Introduction

Blockchains are already radically transforming our financial system. However, properties such as trustlessness and immutability are not only useful in monetary applications.

Governance is another potential candidate ready to benefit from this technology. Blockchains could enable entirely new types of organizations that can operate autonomously without the need for coordination by a central entity. This article gives an idea of ​​what these organizations may look like.


What is a DAO and how does it work?

The acronym DAO stands for “Decentralized Autonomous Organization”. Simply put, a DAO is an organization that is governed by computer code and programs. As such, it has the capacity to operate autonomously, without the need for a central authority.

Through the use of smart contracts, a DAO can work with external information and execute orders based on it, all without any human intervention. A DAO is generally managed by a community of stakeholders incentivized by a token mechanism.

A DAO's rules and transaction records are transparently stored on the blockchain. Rules are usually decided by stakeholder voting. Typically, decisions are made within a DAO through proposals. If a proposal is voted on by the majority of stakeholders (or meets other rules defined in the network consensus rules), it is then implemented.

In some ways, a DAO functions similarly to a corporation or national state, but it is the DAO that operates in the most decentralized manner. While traditional organizations work with a hierarchical structure and many layers of bureaucracy, DAOs have no hierarchy. Instead, DAOs use economic mechanisms to align the interests of the organization with those of its members, usually through game theory.

Members of a DAO are not bound by any formal contract. Rather, they are linked by a common goal and network incentives linked to the rules of consensus. These rules are completely transparent and written in the free software that governs the organization. As DAOs operate without borders, they may be subject to different jurisdictions.

As its name suggests, a DAO is decentralized and autonomous. It is decentralized because no single entity has the power to make and implement decisions. And it is autonomous because it can operate alone.

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

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


DAOs and the principal-agent problem

DAOs face an economics problem called the principal-agent dilemma. This happens 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”). If the agent is motivated to act in his own self-interest, he may ignore the interests of the principal.

This situation allows the agent to take risks on behalf of the principal. What reinforces the problem is that there may also be an information asymmetry between the principal and the agent. The principal may never know that he or she is being cheated and has no way of ensuring that the agent is acting in his or her best interests.

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

By enabling a higher degree of transparency through blockchains, the well-designed incentive models behind DAOs can eliminate some of this problem. Incentives within the organization are aligned, and there is very little (or no) information asymmetry. As all transactions are recorded on a blockchain, the operation of DAOs is completely transparent, which, in theory, makes them incorruptible.


DAO Examples

Although very primitive, 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 without hierarchy between participants.

The Bitcoin protocol defines the rules of the organization, while the currency bitcoins provide users with the ability to secure the network. This ensures that different participants can work together for Bitcoin to function as a decentralized autonomous organization.

In the case of Bitcoin, the common goal is to store and transfer value without a central entity coordinating the system. But what else can DAOs be used for?

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

Additionally, these innovations introduced a subset of DAOs called “decentralized autonomous corporations” (DACs). A DAC can provide services similar to a traditional company, for example, a ride-sharing service. The difference is that it operates without the corporate governance structure found in traditional businesses.

For example, a self-owned car that provides ride-sharing services as part of a DAC could operate autonomously, transacting with humans and other devices. Thanks to the use of blockchain oracles, it can even trigger smart contracts and carry out certain tasks by itself, such as going to the garage.


Ethereum et « The DAO »

One of the earliest examples of a DAO is the aptly named “The DAO”. It was made up of complex smart contracts running on the Ethereum blockchain and intended to act as an autonomous venture capital fund.

DAO tokens were sold in an initial coin offering (ICO) and provided equity and voting rights for this decentralized fund. However, shortly after its launch, around a third of the funds were drained in one of the largest hacks in cryptocurrency history.

The result of this event was Ethereum splitting into two chains following a hard fork. In one, the fraudulent transactions were reversed, as if the hack never happened. This chain is now called the Ethereum blockchain. The other chain, in accordance with the principle of "the code is the law", left fraudulent transactions maintained according to the principle of immutability. This blockchain is now called Ethereum Classic.


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What are the problems DAOs face?

The regulatory environment surrounding DAOs is completely uncertain. It remains to be seen how different jurisdictions will create the regulatory framework around these new types of organizations. However, this still uncertain regulatory landscape could pose a significant barrier to the adoption of DAOs.


Coordinated attacks

The advantages of DAOs (decentralization, immutability, reliability) inherently carry significant disadvantages in terms of performance and security. While some of the potential organizations that can arise as DAOs are undoubtedly exciting, they introduce a lot of risks that are not present in traditional organizations.


Centralization points

It is obvious that decentralization is not a state, but rather a range, in which each level is suitable for a different type of use. In some cases, full autonomy or decentralization may not even be possible or make sense.

DAOs can enable more participants to collaborate than ever before, but the governance rules defined in the protocol will always be a point of centralization. Arguably, centralized organizations can operate with much greater efficiency, but forgo the benefits of open participation.


To conclude

DAOs allow organizations to no longer depend on traditional institutions. Instead of a central entity coordinating participants, governance rules are automated and direct actors toward the most beneficial outcome for the network.

The Bitcoin network can be considered a simplistic DAO, and as of now, other implementations are rare. The key to designing good DAOs is to establish an effective set of consensus rules that solve complex participant coordination problems. The real challenge for implementing DAOs may not be purely technological, but rather social.

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