As you read this, the next chapter in the story of Crypto is unfolding: it’s all about decentralized autonomous organizations (DAOs) and the real-world benefits they offer financial institutions and organizations. As the worlds of decentralized finance (DeFi), non-fungible tokens (NFTs) and GameFi continue to grow and evolve at a breakneck pace, DAOs also offer unique solutions to their smart contract-powered cousins.
The last few months have seen some DAOs enter the public consciousness and dominate headlines with some audacious maneuvers (some call publicity stunts). These include raising millions of dollars on a failed auction for an original version of the U.S. Constitution, trying to bring Blockbuster back to life and SpiceDAO apparently buying a copy of the book Dune in order to gain copyright (that’s not how it works).
Despite these missteps, DAOs are set to revolutionize the investment space as they offer several advantages over their traditional centralized business equivalents. We will see it continue to gain traction this decade as the worlds of DeFi and TradFi continue to merge and learn from each other.
What is a DAO?
A decentralized autonomous organization (DAO) is an open-source blockchain protocol that, as its name suggests, is created to facilitate decentralized and automated decision-making in an organization. It usually meets some basic criteria, including:
- It is controlled by specific rules,
- It is created by its elected members,
- It automatically performs certain actions under specific conditions,
- It doesn’t require the help of any intermediaries.
How do DAOs work?
DAOs are built on open-source blockchains, meaning all information related to them can be viewed by the public. They are collectively owned and managed by their members, and all decisions are made via proposals that get voted on during specified time periods. The direct democracy component is both an asset and a liability, as it has the potential to paralyze the pace of action if not managed well.
DAO decision making
The rules that govern the DAO are encoded into the blockchain, and they cannot be changed once the organization is up and running except by a membership vote. Votes are weighted depending on capital contributions, ownership balances, and holdings of the native token.
This is all made possible by smart contract technology. Smart contracts allow for the automation of transactions and the disintermediation of decision-making, thereby increasing productivity in many different fields, from finance and commerce to art and the creative industries.
With DeFi and NFTs, smart contracts are used to replace third parties in transactions, including those related to lending and investing. However, with DAOs, the chain is used to transfer some or all of the decision-making power from a centralized authority to the organization’s members, with rules and guidelines encoded into the blockchain. Smart contracts are birthing a world where many organizations will be able to coordinate online in a trustless environment, relying solely on software.
Types of DAOs
Most DAOs can be divided into one of 3 categories: Protocol DAOs, Investor DAOs or Community DAOs
Protocol DAOs (such as Uniswap and Compound) are created by communities that propose and vote on rules to govern their DAO. Votes are weighted based on the number of governance tokens held by each participant.
Investor DAOs (like Flamingo and PleasrDAO) act like a crowdfund of sorts where each contributor purchases the specific DAO’s governance token or native asset with other crypto in order to gain voting rights.
Finally, Community DAOs like Friends With Benefits normally start with no express purpose but a social element that connects all the members. Over time as they get better organized, the community eventually adopts a DAO in order to democratize the governance process.
What Benefits Do DAOs Offer Institutions and Crypto Projects To Function Better?
Since DAOs are not run by boards but instead are governed collectively in a democratic process, their joint governance is able to stretch across the globe to potentially tens of thousands of participants. Because all decision-making is done via the blockchain, relevant data can be cryptographically verified. All decisions made by members are viewable by the rest of the organization, preventing misconduct. The technology also allows for vote delegation, which reduces the costs and time associated with proxy-based voting schemes.
As a general rule, DAOs avoid legal agreements in favor of software. This provides efficiency that traditional organizations don’t possess. By making the decision-making process more transparent, secure, and automatic, DAOs have the potential to achieve great flexibility and responsiveness.
DAOs are also able to rapidly pool capital due to the convenience of contributing digital currency through mobile phones or browser-based blockchain wallets. Transactions are processed much faster than in the traditional system, and assets are protected by internal controls, which saves on costs that would otherwise be spent detecting fraud or other malicious activity.
With the ability to quickly and efficiently pool capital, DAOs provide individuals and entities with access to countless unprecedented investment opportunities. There’s really no precedent for this kind of organization – something that allows investors from all over the globe to self-organize for a wide array of purposes.
The Drawbacks of DAOs
However, despite their many benefits, DAOs are still relatively new to the game. As such, there is still a great deal to iron out. DAOs are not formally recognized yet, which makes it difficult for them to interact with traditional business entities. This has the potential to pose risks. Regulatory bodies in the US and other countries have already signaled an interest in DAOs, though exactly how they will be regulated in relation to traditional securities remains to be seen.
What’s more, despite the operational efficiencies that smart contracts provide, they still require member participation – a time-consuming activity and one for which people are unequally prepared. As is well known, the information-processing capacity among humans is limited. Not to mention, many of the barriers to consensus building that exist in legacy institutions can be replicated in DAOs.
This means that although automation of many organizations would be possible in theory, it may not always be practical, since users must remain engaged and abreast of relevant happenings to make well-informed decisions. After all, most of us prefer to live in societies where we do not have to vote on every minor issue and can instead be represented by someone who broadly shares our ideas and attitudes.
At present, DAOs are exploring more complicated governance models that involve greater delegation and siloing of responsibilities. Only time will tell if these new blockchain models will evolve into something as promising as optimists have been hoping for.
Furthermore, DAOs have also been targeted by hackers, most notably the infamous 2016 hack of The DAO that resulted in an Ethereum hardfork and the creation of Ethereum Classic and the current iteration of ETH. In the wake of BadgerDAO’s $120m hack in 2021, , DAO security is more of a concern than ever before.
DAOs have rightfully become an important sector and tool for decentralized communities to function more optimally and democratically. Thanks to their unique properties and use of smart contracts, they could well become the de facto future standard of running all organizations and businesses in the most transparent and fair way.
However, mass adoption won’t arrive if the current generation of DAO protocols and their communities do not put in the work to make them as safe and easy to use as possible. Creating and adapting the right applications of blockchain technology that fits our specific needs still requires a human element, one that will always open the door to abuse if allowed to, just as with traditional organizations.