Decentralized autonomous organizations (known as DAOs for short) are blockchain-powered communities where control is placed in the hands of everyday users.
Blockchain technology is vital to their operation for many reasons — with smart contracts enshrining the DAO’s rules, and allowing members to transparently vote on proposals.
This is the first of a series of articles exploring how DAOs work. Here, we’re going to explain blockchain governance is revolutionizing the world of finance… and making it fairer.
What is a DAO?
Whereas traditional companies and organizations have a hierarchical structure, with closed committees often making decisions, DAOs generally place all of their members on the same level. This ensures everyone has an interest in the project’s continued success — and done right, prevents individuals and small groups from having a disproportionate influence on its future direction.
Another key difference between DAOs and traditional institutions lies in how the blockchain delivers automation. Transactions can be executed instantaneously once the parameters set out in a smart contract are met, meaning there’s no longer a need for middlemen.
How DAOs work
In a nutshell, DAOs create a democratic-like experience via smart contracts.
These smart contracts define the organization’s rules and control the treasury, and once the contract is live on the blockchain, no entity can change the rules except through a vote.
These votes govern the decisions made within a DAO ensuring transparency and inclusion.
There are variations on the governance models used by decentralized autonomous organizations — but more often than not, a member’s right to vote on proposals hinges upon whether they own the DAO’s governance token. Beyond giving users a voice, these digital assets also provide a financial incentive.
Depending on a DAO’s rules, members may need to own a specific number of tokens before they’re eligible to submit proposals related to the organization’s policies, or how it should spend funds. And during the democratic process, participants may receive one vote for every token they own — giving them a louder voice.
Careful consideration is also paid to the format of the vote. Typically, a quorum (minimum number of voters) needs to be reached — meaning a set proportion of all members have to cast a ballot in order for a proposal to be valid. From there, a certain percentage would need to vote in favor of the motion to pass. The amount of time set aside for voting may also vary.
Benefits of DAOs
DAOs have been established for an array of purposes. Perhaps one of the better-known examples is Uniswap, a decentralized exchange where its users have a say over the day-to-day running of the platform — as well as which new features should be prioritized. They’ve also proven to be a successful vehicle for crowdfunding, with a DAO quickly raising $40 million in an attempt to buy an original copy of the US Constitution. Unfortunately, they were outbid.
Just some of the biggest DAO benefits include:
- Transparency and trustlessness: As DAOs operate on blockchain technology, all actions, votes, proposals, and decisions are recorded on the blockchain ensuring transparency and accessibility.
- Reduction of intermediaries: DAOs eliminate the need for middlemen (e.g. banks, managers, etc.) by ensuring contracts/decisions are conducted via automated smart contracts. This, in turn, reduces costs, bureaucracy, and decision-making manipulations.
- Decentralization of power: One of the most significant benefits of DAOs is the decentralization of power over the organization’s changes. Decisions are mostly collective, preventing the concentration of power and aligning with the ethos of “decentralization”.
Downsides of DAOs
As with anything, there are some drawbacks with decentralized autonomous organizations that also need to be considered. For one, a DAO is only as good as its smart contract — and vulnerabilities in the code may put user funds at risk. Other potential disadvantages could be:
- Governance complexities: Establishing an efficient and fair governance model is a significant challenge for DAOs. An infamous example is The DAO which suffered a governance-related vulnerability resulting in substantial fund losses and a hard fork in the Ethereum blockchain.
- Token distribution and equity: On the topic of fairness, token distribution can be tricky for DAOs. Inequitable distribution can lead to the centralization of power, contradicting the “decentralization” ethos. For example, MakerDAO faces criticism over the centralization of voting power among a small group of large token holders raising questions about true decentralization.
- Regulatory uncertainty: As with most blockchain-based tools and solutions, DAOs exist in a regulatory grey area, deterring potential participants from being involved in this novel technology.
How do DAOs make money?
There are various methods to generate revenue in DAOs, such as:
- Token sales: When a new DAO launches, the project owners can choose to sell or distribute governance tokens to raise funds and bring new community members to the DAO.
- Venture capital funds: Some DAOs function as venture capital funds, acting as investment vehicles managed by general partners. These partners invest in projects, startups, NFTs, or other assets aiming for returns on investments.
- Crowdfunding: DAOs can also raise funds via crowdfunding where the DAO’s community members can chip in to build a solution or fix an issue that aligns with their goals and ethos.
DAOs and blockchain technology
A common mantra in the crypto space is “don’t trust, verify” — and the openness of DAOs on blockchains means anyone can scrutinize the smart contracts they run on for themselves. Independent cybersecurity firms are also tasked with examining code for vulnerabilities, with projects sometimes offering bug bounties to white hat hackers who uncover issues.
Many early DAOs were launched on the Ethereum blockchain because of how it offers smart contract functionality. But owing to scalability concerns, high fees and slow transaction speeds, Layer 2 networks have become a popular alternative. Rootstock also allows DAOs to benefit from the security of the Bitcoin blockchain, while offering full EVM compatibility.
New use cases for decentralized autonomous organizations are emerging all the time, empowering like-minded individuals with the chance to rally together and build communities based on the causes they’re passionate about.
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And stay tuned for our next article in the DAO series.