What is a DAO?

A DAO (Decentralized Autonomous Organization) can be seen as the most complex form of a smart contract, where the bylaws of the decentralized organization are embedded into the code of the smart contract, using complex token governance rules.

Historically, the Bitcoin network was considered the first true autonomous corporation, that was coordinated solely through a distributed consensus protocol, which anybody was free to adopt. Today, DAOs moved up the technology stack, thereby becoming fully virtualized through software. In case of a Bitcoin-style autonomous corporation, a complex stack of technologies and human-machine systems has to be put in place in order to create a functioning autonomous infrastructure.

At today’s evolutionary stage, a DAO materializes as a smart contract – a piece of code – executed on top of an increasingly opaque stack of distributed networking and consensus technology like the Ethereum blockchain or similar blockchains.

Ethereum blockchain technology stack
Blockchain Technology Stack Of Ethereum and similar Blockchains (Inspired by Florian Glatz)

 

Decentralized Organizations (DO)

The idea of a decentralized organization takes the concept of traditional organizations and decentralizes it. Instead of a hierarchical structure managed by a set of humans interacting in person and controlling property via the legal system, a decentralized organization involves a set of people interacting with each other according to a protocol specified in code and enforced on the blockchain.

A Decentralized Organization (DO) may or may not make use of the legal system for some protection of its physical property, but even this such usage is secondary. For example, one can take the shareholder-owned corporation above, and transplant it entirely on the blockchain; a long-running blockchain-based contract maintains a record of each individual’s holdings of their shares, and on-blockchain voting would allow the shareholders to select the positions of the board of directors and the employees.

Smart property systems can also be integrated into the blockchain directly, potentially allowing DOs to control vehicles, safety deposit boxes and buildings. DAOs are the holy grail of DOs: it is an entity that lives on the internet and exists autonomously, but also heavily relies on hiring individuals to perform certain tasks that the automaton itself cannot do.

 

Disrupting Governance with DAOs

Governance is the way rules, norms and actions of how people interact with each other are structured, sustained, regulated and held accountable. It regulates the process of decision-making among the actors involved in a collective problem that leads to the creation, reinforcement, or reproduction of social norms and institutions. The degree of formality depends on the internal rules of a given organization and, externally, with its business partners. As such, governance may take many forms, driven by many different motivations and with many different results.

Governance refers to all processes of governing, whether by a government, market or network, family, tribe – formal or informal – through the laws, norms, power or language. Blockchain can disrupt traditional governance structures of all kinds, and challenge the way we currently think about governance.

Tokens an Decentralised Autonomous Organizations

With large parts of our society traditionally organized in top-down command and control ways, blockchain promises for more decentralized and spontaneous coordination instead of rigid structures by addressing two problems of traditional governance structures (1) Principal-Agent Dilemma, and high (2) transaction costs of coordination.

Smart Contracts in a trustless trust environment – and DAOs are the most complex form of a smart contract – tackle an age-old problem of governance, which in political science and economics is referred to as the principal-agent problem. This dilemma occurs when the agent – a person or entity – is able to make decisions on behalf of, or impacting, a so-called principal – another person or entity. In such setups, moral hazard occurs when one person takes more risks because someone else bears the cost of those risks, usually when there is an underlying information asymmetry in play. If the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk, agents are motivated to act in their own best interests, which are contrary to those of their principals.

Blockchain and smart contracts reduce transaction costs and levels of bureaucracy and introduce the possibility of finding new ways of aligning interests and governing groups of people in a much more decentral way than we know today.

 

How DAOs work

Decentralized Autonomous Organisations (DAOs) run through rules encoded as computer programs called smart contracts. It is an entity that lives on the internet and exists autonomously, but also heavily relies on hiring individuals to perform certain tasks that the automaton itself cannot do.

  • Tokens of Transaction: In order to exist a DAO needs some kind of internal property that is valuable in some way, and it has the ability to use that property as a mechanism for rewarding certain activities. The funding takes place directly upon creation of the organization. DAOs do not have a hierarchical structure, nor executives or management.
  • Autonomous: Once deployed the entity is independent of its creators and cannot be influenced by outside forces. DAOs are open source, thus transparent and incorruptible. A DAO’s financial transaction record and program rules are maintained on a blockchain. This approach eliminates the need to involve a bilaterally accepted trusted third party in a financial transaction.
  • Consensus: In order to withdraw or move funds from a DAO, a majority of its stakeholders (this percentage could be specified in the code of the DAO) must agree on the decision. Even if bugs are found in the code, they could not be corrected until a voting procedure has taken place and the majority of voters agreed on it, which could leave known security holes open to exploitation.
  • Contractors: A DAO cannot build a product, write code or develop hardware. It needs a contractor to accomplish its goals. Contractors get appointed via voting of token holders.
  • Proposals: Proposals are the primary way for making decisions in a DAO. To avoid people overloading the network with proposals, a DAO could require a monetary deposit to prevent people from spamming the network.
  • Voting: After submitting a proposal, voting takes place. DAOs allow people to exchange economic value with anyone in the world, like investing, money raising, lending, borrowing, without the need of an intermediary, just by trusting the code.

 

All cryptocurrencies which use public blockchains are DAOs (Bitcoin, Ethereum, Dash, Digix, etc.). Modern DAOs are complex smart contracts on top of a blockchain. The DAO was an example of a DAO on top of the Ethereum blockchain.

dao

 

DAOs as Crowdfunding Vehicles

Since smart contracts run on top of public blockchain networks such as Ethereum, they can be programmed to collect and manage real economic value in arbitrarily large amounts referred to as ICO. The DAO was an example for such an ICO. Its aim was to be a decentralized autonomous investment fund without fund managers. In the biggest ICO at its time, TheDAO ended up collecting an equivalent of 150m USD in cryptocurrency. Everybody willing to invest was guaranteed a proportional share of the future revenues of the company. Additionally, those shares could be traded for any other asset listed on cryptocurrency exchanges, spanning across both fiat and cryptocurrencies.

Despite The DAO experiment ending prematurely with a spectacular and highly controversial “hack” and a subsequent hardfork of the Ethereum Blockchain, the idea of a new kind of crowdfunding model, based on blockchain token issuance as ownership shares in the funding target’s future success, ignited the minds of entrepreneurs worldwide and has ever since sparked an ICO frenzy.

Voting Process of TheDAO – Source: https://daohub.org

A growing number of startups are beginning to raise risk capital to fund the development of individual products, services or protocols, in a way that shares the future success of the company with its users and investors. Instead of complex, uncertain and strictly-regulated legal contractual relationships between investors and founders, those startups rely fully on DAO-type smart contracts to manage those relationships. Circumventing legal systems and thereby legality itself, is, however, not the primary interest of most of those startups. Instead, it is the much lower barrier to entry as well as the new untapped market potential that motivates entrepreneurs to go down the route of token crowd sales. Ideals of a new kind of sharing economy, where the users of a service are at the same time its owners, give those startups moral grounds for venturing into legally gray areas.

 

Need for Legal Certainty

Startups trying to operate as DAOs are in need of a legal framework that allows them to conduct business not only within the closed world of a blockchain network but to interact with the physical world, the world of traditional financial instruments and that of intellectual property. To achieve this goal, two major barriers need to be overcome.

Firstly, startups need to know which kinds of regulations apply in which jurisdiction when selling cryptographic tokens, that may in some form represent a stake in future profits. The potential applicability of contemporary securities regulation is self-evident. Secondly, startups need a workable legal contractual framework, which allows DAOs to be embedded into our current institutional framework around the three above-mentioned fields of physical and intellectual property as well as traditional finance.

Both of those open problems are tough because they require a lawyer’s intuition in a field, that has before only ever been the subject of science fiction literature. To an appreciable extent, however, partial answers may be developed by a suitably staffed entity, that is experienced in solving complex compliance issues arising in areas such as international private, financial, trade, corporate and tax law.

 

Further Reading

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