Introduction

Blockchains are fundamentally transforming our traditional financial system, as core principles such as trust and immutability are useful for more than just financial applications.

One potential candidate ripe for disruption of this technology is the state. Blockchains offer the opportunity to create entirely new types of organizations that can operate autonomously without the need for regulatory coordination. In this article we will tell you about what they look like and what they are capable of.


What is a DAO and how does it work?

The abbreviation “DAO” stands for Decentralized Autonomous Organization (DAO). In simple terms, a DAO is an organization that is managed using computer code and a specific set of programs. On this basis, it has the ability to function autonomously, without the need for intervention from governing bodies.

Using smart contracts, a DAO can also work with external information and execute commands based on it, all without the need for human intervention. Basically, such decentralized organizations are governed by a community of stakeholders whose work is incentivized through some kind of token-based mechanism.

All rules and records of transactions in the DAO are stored on the blockchain in a completely transparent format. Rules are usually determined by stakeholder votes, decided upon through various proposals. If a proposal is voted for by a majority of participants (or it satisfies the network consensus rules), it becomes eligible for implementation.

In a sense, the DAO operates like a corporation or a kind of state, but in a more decentralized manner. While traditional organizations follow a hierarchical structure and multi-level bureaucracy, in a DAO there is no such hierarchy. Instead, DAOs use economic mechanisms to keep their participants engaged, usually through game theory.

Members of the DAO are not bound by any formal contract. Their work is based on a common goal and incentives associated with consensus rules. These rules are completely transparent, and the software is written as open source and managed across the organization. Because DAOs operate on a borderless basis, they can be located in different legal jurisdictions.

As the name suggests, a DAO functions in a decentralized and autonomous manner. Such a principle as decentralization is due to the fact that no third-party organization has the right to propose or make any decisions, and autonomy implies the ability to work independently, without the need to manually perform various operations.

Once deployed, the DAO cannot be unilaterally controlled, but instead all management decisions are made on behalf of the community. If the governance rules defined in the protocol are designed correctly, they should guide participants toward the most beneficial outcome for the network.

Simply put, DAOs are an operating system for open collaboration. Such an operating system allows individuals and institutions to interact to develop the ecosystem, in the absence of knowledge and trust in each other.


DAO and principal-agent theory

Based on their functionality, decentralized organizations are a solution to an economic problem called the “principal-agent dilemma.” This occurs when a person or entity (“agent”) has the ability to make decisions and take actions on behalf of another person or entity (“principal”). If the agent is motivated to act in his own interests, he may ignore the interests of the principal.

This situation allows the agent to make risky decisions on behalf of the principal. The problem is compounded by the fact that information asymmetries may also exist between the principal and the agent. The principal may never know that he is being taken advantage of, and he has no way of ascertaining that the agent is acting in the common interest.

Examples of this problem might be: officials representing citizens, brokers representing investors, or managers representing shareholders.

Thanks to the high degree of transparency provided by blockchains, well-designed incentive models behind DAOs can eliminate parts of this problem. On this basis, incentives within the organization can be aligned, and information asymmetry becomes extremely low (or completely absent). Since all transactions are recorded on the blockchain, the operation of the DAO is completely transparent, and in theory, such an organization is incorruptible and resistant to the above-mentioned activities.


DAO Examples

Although the Bitcoin network is very primitive, it can be considered the first example of a DAO. Bitcoin operates in a decentralized manner, and all internal operations are coordinated by a consensus protocol, with no hierarchy between participants.

The Bitcoin protocol defines the rules of the organization, while Bitcoin as a currency incentivizes users to protect the network. This ensures proper and healthy interaction among all participants who collaborate with each other to make Bitcoin work as a decentralized autonomous organization.

The overall goal in the case of Bitcoin is to store and exchange currency without intermediaries, in the form of central authorities that coordinate the work of traditional financial systems. But what else can a DAO be used for?

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

At the top of this technological solution is a subset of DAOs, the so-called decentralized autonomous corporations (DAC). DAK can provide a similar range of services as in traditional companies, for example, sharing consumption services. The difference is that decentralized corporations operate without the corporate governance structure found in their traditional counterparts.

For example, a car that drives itself and provides ride-sharing services as part of a DAC could operate autonomously, based on transactions with people and other devices. Using blockchain oracles, he can even run smart contracts and independently perform certain tasks, such as going to the mechanic.


Ethereum and The DAO

One of the early examples of a DAO was a project with aptly chosen name: “The DAO”. It consisted of complex smart contracts running on the Ethereum blockchain, the functionality of which was assumed to be an autonomously operating venture fund.

The DAO tokens were sold as part of an initial coin offering (ICO), thereby giving its investors ownership and voting rights in a decentralized fund. However, shortly after the launch of the project, about a third of the funds were lost as a result of one of the largest hacker attacks in the history of cryptocurrencies.

As a result of this event, a hard fork of Ethereum occurred and the network was split in two. On one network, hacker transactions were canceled as if the attack never happened. This chain is now the main Ethereum blockchain. The other chain, adhering to the “code is law” principle, left the fraudulent transactions unchanged and remained unchanged. This blockchain is called Ethereum Classic.


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What problems does the DAO involve?

The regulatory environment surrounding DAOs is completely uncertain. The formation of a regulatory framework on the part of different state jurisdictions also remains in question. Thus, the persistent lack of a defined regulatory mechanism can be a major barrier to the acceptance of decentralized organizations.


Coordinated hacker attacks

By their nature, the properties of DAOs (decentralization, immutability, trust) involve significant disadvantages in terms of performance and operational security. While the potential of such organizations can be impressive, there are many risks involved that are not present in traditional organizations.


Centralization points

It can be argued that decentralization is not a state, but a range in which each of the network layers is suitable for different use cases. In some cases, complete autonomy and decentralization may not be possible or even make sense.

DAOs can allow a wider range of participants to collaborate on a completely different level, but the rules established by the state, which will be provided in the protocol, will always be the point of centralization of the project. One of the positive arguments in this case is that centralized organizations can work much more efficiently, but for this they sacrifice their main advantage - open participation.


Conclusion

DAOs enable organizations to free themselves from the shackles of traditional institutions. Instead of a central coordinating body, all governance rules are automated and direct participants to the most beneficial outcome for the network.

The Bitcoin network can be considered a simplified version of a DAO, while there are very few other similar implementations. The key to designing good decentralized organizations is to create an efficient set of consensus rules that will solve the complex problems associated with coordinating the activities of all participants. So, with all that said, the real challenges facing a proper implementation of a DAO are mostly social rather than technical.

If you want to learn more about decentralized organizations, we recommend reading the report from Binance Research: The Theory and Practice of DAOs.