What Is a DAO? CoinMarketCap’s Definitive Guide
Blockchain

What Is a DAO? CoinMarketCap’s Definitive Guide

4 months ago

We walk you through all the things you need to know to get caught up on DAOs.

What Is a DAO? CoinMarketCap’s Definitive Guide

Inhaltsverzeichnis

A DAO stands for a decentralized autonomous organization — one of the most forward-looking revolutions of Web3 technology that allows for the creation of digital communities. Since everything is decentralized, there is no need for the presence of a centralized intermediary that regulates how this organization functions. In fact, all the functions of the organization are written into and enforced by code.

There are two critical features of a DAO that help distinguish it from other centralized organizations. The first is the lowered barrier of entry for users, and second is the fact that all of the data about the DAO is available publicly on the blockchain. Most DAOs also have some sort of tokenomics that facilitate crucial decision-making; if you are part of a DAO, then you can easily vote on key decisions.

What is the true potential of a DAO? To what extent are these kinds of organizations useful? Are there any downsides to such an organization? We will explore all these questions in this article.

Let's dive in.

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What on Earth Is a DAO?

Think of a DAO as a digital organization that exists on a blockchain. There is (usually) no restrictions as to who can join the DAO, as long as they have something that they plan to contribute.

To become a member of a DAO, however, you must purchase the governance tokens of that DAO. Subject to the proportion of their governance tokens, DAO token holders can vote on key decisions that the DAO takes.

Now, just as any other human organization where almost anyone in the world can join, DAOs are often made up of people from myriad backgrounds. A DAO does not require users to provide any KYC-related information, which essentially means the DAO members can truly remain anonymous and still continue to contribute to the organization.

The purpose of a DAO can be anything: a self-fostering community of developers who share tips and tricks amongst each other and further train upcoming developers; a decentralized venture fund which collectively funds emerging protocols in DeFi; the list goes on.

As we just said, the purpose of a DAO can truly be anything — as long as it has something through which the members can vote (in most cases, a governance token). All the actions of a DAO — from its operations to management — are written into code: it is a self-governed entity.

Now, there are certain crucial distinctions that we must make to understand what a DAO is and what a DAO isn't. For this, we will have to move into more confusing waters. Bear with me as I break things down.

Is a DAO the Same as a Smart Contract?

No, it's not. A smart contract differs from a DAO because it involves a limited number of participating entities, whereas a DAO can potentially have n number of entities that participate in it. It might be argued that there are some contracts which have an infinite number of participants, but there is another crucial difference.
A smart contract is activated only when a user initiates an execution on the level of the smart contract. If the smart contract does not receive that stimulus from the user, then it lays dormant. While the same can be said for a DAO, the truth is that DAOs can have multiple processes going on without the need for an external stimulus. Since a DAO is a self-contained organization, its entire function is managed internally.

That said, DAOs can often have their rules of governance written into smart contracts.

Is a DAO Different From a Decentralized Application or a Decentralized Organization?

A decentralized application can (mostly) be a smart contract— and because it is simply an application, it does not have any financial aspect to it. For instance, Tor is often considered to be a decentralized application because a) you don't need to pay money to use it and b) it is not governed by any single organization. This is in opposition to a DAO, which always has a financial aspect in its governance token.

A decentralized organization, on the other hand, is simply any organization that has been decentralized. An example of this would be an organization where members are responsible for the upkeep of a certain community by providing educational services. Since this decentralized organization provides educational services, it will have teachers, advisors, principals and so on. However, because this organization is not autonomous, and could have leaders making the decisions in a centralized fashion, it is not a DAO.

Let us quickly circle back to what a DAO actually is.

A DAO is very simply an organization which is self-contained, automated and decentralized. As an entity, it might "hire" external people to achieve its tasks — but all decisions are voted on by every member of the DOA.

Now that we understand what a DAO really is, let's attempt to understand how governance works in DAOs.

What Does a DAO's Governance Look Like?

At the center of every DAO is the revolutionary governance mechanism. The lack of a centralized "principal" means that all the members who participate in governance influence the system's actions.
Thus, a DAO is principally governed by its agents (who are its members), whose voting on the system leads to fundamental state transitions.
This is best showcased in the below graphic taken from DAOStack's whitepaper.

Now, a simple blockchain governance structure would look something like this. Let us take an example of an investment vehicle that invests in emerging DeFi protocols — we’ll call it InvestorDAO.

There are three primary stakeholders for our fictional InvestorDAO.

  1. InvestorDAO members who can participate in decisions on which protocols must be invested in and how much should that allocation look like.
  2. Potential DeFi protocols who pitch their projects to the InvestorDAO.
  3. InvestorDAO members who have a high reputation within the DAO and have a heavier influence on the DAO's decisions.

For the purposes of our current example, let us only stick to the first two stakeholders.

The native governance token for the DAO is INV.

Now, let us assume that a DeFi protocol presents itself to the DAO offering almost 100x returns on the DAO's capital if invested at a specific period. The protocol offers 100% exclusive investment to the DAO ,along with a couple other features. The pitch deck for this protocol is shared amongst all the DAO members.

The most likely scenario to play out in this case is Scenario 1.

Scenario 1

If the number of members who vote above 65% in favor of the protocol (let's say that's the minimum threshold percentage required for approvals), the collective capital of $50M can be invested into the protocol. Members of the DAO with adequate legal knowledge can help with the contract. If on the other hand, the DAO rejects the proposal, then the investment is abandoned.

This is what an ideal scenario with a DAO of the example purpose would look like. Let's stretch our imagination a bit to imagine an alternative scenario.

Scenario 2

Ignoring the pitch deck, suppose that a member of the DAO has managed to amass a vast voting share within the DAO — this is because they have a sizable quantity of the governance tokens in their wallet. Now, this very member presents a proposal to transfer all the money to their personal wallet. You'd imagine that that would be impossible, right? No, it is possible. If the member manages to acquire >65% voting power within the DAO, then they can simply direct the funds to be transferred to their own wallet. This will drain the DAO of all of its funds and the members will be left helpless.

This is where our third stakeholder from above comes in. If there are some members of the DAO who have more reputation than other members, then their vote will have a heavier influence in decisions. And because their vote is tied up to their reputation, they would not want to vote in a biased fashion. This second scenario is one of the biggest challenges that DAOs face today.

That said, this is the usual governance structure of most DAOs. We can go into further detail about DAO governance, but for the sake of this article, we will leave it here.

What Are the Different Types of DAOs?

One of the most famous DAOs is the The DAO, which was initially created as an experiment in April 2016 to serve as a fundraising mechanism for Ethereum.

Everyone who contributed to the DAO received governance tokens that could then be used to decide on key decisions for the network. The DAO managed to raise over $150M, out of which $60M were taken due to a vulnerability in the smart contract code.

This was one of the first hacks in crypto at such a massive scale. Several people started to blame DAO as an entity that was prone to various security issues. However, a crucial thing to bear in mind is that all the transactions (including the hack) can be found on blockchain today.

From their initial conception and The DAo disaster, DAOs have traversed a great distance. There are several different types of DAOs in the ecosystem today.

  • Investment DAOs: one of the most recent examples of this is the ConstitutionDAO, which was very close to buying the U.S. Constitution in fall 2021.
  • Protocol DAOs: Uniswap, a popular protocol for swapping altcoins which released its own governance token in 2021.
  • Service DAOs: think of professionals coming together and providing not only services to potential users, but also helping transform users into professions; a popular example of this is the DeveloperDAO.
  • Project DAOs: helping solve a particular problem for users in crypto; BadgerDAO.
  • Community DAOs: a group of people coming together to exchange value and/or even buy an NFT; PleasrDAO.

Some DAOs have gained more popularity than others.

  • Every member of a DAO can exercise control over its internal capital via the governance token. Some of these DAOs often pay salaries out to people who are actually employed by them. For instance, empty set dollar is a DAO that features an algorithmic stablecoin. The DAO is said to pay over $150K to its community manager.
  • In the same vein, some DAOs can even serve as grant providers for protocols or even some blockchain networks. For instance, Moloch DAO functions as a grants provider for Ethereum. The LAO is also a DAO that has served as an investment vehicle for several protocols building on Ethereum.
  • MakerDAO is an example of a protocol DAO mentioned above which has become popular since the rise of DeFi in the summer of 2020. It is an algorithmic stablecoin protocol, and the members can participate in key voting decisions.
  • CurveDAO is another well-known DAO in the ecosystem, primarily because it provides higher voting power and revenue sharing for all the members who lock their tokens in the DAO. The longer you hold the CRV tokens, the heavier your voting power in the DAO gets.

These DAOs continue to redefine how individual members can participate in strategic decisions of a protocol — as opposed to how little say stockholders have in the decisions of a corporation. But we must remember that DAOs are a relatively new type of organizational structures, and they have their own set of limitations.

Could DAOs Run the World?

Potentially, DAOs can do everything. If a DAO has well-encoded rules and has foreseen different scenarios that could arise, then there is a possibility that it could replace traditional structures seen in the world today.

However, we must take all of this with a pinch of salt. DAOs are relatively new organizational structures which do not have a proven track record of succeeding in most instances. In their current form ,a lot needs to be done before they can truly start replacing traditional structures.

What Are the Major Challenges With DAOs?

We already considered one key issue with governance for DAOs earlier when we discussed how someone who has a specific threshold of governance tokens within the DAO can influence the decisions of the DAO in their favor. This can be counteracted with a reputation mechanism —but there could potentially be a scenario where a key member of the DAO can acquire a reputation within the DAO only to abuse it later on.
We have already seen how CurveDAO facilitates this reputational problem: with CurveDAO, the longer you lock your tokens in, the greater your voting power gets. Thus, any protocol that wants to increase their presence within the Curve protocol can simply bribe these holders to vote in their favor. A similar case occurred with Mochi Finance just a few weeks ago.
In most cases, however, reputation serves as a key solution to the problem of voting power centralization. Most rational agents of a DAO with a high value of reputation power will mostly be unbiased in their decisions — as several cases in the past have proven. Also, the fact that other members of the DAO look up to them in key decisions gives them a moral obligation to be fair. Furthermore, reputation scores (or tokens even) are a non-transferable asset. Therefore, a devious entity cannot buy that reputation.

There can be extreme cases where an entity with high governance power and reputation dominates the DAO's decisions, but that — like I said — is more of an extreme case.

Do All Members Participate When a DAO Votes on Something?

Not every DAO governance token holder will vote on every decision.

A low voter turnout could be fixed by having the underlying smart contracts require each member to do — if they fail to do so for a specified period of time, their membership can be cancelled (slashed). However, this is an ideal scenario and might not necessarily apply in real life DAOs.

For example, it was reported in November 2020 that only 5-6% of total MKR was being used in the MakerDAO's governance. This was attributed to two primary reasons.
  1. The first reason was the lack of incentive for the MKR token holders to participate in decisions. If someone has a sizable quantity of MKR tokens in their portfolio, along with other assets, they are not as highly incentivized to devote their time and attention to understanding the key decisions on which they must vote.
  2. The second reason is a lack of participation due to prerequisite effort required. If you hold 5,000 MKR tokens and want to participate in governance, then you will have to devote a good number of hours to understand what decisions are being made, what's at stake, how the change might affect the protocol and so on. Any lack of interest on the end of users to do so would lead to decreased participation.
A comment in the MakerDAO forum outlined that rational "self-interest" would always outweigh the reality in a pretty ingenious way.

This is the sad reality of participating in governance. Not everyone is able to take the time to fully understand all proposals, and many DAO members will ignore their voting rights because of a lack of time or interest.

There also may be a lack of understanding around the human mind itself when it applies to crypto. People tend to feel that just because humans want to move away from centralized systems to an ecosystem where they have as much power as their counterpart, they will be willing to put a hundred times more effort into ensuring the ecosystem remains intact.
However, we must understand we cannot decentralize humanity. We have been programmed to want to have someone "in power" who makes key decisions for us, because we are too busy with other things to do that ourselves.
The crucial distinction that must be made here is the fact that — despite all its claims — a DAO is not as decentralized as it hopes to be. Even in the best possible scenarios, there can be a concentration of power within a few hands, who can then influence the decisions that the DAO makes. And all of this is possible only because the core stakeholder in a DAO is a human.

Closing Thoughts

You might think it’s hypocritical of me to still say that DAOs have immense potential — after just writing that it is impossible to decentralize humanity.

However, DAOs do have this great potential because they resolve human problems by using code. If the primary rules of a DAO are written into code, then they cannot be tampered with. No one can change the smart contract where those rules have been written. This immutability (coupled with the transparency that blockchain brings) is enough to cement DAOs' position within the larger crypto ecosystem as genuine replacements to hierarchical organizational structures — systems where those in power freely change the rules to suit their self-interest.

Moreover, the potential use cases for DAOs are truly limitless. A DAO with (potentially) 1M members can have representatives who can then take key decisions. Because everything would be encoded, it would be ensured that every agent of DAO gets to have a say in the decision. No human can tamper with the infrastructure.

At the end, I would just like to leave you with a personal thought. A DAO seems like a panacea that cures all our problems — but we must remember that it is almost impossible to change human nature. Humans are programmed to want to fight amongst each other to rise to the top. Evolutionarily, a society where everything is always equal has never existed. And I doubt it ever will.

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