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What are Decentralised Autonomous Organisations (DAOs)?

José Oramas 27 October, 2021 | 5 min read

Decentralised Autonomous Organisations are powerful tools from the DeFi space, built with blockchain technology and meant to disrupt the typical hierarchical system with an automated, democratic, and decentralised governance system.

A DAO is, at its core, an organised, internet-native group with a joint mission with a set of rules established in a blockchain. Here we look at what this relatively new system is, its characteristics, and some history behind the most famous Ethereum organisation: The DAO.

The DAO

The DAO was a group of Ethereum developers who decided to create an organisation powered by its community through the use of blockchain and cryptocurrencies. The DAO, as it was called, was launched in 2016 on the Ethereum blockchain, intended to act as an investor-directed venture capital firm.

The DAO quickly became one of the most valuable, high-profile projects built on the Ethereum network, raising $150 million worth of Ether through a crowdfunding campaign. Yet, its success didn't last for long. After its debut, the DAO fell victim to malicious actors who found a security hole in the smart contract and stole $60 million worth of Ether.

But what happened? Well, the problem was that to fix the bug —found in a framework gap— developers would have to alter the original code of the smart contract, but this required a majority approval of the DAO members. During the voting process, hackers exploited the vulnerabilities in the smart contract.

Ethereum developers had to fork the network to return the funds, which was deemed controversial. The Ethereum blockchain was split into two branches: the new Ethereum (ETH) and the original Ethereum blockchain, renamed Ethereum Classic (ETC).
This is how the first DAO became defunct.

How DAOs Work

The way a DAO functions might be complex, but let's break it down by reviewing how a DAO is launched.

Establishing a DAO

Let's say you and your colleagues want to launch your own DAO. First, you'd need a well-established but non-hierarchical structure where every member has a voice and a right to make it heard. Otherwise, it would fall short of the same traditional corporate system DAOs are trying to disrupt.

The Members of your DAO will have specific roles where they perform different tasks for the organisation. These roles are mainly, but not limited to:

  • Token holders: members with total control of the DAO's funds and are rewarded for their commitment to the community.
  • Curators: responsible for whitelisting smart contract addresses.
  • Contributors: companies or individuals that add value to the DAO, like providing research and strategic services in exchange for tokens.

After the DAO has a clear vision of what it wants to become and reach and fundamental roles are established, then smart contracts are written.

Smart Contracts

Smart contracts are the backbone of DAOs. Developers must create a smart contract with a set of rules that will define and keep the DAO running. These smart contracts are programs that execute themselves when certain conditions are met.

After the smart contract is finished and fully tested, members with staked tokens have the right to vote or submit protocol changes or governance proposals. This model is designed to avoid users spamming proposals, as only members who want to submit proposals have to stake money first.

Funding and Deploying the DAO

After the smart contract is live and tested, you need to determine how the DAO will receive funds. Usually, a DAO receives funds by selling tokens via an Initial Coin Offering (ICO) —these tokens will give holders voting rights.

The next step is to deploy the DAO on the blockchain. It can be challenging to manage the system from this point on as certain problems will inevitably arise. We need to keep in mind that DAOs are relatively new systems and thus are prone to security flaws, malicious actors, and engineering errors.

The Base Model of DAOs —Some Pros and Cons

DAOs are disruptive systems to the eyes of hierarchical, corporate businesses for the decentralisation they promote. By using blockchain technology, power is not held by the hands of top executives and decision making is passed to stakeholders. A DAO's autonomy relies on smart contracts that execute a specific action without the need for human intervention.

In the eyes of the crypto community, DAOs are a more democratic and fair governance system that can benefit businesses from global industries. Yet, this can be far from reality. The voting power depends on the amount of token a member has, whether the member got it from investing in the DAO or contributing to the project. This, we can argue, can end up emulating the same structural power of today's corporate systems.

If a DAO wants to succeed in the long term, it needs a concise and well-planned roadmap. Not many DAOs have lasted for long —the lifespan of most DAOs barely reaches 1 year. We can attribute this to several problems, like mismanagement of funds, security flaws, and lack of legal status.

Unstoppable code was the main problem of The DAO in 2016. It's hard to alter the smart contract protocol of the DAO once deployed to the blockchain due to its immutable nature. Hackers can take advantage of security gaps on the same framework that keeps the DAO safe from being altered. When The DAO was exploited in 2016, users couldn't do anything but watch how some users drained the funds from the protocol. Technically speaking, the hackers followed the protocol's rules. They just took advantage of the security hole found in the code.

Additionally, the legal status of DAOs remains unclear across the United States and the rest of the world, something that drives potential investors away. In the US, for example, the Securities and Exchange Commission (SEC) viewed DAO tokens as unregistered securities, mainly because the offer and sale of digital assets are subject to federal laws.

If the DAO is for-profit, then it's subject to regulatory laws. When The DAO was launched in 2016, the problem for US authorities was how to regulate a decentralised and stateless organisation. Several crypto laws have been passed through time that has set back the crypto and the DeFi space. But now, the only place where DAOs are recognised as legal entities is in Wyoming, which has been one of the few crypto-friendly states in the US.

Most DAOs and upcoming projects are concentrated in Wyoming because they are considered LLC (Limited Liability Company) businesses. This is due to the DAO Law, a bill introduced by Wyoming lawmakers in May and approved in July this year. The DAO Law stipulates that DAOs can legally function as member-managed organisations and receive all the benefits of LLC entities.

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Characteristics of DAOs

  • Leaderless: The DAO is managed by stakeholders instead of managers or presidents.
  • On-chain governance: protocol changes and proposals are submitted by token holders and voted by their members.
  • Open to everyone: everyone can become part of a DAO. The way to do this is by staking a certain amount of tokens or NFTs (Non-Fungible Tokens)
  • Open source: The code written in the smart contract is visible to anyone. Likewise, users can see the transaction data and decisions made in the blockchain

Some of the Most Important DAOs

Aragon: a popular protocol that allows developers to create their own DAOs on the Ethereum blockchain with a set of pre-made contracts.

PhoenixDAO: a DeFi protocol designed to be controlled by its community of PHNX stakeholders.

MakerDAO: one of the oldest and most popular DAOs in DeFi history. Maker is a community-driven platform that uses governance mechanisms from the Maker Protocol. Maker is also the company behind Ethereum-based cryptocurrency DAI Stablecoin.

What's the Future of DAOs?

DAOs are still in their infancy. Many experts in the crypto community have agreed that while DAOs can potentially replace hierarchical structures with a more democratic governance system, there is still much room for improvement if they want to succeed in the long run.

DAOs proposed a system that is considered a great solution, at least in theory, to centralised models. While there is a lot of room for improvements, DAOs can become an essential part of the generation of collaborative projects, and also fundamental pillar of the decentralised web, or Web 3.0, which is intended to be a democratic, stateless space powered by blockchain technology and every member is compensated for their attributions to the ecosystem.

Author's avatar
José Oramas
Fintech and finance writer, with keen interest in blockchain and crypto.

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