Crypto for Experts DeFi

DAOs explained: What is a Decentralized Autonomous Organization?

What is a DAO

Crypto and the DeFi infrastructure have eliminated the need for intermediaries and central governing authority in financial services. DAOs seek to apply the same idea to companies.

What if blockchain technology could render the corporate organizational structure obsolete? DAOs offer the possibility for a fully democratic organization of people and resources using the blockchain.

Decentralized Autonomous Organization – Definition

DAO, or a Decentralized Autonomous Organization, is a blockchain-based organization run by smart contracts, which offers an alternative organizational model for companies and non-commercial entities. 

Just like in a traditional organization, DAO’s members unite around a common goal. This could be a financial goal, but not necessarily. A DAO can serve different functions performed by traditional forms of organizations like a company, charity association or a cooperative. 

In achieving the agreed aims, the members of a DAO manage its resources and efforts in a non-hierarchical, 100% transparent way. Built on an open-source blockchain, DAOs provide for full transparency of financial records. Transaction data, the code and voting records are all publicly accessible. 

Key to the functioning of a DAO is its native token. Token holders obtain voting rights for any issue critical to the running, protection and future development of the DAO. Collaboration and democratic decision-making replace the usual hierarchical and centrally governed corporate structure.

How a DAO works

The most unique aspect about a DAO is the use of smart contracts in place of people to run the organization. Smart contracts are computer code that operates on a blockchain and serves to carry out a particular function when certain conditions are met. 

So, real people come together to found a DAO but there isn’t a management board to execute the decisions. Instead, smart contracts automatically perform operations based on a previously established set of rules written in the code. Only a democratic vote by all members can change the smart contract. 

Each DAO can have its own rules on what constitutes a majority and the exact form of the voting process. A member’s level of involvement in the community can vary, from simply voting on proposals to participating in the development of the protocol. Token ownership mediates the level and form of participation.

Can DAOs grow?

In people-run organizations, the personal interest of the CEO can easily come into conflict with the interest of stakeholders. DAOs eliminate this problem by horizontal, community-led management using governance tokens. The aspect of token ownership in a DAO aligns stakeholders’ self-interest with the common interest of the organization.  

A successful protocol attracts more people to become members by investing in the token, which thereby increases the token’s value. Therefore, members have an incentive to use their voting power in a way that will benefit the development of the protocol.

As a result, the lack of hierarchy in such a horizontally run structure does not translate into a lack of efficiency. This kind of a decentralized organization can grow and develop.

The DAO Story

The DAO was one of the earliest practical applications of the concept of DAO. Unfortunately, this proved like a bad start for the reputation of these protocols. The story of this early example ended with the infamous split of the Ethereum network. 

In principle, The DAO sought to operate as a decentralized venture capital fund. Participants could deposit funds and obtain the appropriate amount of governance tokens. It started collecting funds in 2016 via a token sale. Interested parties invested Ether (ETH) and received in return a number of tokens proportional to the contribution amount. 

The founders indicated that The DAO token did not represent stocks or shares in any company, corporation or other entity under any jurisdiction. Token ownership provided investors with voting rights in the DAO. They could decide and vote on which projects within the organization would receive financing. In this sense, the DAO resembled a crowdfunding platform.

Three stakeholders took part in the creation and maintenance of The DAO. 

  • First, the creators wrote the open source code that established the platform
  • The interested investors decided to take part in the DAO and expressed interest to obtain voting rights in return for contributing cryptocurrency. 
  • The curators collected, verified and put up for voting different proposals, without assessing the submitted projects or rejecting any.

However, this type of crowdfunding-like operation raised legal challenges, because it exposed the inadequacy of existing regulations. Due to the innovative nature of the DAO, it poses a difficulty to identify who is responsible for its activities and what rules apply.

The DAO hack

The DAO was among the first projects built on the Ethereum network, which was only one year old at the time. Eventually, hackers exploited a vulnerability in the base code of the DAO bringing the story to a dramatic end. About USD 150 million in ETH remained stuck in the DAO pools. To recover these funds, some Ethereum developers decided to go for a hard fork, which created today’s Ethereum, while the original Ethereum blockchain continued to exist as Ethereum Classic. 

Takeaways

With the advent of DeFi protocols, many consider DAO to be a critical part of decentralized finance and one of the most nascent applications of blockchain technology. DAOs provide for fully transparent, consensus-based decision-making. They come in many forms and serve different functions. The legal aspects of regulating this type of organizations can pose a challenge.

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