Decentralized Autonomous Organization (DAO) Explained

A decentralized autonomous organization (DAO) is an entity with no central leadership. Decisions are made bottom-up and governed by a community organized around a specific set of rules applied to a blockchain.
Decentralized Autonomous Organization (DAO) Explained | Coinscreed
Dentralized Autonomous Organization

DAOs are Internet-native organizations collectively owned and managed by their members. They have internal treasuries that are only accessible with the consent of their members.

Decisions are made through proposals voted on by the group over a period of time.

A decentralized autonomous organization works without hierarchical management and can serve a variety of purposes.

Freelancer networks where contracts pool their funds to pay for software subscriptions, charities where members approve donations, and corporate venture capital firms are all possible with these organizations.

Before proceeding, it is important to distinguish a DAO, an Internet-native organization, from The DAO, one of the first such organizations ever formed.

DAO was a project founded in 2016 that ultimately failed and led to a dramatic split in the Ethereum network.

How does a DAO work?

As mentioned above, a DAO is a bottom-up organization where decisions are made; a collective of members owns the organization.

There are several ways to participate in a decentralized autonomous organization, especially through owning a token.

DAOs work with smart contracts, which are essentially pieces of code that run automatically when a set of criteria are met.

Smart contracts are deployed on various blockchains these days, although Ethereum was the first to use them.

These smart contracts set the DAO rules. Those who participate in a DAO are given voting rights and can influence the way the organization works by deciding on or creating new governance proposals.

This model prevents DAOs from receiving proposal spam: a proposal is only approved if a majority of stakeholders agree to it.

How this majority is determined differs from DAO to DAO and is specified in smart contracts.

DAOs are fully autonomous and transparent. Because they are built on open-source blockchains, anyone can see their code. Anyone can also check their internal treasures as the blockchain records all financial transactions.

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Decentralized Autonomous Organization (DAO) Explained | Coinscreed
How DAOs work.

DAO launches occur in 3 stages

Smart Contract Creation: First, a developer or group of developers needs to create the smart contract behind the decentralized autonomous organization.

Once launched, they can only change the rules set by these contracts through the governance system.

That means they have to test contracts extensively to make sure they don’t miss any important details.

Funding: After smart contracts are created, the DAO must determine a way to receive funding and approve governance.

Most of the time, tokens are sold to raise money; These tokens grant voting rights to the holders.

Deployment: Once everything is set up, the DAO needs to be deployed on the blockchain. From this point on, the stakeholders decide on the future of the organization.

The creators of the organization – the ones who wrote the smart contracts – influence the project no more than other stakeholders.

Decentralized Autonomous Organization (DAO) Explained | Coinscreed
DAOs are launched in 3 stages.

Why do we need DAOs?

As Internet-native organizations, DAOs have several advantages over traditional organizations. A key advantage of DAOs is the lack of the necessary trust between two parties.

While a traditional organization requires a lot of trust in the people behind it – especially on behalf of investors – with DAOs only the code needs to be trusted.

Trusting this code is easier because it is publicly available and can be extensively tested before release. All post-launch actions of a DAO must be approved by the community and are fully transparent and auditable.

Such an organization has no hierarchical structure. However, it can continue to perform tasks and grow while being controlled by stakeholders via its native token.

The lack of hierarchy means that each stakeholder can come up with an innovative idea that will be considered and improved by the whole group.

Internal disputes are usually easily resolved through the voting system according to the pre-established rules in the smart contract.

By allowing investors to pool funds, DAOs also give them the opportunity to invest in early-stage startups and decentralized projects and share the risk or any rewards that may arise.

How do DAOs solve the principal-agent dilemma?

The main benefit of DAOs is that they provide a solution to the principal-agent dilemma. This dilemma is a conflict of priorities between a person or group (the principal) and those making decisions and acting on their behalf (the agent).

Problems can arise in some situations, with the relationship between stakeholders and a CEO being a common one.

The agent (the CEO) may operate in a way that is inconsistent with the priorities and goals set by the principal (the stakeholders) and instead act in their own best interests.

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 can use extreme leverage to get a performance bonus, knowing that the organization covers all the downsides.

DAOs solve the principal-agent dilemma through community governance. Stakeholders are not required to join a DAO and only do so after understanding the rules governing it.

They don’t have to trust any agent acting on their behalf, instead of working as part of a group whose incentives are aligned.

The interests of token holders are aligned as the nature of a decentralized autonomous organization encourages them not to be malicious.

Because they are involved in the network, they will want to see success. To act against them would be to act against their own interests.

What was The DAO?

The DAO was an early iteration of modern decentralized autonomous organizations. It was launched in 2016 and designed as an automated organization that acts as a kind of venture capital fund.

Those who owned DAO tokens could benefit from the organization’s investments by collecting dividends or benefiting from the token’s appreciation.

Initially viewed as a revolutionary project, DAO raised $150 million in Ether (ETH), one of the largest crowdfunding efforts of the time.

DAO was released on April 30, 2016, after Ethereum protocol engineer Christoph Jentzsch released open-source code for an Ethereum-based investment organization. Investors bought DAO tokens by moving ether into their smart contracts.

A few days after the token sale, some developers raised concerns that a flaw in DAO’s smart contracts could allow malicious actors to siphon their funds.

While a governance proposal was put forward to fix the bug, an attacker took advantage and embezzled over $60 million in ETH from the DAO wallet.

Back then, around 14% of all ETH in circulation was invested in the decentralized autonomous organization. The hack was a major blow to DAOs in general and to the then 1-year-old Ethereum network.

Debate ensued within the Ethereum community as everyone struggled to figure out what to do.

First, 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 them, responded to this suggestion, claiming that the funds were obtained in a “legal” manner according to smart contract rules.

They said they were ready to take legal action against anyone who tried to confiscate the funds.

The hacker even threatened to bribe ETH miners with some of the stolen funds to stop a soft fork attempt. In the subsequent debate, a hard fork was identified as the solution.

This hard fork was implemented to restore the history of the Ethereum network before the DAO was hacked and allocate the stolen funds to a smart contract that allowed investors to withdraw them.

Those who disagreed with the change opposed 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. They’re an extremely new technology that has drawn a lot of criticism due to ongoing concerns about its legality, safety, and structure.

The MIT Technology Review, for example, revealed that it thinks it is a bad idea to entrust major financial decisions to the masses.

While MIT shared its thoughts in 2016, the organization never seems to have changed its mind about DAOs — at least publicly.

The DAO hack has also raised security concerns, as bugs in smart contracts can be difficult to fix even after they are discovered.

DAOs can be spread across multiple jurisdictions and there is no legal framework for them. Any legal issues that may arise will likely require those involved in a complicated legal battle to grapple with various regional laws.

For example, in July 2017, the United States Securities and Exchange Commission released a report stating that the DAO had sold unauthorized securities in the form of tokens on the Ethereum blockchain, in violation of parts of the country’s securities law.

Examples of DAOs

Decentralized autonomous organizations have gained prominence in recent years and are now fully embedded in many blockchain projects.

The field of decentralized finance (DeFi) uses DAOs to be able to fully decentralize applications, for example.

For some, the Bitcoin (BTC) network is the first existing example of DAO. The network scales through community agreement, although most network participants have never met.

It also lacks an organized governance mechanism and instead requires miners and nodes to signal support.

However, Bitcoin is not considered a DAO by today’s standards. By current standards, 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 top of the Ethereum blockchain, are responsible for launching cryptocurrency-backed stablecoins.

In some cases, organizations that originally launched these DAOs slowly relinquish control of the project, only to one day become irrelevant.

Token holders can actively vote on governance proposals to hire new contributors, add new tokens as collateral for their coins, or adjust other parameters.

In 2020, a DeFi lending protocol launched its own governance token and distributed it through a liquidity mining process.

Essentially, everyone who interacted with the protocol received tokens as a reward. Since then, other projects have replicated and adapted the model.

Now the list of DAOs is extensive. Over time it became a clear concept that has gained traction.

Some projects are still trying to achieve full decentralization through the DAO model, but it is worth noting that they are only a few years old and have not yet reached their final goals and objectives.

As internet-native organizations, DAOs have the potential to completely transform the way corporate governance works.

As the concept matures and the legal gray area in which they operate is eliminated, more and more organizations can adopt a DAO model to govern some of their activities.