Both in academic and casual discourse, one of the most common topics that come up is the legitimacy of governance. Which form is the most optimal? Is liberal democracy a tyranny of the minority? Is social democracy a tyranny of the majority? Is democracy itself just a veneer for a hidden hierarchical structure? These and other questions are as old as the first city-states.
Whenever a ruler has the power to rule on behalf of others, moral hazards pop up. Decentralized autonomous organization (DAO) is an attempt to solve this age-old governance legitimacy problem. Let’s examine what it is and how it aims to accomplish this ambitious project.
In this guide:
What is a DAO?
Imagine a hundred survivors, shipwrecked on a desolate island. To survive, they would need to cooperate and to do so, they would need to follow some basic rules. In turn, when there are rules to follow, there are rulers and rule enforcers.
This is when the principal-agent dilemma appears. Those who make decisions on behalf of others are agents, while the others are the principal. Because the decision-maker — agent — distributes the risk of their actions to others, this inevitably leads to greater risk for the principal. After all, they have to suffer the full brunt of the decision’s consequences.
Furthermore, it is often the case that the agent prioritizes their personal interest above the principal’s. This, too, inevitably happens because the principle cannot fully track and control the agent’s moves. While legal contracts and the court system alleviate these moral hazards in the traditional organizations, decentralized autonomous organizations drastically reduce both the risks and the costs of managing them.
How do DAOs govern?
A decentralized autonomous organization uses blockchain to facilitate self-enforcing rules or protocols. Of course, the blockchain’s smart contracts store these rules, while the network’s tokens incentivize users to safeguard the network and vote on rules.
The following three steps create a DAO:
- Developers have to fully grasp the governance problem they are trying to codify in order to create a successful smart contract that serves as DAO’s foundation.
- Developers define the governance’s tokenomics — such as monetization so that there is a proper balance between rewards and punishment of malicious behavior.
- Developers launch the blockchain-powered DAO, preferably having the same token stakes as the rest of the stakeholders. This way, there is no imbalance of power. However, most developers release their stakes over time.
Consequently, DAOs are both transparent and autonomous. The number of tokens one holds translates to the weight behind voting rights, enabling one to direct new governance proposals. This prevents the DAO from being overwhelmed with proposals, which could create instability. Instead, governance proposals pass only when the majority of stakeholders affirm it.
Needless to say, each DAO has different rules on what constitutes a majority and the voting process.
Everything about DAOs
The first DAO was created in 2016, called “The DAO,” running on the Ethereum blockchain. Unfortunately, during this early stage of development, The DAO had an exploit that hackers summarily…exploited. This resulted in Ethereum’s hard fork due to $150 million worth of ETH locked within DAO pools allocated for Ethereum’s development.
In order to return those funds, some Ethereum developers decided to create a hard fork — the present-day Ethereum. The original Ethereum blockchain continued on as Ethereum Classic with its ETC coin. Suffice to say, it was a bad start for DAO’s reputation. However, as DeFi protocols emerged in late 2020, DAO has become an integral part of decentralized finance.
A comparison to understand DAOs
The best way to understand DAO implementation is to compare different levels between the most popular cryptocurrencies and DeFi protocols:
- Bitcoin – represents the most basic DAO precepts. Fundamentally, blockchain is a peer-to-peer (P2P) network that allows users open access to execute transactions, validate them and add new blocks. In other words, Bitcoin is an organization of nodes that is autonomous and decentralized. However, it is not a decentralized autonomous organization because Bitcoin lacks complex governance rules that are characteristic of DAOs.
- Ethereum – represents the 2nd generation blockchains because it offers smart contract capability. Smart contracts are necessary ingredients for DAOs to be possible. Nonetheless, Ethereum itself is not a DAO but a framework for developing DAO projects. For example, just like Unreal Engine 4 is not a game but a framework for creating video games.
- Uniswap – is the first DeFi protocol to have pioneered Automated Market Makers (AMMs), which led it to become the most popular decentralized exchange (DEX). Currently, Uniswap holds $6.8 billion TVL (total value locked) across liquidity pools by liquidity providers (yield farmers). The network has its own governance token UNI, which is used for voting on improvements and funding liquidity pools. As such, Uniswap is a full-blown DAO, but one has to own 1% of UNI’s total supply in order to propose new governance rules or tweak existing ones.
- MakerDAO – is the most comprehensive example of DAO. As a DeFi protocol similar to Uniswap or Compound, but for lending, it also runs on Ethereum. MakerDAO has two tokens, stablecoin DAI and governance token MKR. The MakerDAO Foundation has been distributing MKR to incentivize contributors, spur voter participation, and decentralize the governance process. Effectively, the foundation’s goal is to abolish itself by giving away all the tokens to the network’s stakeholders.
DAOs can be complicated and vary
When we compare Uniswap with MakerDAO, it is clear that rules make all the difference. Because Uniswap protocol instituted a requirement of owning 1% UNI’s supply, it effectively barred over 90% of users from participating in directing the network’s development. On the other hand, MakerDAO’s foundation is about to dissolve in the next couple of months.
Accordingly, it is fair to say that a proper decentralized autonomous organization has total decentralization — with no central overseers. Correspondingly, DAOs start in a semi-centralized state. First, the core developer team has to tend the protocol as it grows, and more users join in. And the greater the number of users, the greater the pool of stakeholders, which pushes the momentum toward complete decentralization.
How does a DAO work?
Let’s say you are working in a company that designs video games. This field of work is highly dependent on technical and artistic talent. Moreover, because of their complexity, video game development often suffers from the so-called “feature creep.”
This is an organizational failure in which the project keeps adding new features beyond the original vision. This often results in either a mess, crippling costs, and drastically prolonged development time, e.g., Star Citizen.
To prevent such feature creep from happening, the gaming studio could set funding rules with a DAO running on the Ethereum blockchain. They can, for example, set a budget threshold, and lock the smart contract funding pool. Then, each action — 3D modeling, programming, sound, voice-over, etc. — is automatically calculated against the budget based on current rates employed by the organization.
Accordingly, each team member would receive tokens to vote on additions. Team leaders would proportionally receive more tokens. If their votes go over the budget threshold, the vote would fail. As a result, the team would become cognizant of the scale of development that can be cost-effectively accomplished.
Likewise, the same DAO usage can be employed for dethroning CEOs of companies, pooling resources to hire vendors or freelancers, pay bonuses, etc.
DAO pros and cons
A strong case could be made that equally distributed voting power is not a positive. One only has to take a look at the Pareto Principle to understand why that would be the case. Economist Vilfredo Pareto noticed a recurring pattern in his studies across entire sectors of the economy.
Hence, Pareto Principle quantifies those observations in an 80/20 rule. Meaning, 80% of consequences are derived from 20% of causes. In organizational terms, 20% — the “vital few” — are responsible for a successful outcome. Most people have already noticed this if they have done group projects at schools or universities.
Therefore, DAOs would have to account that not all votes should be counted equally. This would translate to some users having more tokens than the majority, which would diminish decentralization. MIT Technology Review arrived at a similar conclusion in 2016.
Another potential DAO disadvantage is that its rules could extend across numerous legal jurisdictions. If a problem occurs that cannot be rectified through token-voting, one would have to engage with a protracted and convoluted legal case.
Nonetheless, a well-designed smart contract results in DAOs providing organizations a transparent and easy way to govern institutions. This is especially true for those organizations in which most members don’t know each other. The scenario is best exemplified within the largest organizations where people don’t know each other — nations. A blockchain DAO for voting can safeguard election transparency and legitimacy, and this has been widely accepted.
Top 5 DAOs
Outside of the previously mentioned MakerDAO, which is the largest and most popular DAO, here are some other DAO candidates of note.
Unlike standard DeFi protocols, Gitcoin doesn’t facilitate yield farming but seeks to gather blockchain developers, as a blockchain-specific platform similar to UpWork or Fiverr. To facilitate their funding, Gitcoin released Gitcoin Grants. Using EIP 1337 token for quadratic voting, Gitcoin Grants matches all received donations.
Each donation is weighed against the number of donors for blockchain projects. This is another example of creatively using a decentralized autonomous organization. Instead of favoring projects funded by a few deep-pocketed donors, Gitcoin Grants favors those projects that receive the greatest community engagement.
Aragon is both a DAO and a platform for creating customized DAOs. This makes it extremely useful for users who don’t have advanced programming knowledge. Aragon takes care of the types of smart contracts and the interface, leaving it up to you to decide how to manage your organization.
Furthermore, Aragon offers Aragon Fundraising, formerly called Apiary, for crowd-funding. Released in April, Aragon Fundraising’s key feature is a bonding smart contract. They are AMMs where users can deposit collateral in exchange for an organization-specific token. This makes Aragon a DAO ecosystem with a broad range of use cases.
Have you ever wanted to own gold, but couldn’t bother with the practical problems of securing it? Digix comes to the rescue by tokenizing gold holdings. Each token — DGX — is worth 1 gram of gold. Digix was one of the very first projects launched as an ICO on Ethereum, which means it has a long track record to verify it is not a scam.
The Safe House vault in Singapore secures the gold and an independent Bureau Veritas firm audits it. Outside of the DGX token that represents gold ownership, the DGD token is used to vote on how the company uses the funds for further development. In turn, users receive DGDs as quarterly dividends.
After Ethereum completed the London hard fork, it crossed another step toward Ethereum 2.0 Proof-of-Stake (PoS) upgrade. Out of five new changes, the introduction of burnable fees is the most significant one, making Ethereum deflationary with 3.26 ETH burned per minute.
MolochDAO’s singular purpose is to fund ETH 2.0 grants. To join MolochDAO, you have to be invited by an existing member. Then, each member holds shares that are equal to voting rights: 1 share — 1 vote. These shares are not transferable or sellable between members and are used to vote/fund proposals.
Aave is currently the top-ranking DeFi lending protocol with over $15 billion TVL (total value locked). If you want to use it to lend money, the protocol issues (mints) ERC-20 aTokens in a 1:1 ratio to deposited assets. This gives users a steady, compounded interest rate. Moreover, Aave has flash loans in which both borrowing and repayment has to transpire within the same transaction.
Naturally, developers can experiment and combine new DeFi uses with these flash loans, which are suited for the purpose. Aave’s governance token LEND (ETHLend) is used for both fee reductions and voting on Aave Improvement Proposals (AIPs). The latter can even be conducted if LEND tokens are locked in as collateral.
Are DAOs truly decentralized?
Decentralized autonomous organizations serve more as open-source access for trustless organization, as opposed to being purely decentralized systems. Outside of voting in general elections, there are not many environments in which equal distribution of votes would be beneficial.
As such, DAOs are on a spectrum of decentralization. In other words, logical delineation of rules, as opposed to geographic decentralization, is far more important. They may lead to centralization, decentralization, or something in between. Whatever the case may be, Aragon makes the best showing thus far, in terms of using rules as legos to construct a trustless DAO.