What Is a DAO and How Does It Work?

Basics

Decentralized autonomous organizations, or DAOs, are a novel form of organizational structure that emerged as a result of blockchain technology. These entities can function autonomously, without requiring any coordination or intervention from a central authority. In a DAO, members of a community can participate in the decision-making and management of the organization without the need for a central governing body.

Token holders in a DAO can cast votes to determine the best course of action for the organization, as power is distributed among them. All transactions and activities in a DAO are publicly visible on the blockchain, ensuring transparency and accountability.

DAOs have a variety of applications, from pooling funds for venture investment to verifying the authenticity of off-chain data. The concept of DAOs is not new, with Bitcoin often being considered the original decentralized autonomous organization.

What Is a DAO?

DAOs are entities that operate independently without centralized leadership. They are governed by rules built into their design and managed by the community instead of a central authority. Unlike traditional organizations, DAOs don't have a single individual or group that can make unilateral decisions. Instead, the DAO model of governance is based on proposals submitted by community members, which are then voted on.

Organizational decision-making is democratized by DAOs, which creates a more equitable and inclusive community. This model is gaining popularity amongst cryptocurrency enthusiasts, as it empowers each member to contribute to the organization's future.

Cryptocurrencies like Bitcoin are also decentralized, not controlled by any central authority like a government or central bank. Instead, computer networks maintain these digital assets through coded rules, making them permissionless and censorship-resistant.

In 2016, the first DAO was introduced, aimed at having all members act as the governing body. This innovative approach extended the principles of cryptocurrency to organizational decision-making, creating a community-led entity with no central authority.

How Do DAOs Work?

DAOs are run by a community of stakeholders who share a common goal and are incentivized by a crypto-economic mechanism. The DAO's rules are written in smart contracts by the core team of community developers, which define the organization's foundational framework.

Proposals made by members are transparently stored on the blockchain, and DAOs function through them. If a proposal is supported by a majority of stakeholders or fulfills a predetermined rule set, it is automatically implemented. The voting power of members may differ based on the number of governance tokens they hold. This approach aims to align the interests of the organization with its members' interests.

In contrast to traditional organizations, DAOs use economic mechanisms instead of hierarchical structures. Members of a DAO are bound not by a formal contract, but by a common goal and network incentives. DAOs operate without borders and may be subject to regulations based on the laws of the jurisdictions they interact with. Once a DAO is deployed, it cannot be controlled by a single party but is instead governed by a community of participants.

DAOs allow individuals and institutions to work toward shared goals without having to know or trust each other. They are often described as an operating system for open collaboration.

Principal-Agent Dilemma

The principal-agent dilemma is an economic problem where an individual or entity (the "agent") may make decisions and take actions on behalf of another individual or entity (the "principal"), potentially disregarding the principal's interests. This problem is exacerbated when there is information asymmetry between the two parties. Examples of this problem include elected officials representing citizens, brokers representing investors, or managers representing shareholders.

By employing blockchain technology, DAOs can provide a greater degree of transparency and well-designed incentive models, which helps to address the principal-agent dilemma. DAOs enable stakeholders to have a higher level of control over decision-making processes, eliminating the need for a single central authority. Furthermore, since all transactions are recorded on the blockchain, there is very little or no information asymmetry. Thus, incentives within the organization are aligned, and the operation of DAOs is completely transparent, theoretically making them incorruptible.

Advantages of DAOs

• DAOs are unique in their decision-making process, as they don't have a central authority figure. Instead, decisions are made collectively by the community. This ensures that everyone has a say in the direction of the organization.
• Transparency is key in DAOs, as every member is accountable for their actions. Voting is done through the blockchain and made publicly viewable. Transactions are also recorded on the blockchain, so everyone has access to them. This fosters a sense of trust within the community and encourages ethical behavior.
• DAOs are community-based and can attract members from all over the world. Every member is allowed to contribute to the project, and proposals can be made by anyone. Unlike traditional corporate structures, DAOs allow everyone to express their ideas and have a say in the direction of the organization.

The Best-Known Examples of DAO

The Bitcoin network is considered by some to be the first example of a DAO, although opinions on this matter vary. The network is coordinated by a consensus protocol that does not establish a hierarchy among participants. Additionally, the Bitcoin protocol defines the organization's rules while bitcoin as currency incentivizes users to secure the network.

But what other applications could DAOs have? More complex DAOs could be used for decentralized venture funds, social media platforms, or even to coordinate IoT devices. A type of DAO called decentralized autonomous corporations (DACs) may offer services similar to traditional companies but without a corporate governance structure. For example, a ridesharing service provided by a DAC could operate autonomously through the use of blockchain oracles, carrying out transactions with humans and smart devices and even performing tasks such as going to the mechanic.

Ethereum’s “The DAO”

In 2016, a DAO called "The DAO" was created using smart contracts on the Ethereum blockchain to act as an autonomous venture fund. DAO tokens were sold in an Initial Coin Offering (ICO) that provided an ownership stake and voting rights. However, soon after launch, a third of the funds were stolen in one of the largest cryptocurrency hacks ever. The event led to a hard fork of the Ethereum blockchain, with one chain reversing the fraudulent transactions and the other chain leaving them untouched. The resulting chains are now known as Ethereum and Ethereum Classic.

Limitations of DAOs

The adoption and growth of DAOs could be hindered by several challenges and limitations. These include legal uncertainty, coordinated attacks, and points of centralization.

Legal

The regulatory landscape around DAOs is still ambiguous in most jurisdictions, with many governments and regulatory bodies yet to define their approach toward this new type of organization. This lack of clarity and continuously uncertain legal status could potentially hinder the widespread adoption of DAOs, as they may be seen as too risky or unregulated.

Coordinated Attacks

Despite offering desirable properties such as decentralization, immutability, and trustlessness, DAOs inherently carry some security risks that are not present in traditional entities. As demonstrated by the infamous hack of The DAO in 2016, this new organizational form can introduce novel risks, and coordinated attacks could cause significant financial and reputational damage to DAOs and their investors.

Points of Centralization

While DAOs allow for a wider range of participants to collaborate than ever before, the governance rules set in the protocol will always be a point of centralization. In some cases, full autonomy or decentralization might not even be possible or make sense. Thus, DAOs should strive to find a balance between decentralization and centralization to maximize efficiency and open participation while minimizing risks.

Conclusion

DAOs enable organizations to operate without a central entity managing the actions of participants by automating governance rules. The Bitcoin network can be seen as an early example of a DAO. Creating efficient consensus rules to solve complex participant coordination problems is crucial for designing effective DAOs. However, the main obstacle to implementing DAOs may not be technological, but rather social.