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What Is a DAO?

October 8, 2021

6m

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The narrative for decentralized organizations surrounding cryptocurrency projects began in 2016, with the launch of The Dao, a project that raised $150 million in crowdfunding. At the time, the event marked one of the largest funding rounds in crypto history.

However, the DAO ‘failed’ shortly after launching, as a hacker stole $50 million in crypto assets. This forced the Ethereum community to fork and migrate to another version of the network in order to undo the hack. Due to the controversy, the idea of decentralized governance had lost its popularity, and scalability protocols soon replaced the hype.

With the arrival of DeFi protocols in 2019 and 2020, DAO-like systems have resurfaced. They might not have the original form, but they all follow the same fundamental principle: absolute decentralization in a trustless environment.

What is a DAO?

A DAO is a decentralized autonomous organization that manages a blockchain network by relaying decisions to the community rather than developers.

Dan Larimer introduced the concept in 2013, using the term Decentralized Autonomous Corporations to describe an entity where crypto holders are shareholders and miners are employees.

Vitalik Buterin, the famous creator of Ethereum, took DAC one step further by imagining a system in which a blockchain network mimics a company that works without managers. At all layers and levels of hierarchies, tasks are processed and controlled by smart contracts rather than individual people.

To work, the DAO requires a set of rules which are embedded into smart contracts. Since smart contracts are self-executable and require no interaction from developers, they can autonomously support the blockchain.

After a community decides on the set of rules for a particular project, the next logical step is to find a way to delegate voting power to the community. Since each blockchain has a token, DAOs use funding phases and presales to sell their tokens to interested investors, who in return gain the ability to influence the direction a DAO takes and how it operates.

The DAO can only launch after distributing its tokens, and at that stage, it becomes independent from its original developers. To move forward or even make the smallest decision, the project’s investors must reach a consensus.

Any user can publicly share a governance proposal, which other members of the community can vote on. However, each proposal creator must provide a stake in the form of crypto assets to create the proposal in the first place. This is a part of the organization’s security mechanism, which prevents massive proposal spam.

Advantages and Disadvantages of DAOs

DAOs are an interesting concept that excited the entire blockchain community back in 2016. Not only do they remove the traditional top-down hierarchical structure, but they also give managing powers to the entire organization.

Everyone has a say in how the project is shaped and how it will work in the future. Anyone can become a part of the organization, and there are absolutely zero restrictions imposed upon the community and what they are capable of doing.

Since locking crypto assets represents an elemental part of the decision-making process, the community is forced to think twice before creating proposals. There is no room for arguing about details, and the most efficient way to progress further is by focusing on the big picture at hand.

There are also major disadvantages that we should not ignore when discussing DAOs - the largest one being the voting system.

Entrusting decisions to everyone within a system can be dangerous, especially if they are financial ones. Since the community owns the project’s assets, they are incentivized to primarily vote for those decisions that will have a positive impact on the asset’s value.

In 2020, the Maker DAO made the controversial decision to not reimburse its fellow community members who were liquidated during the March flash crash earlier that year, for fear of creating immense selling pressure for the MKR token. Despite the fact that the liquidation cascade occurred as a result of Maker’s failure and not overt risk exposure, greed drove a majority of the community to decide that the affected users should not be reimbursed.

Apart from greed, another serious problem is that blockchain projects with DAOs cannot make decisions as fast. In the case of The DAO hack, the community was not able to do anything as the hackers stole assets in real-time. If developers had the privilege to do anything that they wish, the attack could have been stopped at the moment it was acknowledged.

Last but not least, decentralized autonomous organizations have no legal ground to conduct business with real-world entities. However, this issue will surely be resolved with time as more governments decide to accept decentralized companies on the blockchain.

DAO in DeFi (Governance Models)

All projects within the DeFi ecosystem use governance models to remain decentralized. Otherwise, we could not claim that DeFi is ‘decentralized finance’ if its projects were managed by centralized groups.

Just like DAOs, governance models grant voting power to their users through tokens. The more tokens a user has, the larger voting power he has. Every major DeFi token that you have heard of acts mainly as a governance token, including UNI, SUSHI, YEARN, and so on.

It is worth noting that governance models have generated far more activity than DAOs. Communities like Yearn Finance and SushiSwap tend to actively participate in governance discussions, creating proposals on almost a weekly basis.

However, the primary problem is that the aspect of decentralization can be completely tarnished by one action: accumulation. If a group of whales was to coordinate a token’s accumulation, they would reach a potion where they can change a project’s direction all on their own.

During its early governance stages, the famous Uniswap DEX experienced a problem in which a couple of other blockchain projects held enough assets to create proposals on their own. Moreover, they also had the ability to steer the voting processes’ direction to a high degree.

Since we are still early in the DeFi market, whales can singlehandedly accumulate large amounts of tokens to manipulate projects later. What would be the purpose of decentralized governance if the top 50 wallets control the entire voting process?

Final Word

DAOs may have their limitations, but the sheer idea of having an entire community decide how to manage and operate a blockchain network, is enough to remain enthusiastic about decentralized organization.

As we have seen, DAOs are mainstream now that they are a fundamental part of the $40 billion DeFi market. In a world where smart contracts automate every single process and feature, there is not much need for developers who were previously forced to approve all sorts of transactions and functions on their own.

Nevertheless, the future of governance models is not bright if developers do not find a way to surpass two major issues: accumulation and greed. Is it an impossible task to solve? Most likely not, but it will take years before we find a suitable solution that can convert blockchain into utopias.

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