The content of this page has evolved over the years (check wayback machine for previous iterations) and was last updated in July 2019, with an excerpt from the book Token Economy which builds – among others – on the educational blogposts that have been published on this website since 2015.
Blockchain and smart contracts are governance technologies that have the potential to provide higher levels of transparency while re- ducing bureaucracy with self-enforcing code. They can minimize existing principal-agent dilemmas of organizations and subsequent moral hazards. Tokens of distributed networks hereby provide incen- tives to automatically align interests in the absence of third parties.
DAOs tackle an age-old problem of governance, which political scientists and economists refer to as the principal-agent dilemma. This occurs when the agent of an organization has the power to make decisions on behalf of, or impacting, the principal – another person or entity in the organization. Examples hereof could be managers that act on behalf of shareholders or politicians that act on behalf of citizens. In such setups, moral hazard occurs when one person takes more risks than they normally would, because others bear the cost of those risks. More generally, it occurs when the agent acts in his own interest rather than the interest of the principal because the principal cannot fully control the agent‘s actions. This dilemma usually increases when there is underlying information asymmetry at play.
Traditional Organizations VS. DAOs
In traditional companies, all agents of a company have employment contracts that regulate their relationship with the organization and with each other. Their rights and obligations are regulated by legal contracts and enforced by a legal system which is subject to the underlying governing law of the country they reside in. If anything goes wrong, or someone does not stick to their end of the bargain, the legal contract will define who can be sued for what in a court of law.
DAOs, on the other hand, involve a set of people interacting with each other according to a self-enforcing open-source protocol. Keeping the network safe and performing other network tasks is rewarded with the native network tokens. Blockchains and smart contracts hereby reduce transaction costs of management at higher levels of transparency, aligning the interests of all stakeholders by the consensus rules tied to the native token. Individual behaviour is incentivized with a token to collectively contribute to a common goal. Members of a DAO are not bound together by a legal entity, nor have they entered into any formal legal contracts.21 Instead, they are steered by incentives tied to the network tokens, and fully transparent rules that are written into the piece of so ware, which is enforced by machine consensus. There are no bilateral agreements. There is only one governing law – the protocol or smart contract – regulating the behaviour of all network participants.
As opposed to traditional companies that are structured in a top-down manner, with many layers of management and bureaucratic coordination, DAOs provide an operating system for people and institutions that do not know nor trust each other, who might live in different geographical areas, speak different languages, and therefore be subject to different jurisdictions. Instead of legal contracts managing the relations of the people, in the Bitcoin Network, all agreements are in the form of open-source code that is self-enforced by majority consensus of all network actors. DAOs do not have a hierarchical structure, except for the code. Once deployed, this entity is independent of its creator and cannot be censored by one single entity, but instead by a predefined majority of the organization’s participants. The exact majority rules are defined in the consensus protocol or the smart contract, and will vary from use case to use case. In some countries, like Austria for example, there are trends in the legal literature to see DAOs as a civil law partnership.
A DAO can be formalized by a smart contract. Use cases range from simple to complex. The complexity depends on the number of stakeholders, as well as the number and complexity of processes within that organization that will be governed by the smart contract. Depending on the purpose and governance rules of the organization, these use cases can have a resemblance to companies or nation-states. The more centralized governance rules are, the more it resembles a traditional company. In a more decentralized setup, the governance rules might resemble nation-states, automatically steering behaviour with tokenized incentives and disincentives. In such cases, the token governance rules incentivize and steer a network of actors without centralized intermediaries, thereby replacing the need for top-down organizations managed by a group of people, with self-enforcing code. Such decentralized organizations can use the legal system for some protection of physical property, but such usage is secondary to the preemptive security mechanisms smart contracts o er. A complex stack of technologies, steered by consensus protocols, has to be put in place in order to create a functioning autonomous infrastructure. Their native protocol tokens enable distributed Internet tribes to emerge.
DAOs are open-source, thus transparent and, in theory, incorruptible. All transactions of the organization are recorded and maintained on a blockchain. Interests of the members of the organization are – if designed correctly – aligned by the incentive rules tied to the native token. Proposals take the primary way for making decisions within a DAO, which are voted for by majority consensus of involved network actors. As such, DAOs can be seen as distributed organisms, or distributed Internet tribes, that live on the Internet and exist autonomously, but also heavily rely on specialist individuals or smaller organisations to perform certain tasks that cannot be replaced with automation. We will likely see many more DAOs, with a wide range of purposes, evolve on top of the technology that Bitcoin once pioneered. In combination with the “Internet of Things,” smart property governance can also be integrated into the blockchain directly, potentially allowing decentralized organizations to control vehicles, safety deposit boxes and buildings.
The Bitcoin Network can be considered to be the first true decentralized and autonomous organization, coordinated by a consensus protocol which anybody is free to adopt. It provides an operating system for money without banks and bank managers, and has stayed attack resistant and fault-tolerant since the first block was created in 2009. No central entity controls Bitcoin, which means that as long as people keep participating in the network, only a worldwide power outage could shut down Bitcoin. The underlying blockchain protocol enables an incentive network, powered by the governance rules tied to its cryptographic token. These token governance rulesets of the consensus layer allow for automated and transparent coordination of a disparate group of people who do not know or trust each other. The Bitcoin Network has shown that tokens can be used as a means of programming behaviour, aka steering the economic behaviour of network nodes. This incentive mechanism has proven to be a motivator in performing services to a network (read more: Purpose-Driven Tokens).
With the emergence of the Ethereum Network, the concept of DAOs moved up the technology stack from blockchain protocol to the smart contract. Whereas before one needed a blockchain network with an attack-resistant consensus protocol to create a DAO, smart contracts made the creation of DAOs easily programmable, o en with just a few lines of code, and without the need of setting up your own blockchain infrastructure.
“The DAO” in 2016, for example, was a very early example for such a complex smart contract on the Ethereum blockchain. The purpose of “The DAO” was to provide an autonomous vehicle for fund management without traditional fund managers. During a four-week token sale, “The DAO” issued DAO tokens against ETH, collecting an equivalent of 150 million USD, resulting in the biggest token sale at its time. “The DAO” tokens were fungible, which means that they could be traded for any other tokens listed on a token exchange. The idea was that every DAO token holder would be a co-owner of this decentralized investment fund proportional to the number of tokens held, and could participate in investment decisions with proportional voting rights. Specialized services to “The DAO” could be conducted by subcontractors hired by “The DAO” token holders by majority consensus. However, due to a programming error in the so ware, this vision of “The DAO” never became reality, as the project was drained of roughly a third of its funds before it became operational. This led to a controversial hard fork of the Ethereum blockchain. One of the major shortcomings was that “The DAO” did not account for who is accountable for decision making in the case of unforeseen events (read more here).
I would like to argue that there is no such thing as a fully decentralized and autonomous organization. Depending on the governance rules, there are different levels of decentralization. While the network might be geographically decentralized, and have many independent but equal network actors, the governance rules written in the smart contract or blockchain protocol will always be a point of centralization and loss of direct autonomy. DAOs can be architecturally decentralized (independent actors run different nodes), and are geographically decentralized (subject to different jurisdictions), but they are logically centralized (the protocol). The question of how to upgrade the code – when and if necessary – is very often delegated to a set of experts who understand the techno-legal intricacies of the code, and therefore represent a point of centralization.
Full text and high-resolution graphics available as paperback & ebook: Token Economy, by Shermin Voshmgir, 2020
About the Author:Shermin Voshmgir is the Author of the Book “Token Economy“ the founder of Token Kitchen and BlockchainHub Berlin. In the past she was the director of the Research Institute for Cryptoeconomics at the Vienna University of Economics which she also co-founded. She was a curator of TheDAO (Decentralized Investment Fund), an advisor to Jolocom (Web3 Identity), Wunder (Tokenized Art) and the Estonian E-residency program. Shermin studied Information Systems Management at the Vienna University of Economics and film-making in Madrid. She is Austrian, with Iranian roots, and works on the intersection of technology, art & social science.
About the Book: This is the second edition of the book Token Economy originally published in June 2019. The basic structure of this second edition is the same as the first edition, with slightly updated content of existing chapters and four additional chapters: “User-Centric Identities,” “Privacy Tokens,” “Lending Tokens,” and How to Design a Token System and more focus on the Web3. Blockchains & smart contracts have made it easy for anyone to create a token with just a few lines of code. They can represent anything from an asset to an access right, like gold, diamonds, a fraction of a Picasso painting or an entry ticket to a concert. Tokens could also be used to reward social media contributions, incentivize the reduction of CO2 emissions, or even ones attention for watching an ad. While it has become easy to create a token, which is collectively managed by a public infrastructure like a blockchain, the understanding of how to apply these tokens is still vague.
The book refers to tokens, instead of cryptocurrencies, and explains why the term “token” is the more accurate term, as many of the tokens have never been designed with the purpose to represent a currency. This book gives an overview of the mechanisms and state of blockchain, the socio-economic implications of tokens, and deep dives into selected tokens use cases: Basic Attention Token, Steemit, Token Curated Registries (TCRs), purpose-driven tokens, stable tokens, asset tokens, fractional ownership tokens, Libra & Calibra (Facebook), and many more.