organizations, DAOs have the potential to completely change the way corporate governance works. As the concept matures and the legal gray area in which they operate is cleared up, more and more organizations could adopt a DAO model to help them govern some of their activities.