What are decentralized autonomous organizations (DAO) and how do they work

A decentralized autonomous organization (DAO) is a group organized around a specific mission that is coordinated through a common set of rules enforced on the blockchain.

One of the main advantages of a DAO is transparency compared to traditional companies, as all processes and funding are transparent and publicly available, significantly reducing the risk of corruption and censorship. Publicly traded companies must provide independently audited financial statements, but shareholders only have insight into the financial health of the organization for a limited time. Since the balance sheet of a DAO exists on a public blockchain, it is fully visible at all times, down to each individual transaction.

DAOs are generally more globally accessible and have lower barriers to entry compared to companies. Given the transparency and greater inclusiveness, there are lower costs for members who disagree with the rules and procedures to exit. DAOs that share a similar mission may need to compete for members in the future and be encouraged to be as transparent as possible and not extract too much value from the group in order to attract top members.

How does a DAO work?

The community can customize the DAO and program it according to its own goals. The code is written in the form of smart contracts, which provide some form of governance mechanism. Members typically use governance tokens to vote on issues such as fund allocation. In many DAOs, a member’s influence can increase proportionally to the amount they have invested in the project. The outcome can be based on the level of participation as well as voting preferences.

What was The DAO?

Perhaps the most infamous DAO to date was the one launched in April 2016 as a decentralized venture capital fund. Members invested ether and in return received DAO tokens that could be used to vote on projects for which funds should be allocated. $150 million was raised; however, a hacking incident occurred, resulting in the theft of $60 million. Interestingly, although the DAO was shut down, anyone can still see all transactions that occurred as they are on a public blockchain. Unfortunately, the DAO hack temporarily left a negative impression and a degree of skepticism for many people, but DAOs are an extremely powerful form of organization, and it did not take long for a revival of DAO activities in the crypto industry to begin.

The development of DAOs continued, but without much attention. Projects such as Aragon, DAOstack, DAOHaus, and Colony learned key lessons from the original DAO and are now building and leading DAOs for some of the largest decentralized finance (DeFi) protocols. The DeFi boom in 2020 brought a new wave of interest in DAOs that supported many leading projects.

DAOs come in all shapes and sizes

• Crypto projects – are considered DAOs if they are managed in a decentralized manner through which token holders can vote on the direction of the project
• Grants – a DAO can be used for the automatic allocation of grants to development funds based on established criteria
• Investing – MolochDAO has been ‘copied’ multiple times to create profit-oriented DAOs that can distribute and transfer shares and other assets among members
• Collectibles – non-fungible tokens (NFTs) are one of the reasons why certain DAOs were established

Crypto projects themselves can be considered DAOs if they are managed in a decentralized manner, where token holders can vote on the direction of the project or various settings. For example, the token holders of MakerDAO, a project that created the decentralized stablecoin DAI, can govern the system and vote on parameters such as fees charged.

Another example is Curve DAO, a project that built an automated market maker (AMM) that generates fees and provides revenue sharing to token holders who lock their tokens. The longer the CRV token is locked, the greater the voting power and reward for the DAO member. Unlike traditional companies where profits are distributed pro rata, this DAO is set up so that voting power and revenue share are weighted according to how long the owner has held the token.

The assets of the DAO can be directly controlled by stakeholders through tokens. Stakeholders can be anonymous and located anywhere in the world. These pseudonymous stakeholders can agree among themselves to allocate the DAO’s assets for any purpose, including hiring employees. DAOs, consisting of hundreds of known and pseudonymous members, have legitimately hired employees solely based on community reputation. For example, the Empty Set Dollar (ESD) DAO pays a salary of $180,000 to its anonymous community manager Lewie, who stated that this is the highest salary of his career.

There are numerous examples of DAOs created for the purpose of funding investments or providing grants. Moloch DAO is a DAO that allocates grants for the advancement of the Ethereum ecosystem. They also allow members to withdraw funds if they disagree with the DAO’s decisions.

There are also increasing examples of DAOs aimed at more specific investment opportunities such as owning NFT art and virtual gaming items. Yield Guild Games is a gaming guild of players and investors that generates yield from NFT-based games such as Axie Infinity, League of Kingdoms, and The Sandbox.

Flamingo DAO is a profit-oriented, NFT-focused DAO. They have actively invested in NFTs and became known when they paid $762,000 in ether for a rare CryptoPunk NFT.

What are the advantages of DAOs?

• Transparency – voting, funding decisions, and other actions can be seen by anyone
• Interoperability – the concept is firmly rooted in DeFi, where there are many tools that can be used like ‘Lego blocks’, as developers say
• Collaboration – by giving everyone a voice, and through collective strength and knowledge, DAO members negotiate with each other and lead discussions on every move and action

Future use cases

There are many interesting use cases for DAOs, and the field is just at the beginning of development. DAOs can experiment with governance systems to rapidly improve what works and what doesn’t. For example, there could be a DAO that uses a form of governance for decision-making consisting of members who bet on prediction markets, and then uses the outcome of those markets to determine individual actions.

One possible use case is a DAO where all members are anonymous, allowing them to build a reputation without revealing their identity. This enables members to be more equal and facilitates rewarding individual contributors rather than exclusively significant members with a large following.

What are the disadvantages of DAOs?

• Flat structure – the absence of a clear authority or chain of command means decentralized organizations operate more slowly as decision-making takes more time
• Disagreements – in the case of strong community dissent, a split into two factions is possible
• Lack of change – in some DAOs, those with the most tokens decide, so governance closely resembles traditional organizations
• Legality – many projects could be considered securities and thus subject to stricter laws

DAOs are powerful ways of organizing, but there are potential problems, and they are not an ideal system for every type of organization. While DAOs can replace aspects of legal contracts with code and save a huge amount of operational overhead, in some cases, legal protection does not exist outside the rules specified in the smart contracts governing the DAO. This can create problems if the control of the DAO is centralized or poorly defined, although some DAOs can form legal entities that stand behind the DAOs themselves. An example is the Wyoming DAO law, approved through the Wyoming state senate committee, which helps create legally recognized DAOs.

Depending on how the DAO is set up, the process of coordination and adaptation can be more complex compared to centralized leadership like an executive director making quick decisions when necessary. Also, initially, when many decisions need to be made, there could be centralization among certain members.

There is also the possibility of apathy where not all members will want to vote. In that case, there will likely be delegation of votes to other members who are more informed and active in voting, and most importantly, in line with their beliefs. These representatives are sometimes referred to as protocol politicians because they often campaign for delegated votes, similar to how existing politicians do. There could be an increasing occurrence of protocol lobbying groups trying to influence the decisions of these politicians. On the other hand, in the future, we might even see DAOs lobbying and becoming major political institutions in society.

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