What is a DAO?

We’ll look at the basics and examples of the advantages and disadvantages of using DAO, along with real-life case scenarios.

DAOs on blockchain: A Solution to the Principal-Agent Dilemma

A decentralized autonomous organization (DAO) is a blockchain-specific organizational model that addresses a perennial challenge present in almost every industry and organization: the principal-agent dilemma. Whenever a system is structured in a way in which an individual or entity (the “agent”) has the ability to make decisions or take actions on behalf of another individual or entity (the “principal”), there is inherent risk in the divergent goals, priorities, or access to crucial information of the respective parties. This is the principal-agent dilemma, and it means that the agent may be motivated to act in accordance with its own self-interest, even if the agent was selected to make decisions on behalf of the principal’s interests. At present, this dilemma is a common challenge that affects a broad spectrum of public and private entities. Aiming to address this problem by reducing or bypassing the need for hierarchical human intervention or centralized coordination, DAOs are often referred to as “trustless” systems. By ensuring that the incentive structures and information flow within an organization are properly aligned in a codified format, DAOs play a leading role in mitigating the typical problems associated with the principal-agent dilemma. Alignment of incentives is a defining concept of blockchain protocols, and DAOs apply similar logic to organizations and governance. A properly executed DAO aligns the incentives of stakeholders — from founders to token holders, to users, and the general community — in governing an organization or decentralized platform. The potential effects of implementing DAOs on a broad scale are enormous, as are the real-world challenges of effectively applying technology that enables a DAO.

How Do DAOs Work? While the specific underlying mechanisms powering a DAO vary across different blockchain projects, there are several general phases a DAO must undergo to launch in a sustainable manner: Smart contract setup: Before a DAO can be deployed, the underlying rules must be defined and encoded in a series of smart contracts. Given that future changes to the DAO’s operational workflows, governance system, and incentive structures will need to be voted on in order to take effect, this phase is arguably the most crucial step to creating a sustainable and autonomous DAO, as any initial mistakes or overlooked details can potentially destabilize the project down the line. Funding: Once the creators of a DAO have established its governing smart contracts, the DAO needs to receive funding in order to operate. The DAO’s smart contracts must entail the creation and distribution of some form of internal property, such as a native token that can be spent by the DAO, utilized in voting mechanisms, or used to incentivize certain activities. From there, individuals or entities interested in participating in the DAO’s growth can purchase or otherwise acquire the DAO’s native token, which typically results in acquiring voting rights. Deployment: Once a DAO receives enough funding to be deployed, all its decisions are made via a consensus vote. As a result, all token holders become stakeholders who can make proposals regarding the DAO’s future and how its funds are spent. If the DAO’s token distribution policy and consensus mechanisms defined in its underlying smart contract architecture are well-designed, the DAO’s stakeholders will naturally work towards the most beneficial outcome for the entire DAO network. The resulting DAO organization can therefore operate independently from its creators or any other central authority. Since DAOs are open source, all their rules, transactions, and activities are recorded on the blockchain and can be reviewed by anyone, which generally ensures full transparency and immutability. In short, a DAO’s stakeholders are bound together by a common goal, which they will vote to advance through the pursuit of specific network incentives defined by the DAO’s underlying consensus policies. Applying DAOs to the Real World Because DAOs embody a marked departure from the structure of traditional organizations and how they operate, there are numerous legal and operational challenges these organizations must overcome. For instance, because DAOs can be physically distributed across multiple countries and jurisdictions, any resulting legal issues would likely require dealing with multiple regional laws and any relevant cross-border contractual relationships. Furthermore, because changing a DAO’s code or smart contract structure requires a consensus vote, malicious actors could possibly exploit a bug or design flaw before the DAO’s stakeholders manage to collectively resolve the issue. This type of exploit crippled one of the earliest crowdfunding efforts on the Ethereum blockchain: In 2016, The DAO was hacked because of vulnerabilities in its code base, which resulted in a controversial hard fork of the Ethereum network to move funds stolen from The DAO to a new smart contract. The incident was a critical moment in the blockchain, and since then, avoiding another such hack has been a priority for developers.

That said, DAOs have continued to gain traction in the marketplace. At present, there are several promising blockchain projects that have fully incorporated decentralized governance mechanisms, particularly within the decentralized finance (DeFi) landscape. Below is a non-exhaustive list of existing blockchain projects that embody the core tenets of a DAO:

Bitcoin: The Bitcoin network can be considered the first rudimentary DAO since it operates fully in accordance with an open-participation consensus protocol that coordinates the behavior of a vast network of participants unknown to each other. However, the Bitcoin network lacks the complex governance mechanisms typically associated with a DAO, and it is rarely referred to as such. Dash is an open-source, peer-to-peer (P2P) cryptocurrency that offers instant payments and private transactions. While the project is a DAO to the extent that all decisions are made collectively via a subset of masternodes, the degree to which the Dash network is decentralized remains debatable given that the network’s governance tokens were distributed in a way that concentrated wealth on a small group of stakeholders, granting them disproportionate voting power over the project.

MakerDAO: MakerDAO is a decentralized lending network built on the Ethereum blockchain and is the protocol behind the stablecoin DAI. The MakerDAO Foundation, which has steered the development of the project since its inception, initiated several moves in April 2020 to achieve full decentralization, namely giving control of the undistributed supply of the project’s governance token (MKR) to MKR holders at large, establishing a process of electing paid contributors, and improving the voter participation process to benefit smaller stakeholders. In this way, the MakerDAO Foundation hopes to make itself obsolete and pass full ownership of the project on to its distributed network of project stakeholders.

Uniswap: In September 2020, Uniswap released a native governance token, UNI, in order to transition Uniswap into a decentralized, community-owned protocol. The Uniswap community, on the other hand, has raised concerns about the level of decentralization that Uniswap’s governance model allows. Because Uniswap has a minimum threshold of 1% of the total UNI supply, 99% of UNI holders (who each hold less than 1%) can’t propose changes to the protocol because they each hold less than 1%. From the examples above, it’s clear that many blockchain projects built with decentralized philosophies are on a journey toward achieving the ideal of complete decentralization. To this point, it’s important to note that the more stakeholders a DAO has, the more decentralized it becomes. This is a major reason so many existing blockchain projects allow for a certain level of centralized decision-making in the initial stages of the project prior to achieving the scale required to transition into a full-fledged DAO. And, given that most DeFi projects are only a few years old, many of these projects have yet to transition into fully-fledged decentralization, although achieving DAO status is oftentimes a central goal of these projects. While the challenges of designing and deploying highly sustainable, value-generating DAOs are significant, DAOs nonetheless represent a potentially world-changing new form of corporate governance. As the legal gray areas surrounding DAOs are clarified, an increasing number of organizations may look to adopt DAO platforms to automate certain aspects of their core business activities. And while the ever-increasing complexity of modern business models means that DAO stakeholders will need to adapt their systems accordingly, the goal of establishing transparent and self-governing organizations is becoming more of a reality.