Introduction

Blockchain has fundamentally changed our financial system. However, properties such as trustlessness and immutability are not limited to monetary applications.

Another application that could be disrupted by this technology is governance. Blockchain makes possible entirely new types of organizations that can operate autonomously without the need for coordination from a central entity. This article will introduce you to the forms of such organizations.


What is a DAO? How does it work?

DAO is short for Decentralized Autonomous Organization. Simply put, DAO is an organization controlled by computer code and programs. Therefore, it is able to operate autonomously without the intervention of a central authority.

By using smart contracts, DAOs can process external information and execute commands based on them - all without any human intervention. DAOs are usually run by a community of stakeholders incentivized through some kind of token mechanism.

The rules and transaction records of a DAO are transparently stored on the blockchain. These rules are usually decided by a vote of stakeholders. Usually, the way to make decisions in a DAO is through proposals. If a proposal is voted in by a majority of stakeholders (or meets other rule sets in the network consensus rules), it will be implemented.

In some ways, a DAO operates similarly to a company or nation-state, but in a more decentralized manner. Traditional organizations use hierarchical structures and many layers of bureaucracy, but DAOs are not hierarchical. Instead, DAOs use economic mechanisms to align the interests of the organization with the interests of its members, often through the use of game theory.

DAO members are not bound by any formal contract, but are bound together by common goals and network incentives, which are closely linked to consensus rules. These rules are completely transparent and written in the open source software that governs the organization. Because DAOs operate without boundaries, they may be subject to different legal jurisdictions.

As the name implies, DAO has the characteristics of being decentralized and autonomous. It is decentralized because no single entity can make and execute decisions. It is autonomous because it can operate on its own.

Once a DAO is deployed, it cannot be controlled by a single party, but rather governed by a community of participants. If the governance rules defined in the protocol are well designed, they should be able to guide participants towards the most beneficial outcome for the network.

Simply put, DAOs provide an operating system for open collaboration, one that allows individuals and institutions to work together without having to know or trust each other.


DAOs and the Principal-Agent Problem

DAOs solve the principal-agent dilemma problem in economics. This occurs when a person or entity (the “agent”) has the ability to make decisions and take actions on behalf of another person or entity (the “principal”). The agent has an incentive to act in its own interest and may disregard the interests of the principal.

This allows the agent to take risks on behalf of the principal. A more serious problem is that there may be information asymmetry between the principal and the agent. The principal may never know that they are being taken advantage of, and there is no way to ensure that the agent is acting in their best interest.

Common examples of this problem are elected officials representing citizens, brokers representing investors, or managers representing shareholders.

The carefully designed incentive model behind DAOs can partially eliminate this problem by allowing blockchains to achieve a higher degree of transparency. The incentives within the organization are aligned, and there is little (or no) information asymmetry. Since all transactions are recorded on the blockchain, the operations of the DAO are completely transparent and, in theory, cannot be tampered with.


DAO Example

Despite being a very primitive network, the Bitcoin network can be considered the first example of a DAO. It operates in a decentralized manner and is coordinated by a consensus protocol with no hierarchy between participants.

The Bitcoin protocol defines the rules of the organization, while Bitcoin as currency provides users with an incentive to secure the network. This ensures that different participants can work together to allow Bitcoin to operate as a decentralized autonomous organization.

The common goal of Bitcoin is to store and transfer value without a central entity coordinating the system. But what other applications does DAO have?

More complex DAOs can be deployed for different use cases, such as token governance, decentralized venture funds, or social media platforms. DAOs can also coordinate the operation of devices connected to the Internet of Things (IoT).

Among other things, these innovations have introduced a subset of DAOs called decentralized autonomous companies (DACs). DACs can provide services similar to traditional companies, such as ride-sharing services, but they can operate without the corporate governance structure of traditional companies.

For example, a car that is owned autonomously and provides a shared service as part of a DAC can operate on its own, transact with humans and other devices. By using blockchain oracles, it can even trigger smart contracts and perform certain tasks on its own, such as traveling to find a mechanic.


Ethereum and “The DAO”

One of the earliest examples of a DAO was just called “The DAO.” It consisted of complex smart contracts, ran on the Ethereum blockchain, and was supposed to function as an autonomous venture fund.

The DAO tokens were sold in an initial coin offering (ICO) and provided ownership and voting rights in the decentralized fund. However, shortly after the launch, about a third of the funds were siphoned off in the largest hack in cryptocurrency history.

The result of this incident was that Ethereum split into two chains after the hard fork. In one chain, the fraudulent transaction was effectively reversed, as if the hacker attack had never happened. This chain is the current Ethereum blockchain. The other chain follows the principle of "code is law", is not affected by the fraudulent transaction, and maintains its tamper-proof properties. This blockchain is now called Ethereum Classic.


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What problems does DAO face?

law

The regulatory environment in which DAOs operate is completely uncertain. It remains to be seen how different jurisdictions will establish regulatory frameworks around these new types of organizations. However, the continued uncertainty in the regulatory environment could be a significant factor hindering the adoption of DAOs.


Coordinated attack

The ideal characteristics of DAOs (decentralization, immutability, and trustlessness) inherently have significant performance and security flaws. While it is exciting that some potential organizations have grown rapidly as DAOs, they also bring many risks that do not exist in traditional organizations.


Centralized focus

It is arguable that decentralization is not a state, but a spectrum, where each level is suitable for different types of use cases. In some cases, full autonomy or decentralization is not even possible or meaningful.

Perhaps DAOs allow for a wider range of participants to collaborate than ever before, but the governance rules set in the protocol will always be a central focus. Some argue that centralized organizations can operate more efficiently but forgo the benefits of open participation.


Summarize

DAOs free organizations from reliance on traditional institutions. Governance rules operate automatically, guiding participants toward the most beneficial outcome for the network, rather than having a central entity coordinate participants.

The Bitcoin network might be considered a simplified version of a DAO, and there are very few other implementations. The key to designing a good DAO is to develop an effective set of consensus rules to solve the complex coordination problems of participants. The real challenge of implementing a DAO may not be purely technical, but social coordination.

If you want to learn more about DAOs, check out Binance Research’s report: DAOs in Theory and Practice.