Decentralized Autonomous Organization (DAO): Definition, Purpose, and Example

What Is a Decentralized Autonomous Organization (DAO)?

A decentralized autonomous organization (DAO) is an emerging form of organizational structure with no central governing body and whose members share a common goal of acting in the best interest of the entity. Popularized by blockchain enthusiasts, DAOs make decisions using a bottom-up management approach.

What Is the Purpose of Decentralized Autonomous Organizations (DAOs)?

One of the major features of digital currencies is that they are decentralized. This means they are not controlled by a single institution like a government or central bank but instead are divided among a variety of computers, networks, and nodes.

Inspired by the decentralization of cryptocurrencies, a group of developers came up with the idea for a decentralized autonomous organization, or DAO, in 2016. The concept of a DAO is to promote oversight and management of an entity similar to a corporation. However, the key to a DAO is the lack of central authority; the collective group of leaders and participants acts as the governing body.

How DAOs Work

DAOs rely heavily on smart contracts to function. These scripts generally automate the group's decisions when the required number of votes is reached. If the group votes on a proposal and it fails, the smart contract doesn't execute anything. For example, imagine a cryptocurrency was governed by a DAO. A faction of members wanted to change how a blockchain's tokenomics worked. This could be an increase in the circulating supply of coins, burning a select amount of reserve tokens, or issuing rewards to existing token holders.

Members could create a proposal and call for a vote, which would be broadcast to all members with voting rights. They could vote, and the smart contract would tally the vote. This type of change might or might not be automated, as it would require altering the blockchain's coding. Regardless, the outcome of the vote would determine the direction the blockchain would take. If the vote was about spending tokens from the treasury on a certain project, the smart contract could automate the transfer of tokens to the entities working on the project.

Voting power is often distributed across users based on the number of tokens they hold. For example, one user that owns 100 tokens of the DAO could have twice the weight of voting power over a user that owns 50 tokens.

The theory behind DAOs is that users who are more monetarily invested in the DAO are incentivized to act in good faith. For instance, imagine that a DAO member owns a majority of the organization's voting power (a majority of the tokens). This user could act in bad faith; however, if the DAO is programmed to penalize bad actors, the user will jeopardize the value of their holdings.

DAOs often have treasuries that house tokens that can be issued in exchange for fiat. Members of the DAO can vote on how to use those funds; for example, some DAOs with the intention of acquiring rare NFTs can vote on whether to relinquish treasury funds in exchange for assets.

Benefits of DAOs

There are several reasons why an entity or collective may want to pursue a DAO structure. Some of the benefits of this form of management include:

• Decentralization: Decisions impacting the organization are made by a collection of individuals as opposed to a central authority that is often vastly outnumbered by their peers. Instead of relying on the actions of one individual (CEO) or a small collection of individuals (Board of Directors), a DAO can decentralize authority across a vastly larger range of users.
• Participation: Individuals within an entity may feel more empowered and connected to the entity when they have a direct say and voting power on all matters. These individuals may not have strong voting power, but a DAO encourages token holders to cast votes, burn tokens, or use their tokens in ways they think are best for the entity.
• Publicity: Within a DAO, votes are cast via blockchain and made publicly viewable. This requires users to act in ways they feel are best, as their votes and decisions will be publicly viewable. This incentivizes actions that will benefit voters' reputations and discourages acts against the community.
• Community: The DAO concept can encourage people from all over the world to seamlessly come together to build a single vision. With just an internet connection, token holders can interact with other owners wherever they may live.
  

Limitations of DAOs

Not everything is perfect regarding DAOS. There are some severe consequences to improperly setting up or maintaining a DAO—here are some of the limitations DAOs face:

• Speed: If a public company is guided by a CEO, a single vote may be needed to decide a specific action or course for the company to take. In a DAO, every user is given an opportunity to vote. This might require a much longer voting period, especially considering time zones and priorities outside the DAO.
• Education: Similar to the issue of speed, a DAO has the responsibility of educating members regarding pending activities. It's much easier for a single CEO to make decisions on company developments, as DAO token holders may have varying educational backgrounds, understanding of initiatives, incentives, or accessibility to resources. A common challenge of DAOs is that while they bring a diverse group of people together, that diverse group of people must learn how to grow, strategize, and communicate.
• Inefficiency: Partially summarizing the first two bullets, DAOs run a major risk of being inefficient. Because of the time needed to educate voters, communicate initiatives, explain strategies, and onboard new members, it is easy for a DAO to spend much more time discussing change than implementing it. A DAO may get bogged down in trivial, administrative tasks due to the nature of needing to coordinate many more individuals.
• Security: An issue facing all digital platforms for blockchain resources is security. A DAO requires significant technical expertise to implement; without it, voting and decision-making may be compromised. Trust may be broken, and users may leave the entity if they can't rely on its structure. Even if multi-sig or cold wallets are used, DAOs can be exploited, treasury reserves stolen, and vaults emptied.

DAO Example: The DAO

The DAO was an organization designed to act as a form of venture capital fund based on open-source code without a typical management structure or board of directors. The DAO was built using the Ethereum network.

The DAO launched in late April 2016 thanks to a month-long crowd sale of tokens that raised more than $150 million in funds. At the time, the launch was the largest crowdfunding campaign ever recorded.

Why Did The DAO Get Disbanded?

By May 2016, the DAO held a large percentage of ether tokens (up to 14% of the total circulating amount), according to reporting by The Economist). At roughly the same time, however, a paper was published that addressed several potential security vulnerabilities, cautioning investors from voting on future investment projects until those issues had been resolved.

Later, in June 2016, hackers attacked the DAO based on these vulnerabilities. The hackers gained access to 3.6 million ETH, worth about $50 million at the time. This prompted a massive and contentious argument among DAO investors, with some individuals suggesting various ways of addressing the hack and others calling for the DAO to be permanently disbanded. This incident also figured prominently in the Ethereum hard forking that took place shortly thereafter, resulting from a community vote (of sorts) initiated by Ethereum developers.

What Are Some Criticisms of the DAO?

According to IEEE Spectrum, the DAO was vulnerable to programming errors and attack vectors. The fact that the organization was charting new territory regarding regulation and corporate law likely did not make the process any easier. The ramifications of the organization's structure were potentially numerous: investors were concerned that they would be held liable for actions taken by the DAO as a broader organization.

The DAO also operated in murky territory regarding whether or not it was selling securities. Further, there were long-standing issues regarding how The DAO would function in the real world. Investors and contractors alike needed to convert ETH into fiat currencies, which could have impacted the value of ether.

Following the contentious argument over The DAO's future and the massive hacking incident earlier in the summer, by the fall of 2016, several prominent digital currency exchanges, such as Kraken, de-listed The DAO's token, marking the effective end for The DAO as it was initially envisioned.

The Bottom Line

Decentralized autonomous organizations (DAOs) are entities using blockchains and tokens to democratize governance to those with voting rights. Members of DAOs decide the direction of the organization and govern how it is run. The intent behind DAOs is to remove centralized control and give decision-making abilities to all users rather than leaving it up to a centralized group or person.