Introduction
Blockchains are already radically transforming our financial system. However, properties such as lack of confidence and immutability are not only useful in monetary applications.
Another potential ripe candidate to be stopped by this technology is governance. Blockchains can enable entirely new types of organizations that can function autonomously without the need for coordination by a central entity. This article will provide an introduction to what these organizations can be like.
What is a DAO and how does it work?
The acronym DAO stands for Autonomous Decentralized Organization. In simple terms, a DAO is an organization governed by computer codes and programs. As such, it has the ability to function autonomously, without the need for a central authority.
Through the use of smart contracts, a DAO can work with external information and execute commands based on it – all without any human intervention. A DAO is typically operated by a community of stakeholders encouraged through some sort of token mechanism.
A DAO's rules and transaction logs are stored transparently in the blockchain . Rules are generally decided by stakeholder votes. Typically, the way decisions are made in a DAO is through proposals. If a proposal is voted on by a majority of interested parties (or meets some other rule defined in the network's consensus rules), it will then be implemented.
In some ways, a DAO works similarly to a corporation or nation-state, but it operates in a more decentralized way. While traditional organizations work with a hierarchical structure and many layers of bureaucracy, DAOs have no hierarchy. Instead, DAOs use economic mechanisms to align the organization's interests with the interests of its members, often through the use of game theory.
Members of a DAO are not bound by any formal contract. They are closely united by a common goal and network incentives tied to consensus rules. These rules are completely transparent and written in the open source software that governs the organization. As DAOs operate without borders, they may be subject to different legal jurisdictions.
As the name implies, a DAO is decentralized and autonomous. It is decentralized because no entity has the authority to make and enforce decisions. And it's autonomous because it can work on its own.
Once a DAO is deployed, it cannot be controlled by a single party, but administered by a community of participants. If the governance rules defined in the protocol are well designed, they should guide actors towards the most beneficial outcome for the network.
Simply put, DAOs provide an operating system for open collaboration. This operating system allows individuals and institutions to collaborate without having to know or trust each other.
DAOs and the principal agent problem
DAOs face an economic problem called the principal agent dilemma. It happens when a person or entity (the “agent”) has the ability to make decisions and act on behalf of another person or entity (the “principal”). If the agent is motivated to act in his own interest, he may disregard the principal's interests.
This situation allows the agent to take the risk on behalf of the principal. What deepens the problem is that there can also be information asymmetry between the principal and the agent. The principal may never know that he is being taken advantage of and cannot be sure that the agent is acting in his best interest.
Common examples of this problem occur with elected officials who represent citizens, brokers who represent investors, or managers who represent shareholders.
By enabling a higher degree of transparency enabled by blockchains, well-designed incentive models behind DAOs can eliminate parts of this problem. Incentives within the organization are aligned and there is very little (if any) information asymmetry. Since all transactions are logged in a blockchain, the operation of DAOs is completely transparent and, in theory, makes them incorruptible.
DAO Examples
Although very primitive, the Bitcoin network can be considered the first example of DAO. It operates in a decentralized and coordinated manner through a consensus protocol without hierarchy among participants.
The Bitcoin protocol defines the organization's rules, while bitcoins like currency provide an incentive for users to secure the network. This ensures that the different players can work together to keep Bitcoin functioning as an autonomous, decentralized organization.
The common goal in the case of Bitcoin is to store and transfer value without a central entity coordinating the system. But what else can DAOs be used for?
More complex DAOs can be deployed for different use cases, such as token governance, decentralized venture funds or social media platforms. DAOs can also coordinate the operation of devices connected to the Internet of Things (IoT) .
In addition, these innovations introduced a subset of DAOs called Decentralized Autonomous Corporations (DACs). A DAC can provide similar services to a traditional company, for example a travel sharing service. The difference is that it works without the corporate governance structure of traditional businesses.
For example, a car that owns itself and provides travel sharing services as part of a DAC could operate autonomously, transacting with people and other devices. Through the use of blockchain oracles, he could even trigger smart contracts and perform certain tasks on his own, like going to the mechanic.
Ethereum and "The DAO"
One of the first examples of a DAO was aptly named “The DAO”. It was made up of complex smart contracts running on top of the Ethereum blockchain that were supposed to act as an autonomous risk fund.
DAO tokens were sold in an initial coin offering (ICO) and provided an equity stake and voting rights in this decentralized fund. However, shortly after launch, around a third of the funds were drained from it in one of the biggest hacks in cryptocurrency history.
The result of this event was that Ethereum split into two chains following a rigid fork. In one of them, fraudulent transactions were effectively reversed, as if the hack never happened. This chain is what is now called the Ethereum blockchain. The other network, obeying the “code is law” principle, left fraudulent transactions untouched and maintained immutability. This blockchain is now called Ethereum Classic.
What problems are DAOs facing?
Legal
The regulatory environment around DAOs is completely uncertain. It remains to be seen how different jurisdictions will create the regulatory framework around these new types of organizations. However, a continually uncertain regulatory landscape can be a significant barrier to adopting DAOs.
coordinated attacks
The desirable properties of DAOs (decentralization, immutability, lack of trust) inherently bring significant performance and security disadvantages. While some of the potential organizations that can emerge as DAOs are undoubtedly exciting, they present many risks that are not present in traditional organizations.
Centering Points
It is arguable that decentralization is not a state but an interval, where each level is suited to a different type of use case. In some cases, full autonomy or decentralization may not even be possible or make sense.
DAOs can allow a broader range of stakeholders to collaborate than ever before, but the governance rules defined in the protocol will always be a central point. It can be argued that centralized organizations can operate much more efficiently – but abandon the benefits of open participation.
Final Thoughts
DAOs allow organizations to free themselves from dependence on traditional institutions. Instead of a central entity coordinating the participants, governance rules are automated and guide actors towards the most beneficial outcome for the network.
The Bitcoin network can be considered a simplistic DAO and, for now, other implementations are scarce. The key to designing good DAOs is establishing an efficient set of consensus rules that solve complex stakeholder coordination problems. The real challenge faced by implementing DAOs may not be purely technological, but social.