What is a Dao?

A DAO stands for a decentralised autonomous organisation, one of the most progressive revolutions in Web3 technology that enables the creation of digital communities. Since everything is decentralised, there is no need for the presence of a centralised intermediary to regulate how this organisation functions. In fact, all the functions of the organisation are written and implemented by code.

There are two critical characteristics of a DAO that help distinguish it from other centralised organisations.

The first is the reduced barrier to entry for users, and the second is the fact that all data about the DAO is publicly available on the blockchain. Most DAOs also have some form of tokenomics that facilitate crucial decision-making; if you are part of a DAO, then you can easily vote on key decisions.

What is the real potential of a DAO, to what extent are such organisations useful, and are there any disadvantages to such an organisation? We will explore all these questions in this article.

Let’s dive in.

Think of a DAO as a digital organisation that exists on a blockchain. There are (usually) no restrictions on who can join the DAO, as long as they have something they plan to contribute.

However, to become a member of a DAO, you must purchase that DAO’s governance tokens. Subject to the proportion of their governance tokens, DAO token holders can vote on key decisions made by the DAO.

Now, like any other human organisation where almost anyone in the world can join, DAOs are often made up of people from myriad backgrounds. A DAO does not require users to provide any KYC-related information, which essentially means that DAO members can remain truly anonymous and still continue to contribute to the organisation.

The purpose of a DAO can be anything: a community of self-promoting developers who share tips and tricks with each other and further empower upcoming developers; a decentralised venture fund that collectively funds emerging protocols in DeFi; the list goes on.

As we just said, the purpose of a DAO can really be anything, as long as it has something through which members can vote (in most cases, a governance token). All the actions of a DAO, from its operations to its management, are written in code: it is an autonomous entity.

Now, there are some crucial distinctions we need to make in order to understand what a DAO is and what a DAO is not. To do this, we will have to wade into more confusing waters. Bear with me as I break things down.

No. A smart contract differs from a DAO because it involves a limited number of participating entities, whereas a DAO can potentially have n number of entities participating in it. One could argue that there are some contracts that have an infinite number of participants, but there is another crucial difference.

A smart contract is triggered only when a user initiates an execution at the smart contract level. If the smart contract does not receive such a stimulus from the user, then it remains inactive. While the same can be said of a DAO, the truth is that DAOs can have multiple processes running without the need for external stimulus. Since a DAO is an autonomous organisation, its entire function is managed internally.

That said, DAOs can often have their governance rules written in smart contracts.

A decentralised application can (mostly) be a smart contract, and because it is simply an application, it has no financial aspect. For example, Tor is often considered a decentralised application because a) you do not need to pay money to use it and b) it is not governed by any organisation. This is in opposition to a DAO, which always has a financial aspect to its governance token.

A decentralised organisation, on the other hand, is simply any organisation that has been decentralised. An example of this would be an organisation where members are responsible for the maintenance of a given community by providing educational services. Since this decentralised organisation provides educational services, it will have teachers, advisors, principals, etc. However, because this organisation is not autonomous and may have leaders who make decisions centrally, it is not a DAO.

Let us quickly return to what a DAO really is.

A DAO is simply an organisation that is autonomous, automated and decentralised. As an entity, it may “hire” outsiders to accomplish its tasks, but all decisions are voted on by all members of the DOA.

Now that we understand what a DAO really is, let’s try to understand how governance works in DAOs.

What does the governance of a DAO look like?
At the heart of every DAO is the revolutionary governance mechanism. The lack of a centralised “principal” means that all members participating in the governance influence the actions of the system.
Thus, a DAO is governed primarily by its agents (who are its members), whose voting in the system leads to fundamental state transitions.
This is best shown in the following graph taken from the DAOStack white paper.

Now, a simple blockchain governance structure would look something like this. Let’s take an example of an investment vehicle that invests in emerging DeFi protocols: we’ll call it InvestorDAO.

There are three main stakeholders for our fictional InvestorDAO.

InvestorDAO members who can participate in decisions on which protocols to invest in and how much that allocation should be.
Potential DeFi protocols that pitch their projects to the InvestorDAO.
InvestorDAO members who have a high reputation within the DAO and have a higher influence on DAO decisions.
For the purposes of our current example, let us limit ourselves to only the first two stakeholders.

The native governance token for the DAO is INV.

Now, suppose a DeFi protocol is presented to the DAO offering nearly 100x returns on the DAO’s capital if invested in a specific period. The protocol offers 100% DAO-only investment, along with a couple of other features. The launch pad for this protocol is shared among all DAO members.

The most likely scenario to develop in this case is scenario 1.

Scenario 1

If the number of members voting above 65% in favour of the protocol (say that is the minimum threshold percentage required for approvals), the collective capital of $50M can be invested in the protocol. DAO members with appropriate legal expertise can assist with the contract. If, on the other hand, the DAO rejects the proposal, then the investment is abandoned.

This is what an ideal scenario would look like with a DAO of the purpose of the example. Let us stretch our imagination a little to imagine an alternative scenario.

Scenario 2

Ignoring the launch pad, let’s assume that a DAO member has managed to accumulate a large voting share within the DAO, this is because they have a considerable amount of government tokens in their wallet. Now, this same member submits a proposal to transfer all the money to their personal wallet. You would imagine that would be impossible, wouldn’t you? No, it is possible. If the member manages to acquire >65% voting power within the DAO, then he can simply direct the funds to be transferred to his own wallet. This will drain the DAO of all its funds and the members will be left helpless.

This is where our third actor from above comes in. If there are some DAO members who are more reputable than other members, then their vote will have a greater influence on decisions. And because their vote is linked to their reputation, they would not want to vote in a biased way. This second scenario is one of the biggest challenges facing DAOs today.

That said, this is the usual governance structure of most DAOs. We could go into more detail on DAO governance, but for the sake of this article, we will leave it here.

What are the different types of DAOs?
One of the most famous DAOs is the DAO, which was initially created as an experiment in April 2016 to serve as a fundraising mechanism for Ethereum.

Everyone who contributed to the DAO received governance tokens that could then be used to decide on key decisions for the network. The DAO managed to raise more than $150 million, of which $60 million was taken due to a vulnerability in the smart contract code.

This was one of the first hacks in cryptocurrency on such a massive scale. Several people started blaming DAO as an entity prone to various security problems. However, one crucial thing to keep in mind is that all transactions (including the hack) can be found on blockchain today.

Since their initial conception and the DAo disaster, DAOs have traversed a great distance. There are several different types of DAOs in the ecosystem today.

Here is a list of some of them with some examples (full disclosure: the inspiration for this list is What is a DAO?) by Steven Tey.

Investment DAO: one of the most recent examples of this is the ConstitutionDAO, which came very close to buying the US Constitution in the fall of 2021.
Protocol DAO: Uniswap, a popular protocol for exchanging altcoins that launched its own government token in 2021.
Service DAOs: think of professionals coming together and providing not only services to potential users, but also helping to transform users into professions; a popular example of this is the DeveloperDAO.
Project DAOs: helping to solve a particular problem for users in cryptography; BadgerDAO.
Community DAOs: a group of people who get together to exchange value and/or even buy an NFT; PleasrDAO.
What are the most popular DAOs in Crypto?
Some DAOs have gained more popularity than others.

Each member of a DAO can exercise control over their internal capital through the governance token. Some of these DAOs often pay salaries to people who are actually employed by them. For example, the empty set dollar is a DAO that features an algorithmic stablecoin. The DAO is said to pay more than $150K to its community manager.
In the same vein, some DAOs may even serve as grant providers for protocols or even some blockchain networks. For example, Moloch DAO functions as a grant provider for Ethereum. LAO is also a DAO that has served as an investment vehicle for several Ethereum-based protocols.
MakerDAO is an example of a DAO protocol mentioned above that has become popular since the emergence of DeFi in the summer of 2020. It is an algorithmic stablecoin protocol, and members can participate in key voting decisions.
CurveDAO is another well-known DAO in the ecosystem, mainly because it provides greater voting power and revenue sharing for all members who block their tokens in the DAO. The longer you hold CRV tokens, the heavier your voting power in the DAO becomes.
These DAOs continue to redefine how individual members can participate in the strategic decisions of a protocol, as opposed to how little say shareholders have in the decisions of a corporation. But we must remember that DAOs are a relatively new type of organisational structure, and have their own set of limitations.

Could DAOs run the world?
Potentially, DAOs can do anything. If a DAO has well-codified rules and has foreseen different scenarios that could arise, then there is a possibility that it could replace the traditional structures seen in the world today.

However, we must take all this with a pinch of salt. DAOs are relatively new organisational structures that do not have a proven track record of success in most cases. In their current form, much needs to be done before they can really begin to replace traditional structures.

What are the main challenges with DAOs?
We already considered a key issue with governance for DAOs earlier when we discussed how someone who has a specific threshold of governance tokens within the DAO can influence DAO decisions in their favour. This can be countered with a reputation mechanism, but there could be a scenario where a key DAO member can acquire a reputation within the DAO only to abuse it later.

We have already seen how CurveDAO facilitates this reputation problem: with CurveDAO, the longer you block your tokens, the greater your voting power. Therefore, any protocol that wants to increase its presence within the Curve protocol can simply bribe these holders to vote in its favour. A similar case happened with Mochi Finance just a few weeks ago.

In most cases, however, reputation serves as a key solution to the problem of centralised voting power. Most rational agents in a DAO with a high value of reputational power will be mostly unbiased in their decisions, as several cases in the past have shown. Moreover, the fact that other DAO members look up to them in key decisions gives them a moral obligation to be fair. Moreover, reputation scores (or even tokens) are a non-transferable asset. Therefore, a tortuous entity cannot buy that reputation.

There may be extreme cases where an entity with high governance power and reputation dominates DAO decisions, but that, as I said, is more of an extreme case.

Do all members participate when a DAO votes on something?
Not all DAO governance token holders will vote on every decision.

A low voter turnout could be solved by making the underlying smart contracts require each member to do so: if they do not do so for a specific period of time, their membership can be cancelled (reduced). However, this is an ideal scenario and might not necessarily apply in real-life daO.

For example, it was reported in November 2020 that only 5-6% of the total MKR was being used in MakerDAO governance. This was attributed to two main reasons.

The first reason was the lack of incentives for MKR token holders to participate in decisions. If someone has a considerable amount of MKR tokens in their portfolio, along with other assets, they are not as incentivised to devote their time and attention to understanding the key decisions they need to vote on.
The second reason is lack of participation due to the prior effort required. If you have 5,000 MKR tokens and want to participate in governance, then you will have to devote a good number of hours to understanding what decisions are being made, what is at stake, how the change might affect the protocol, etc. Any lack of interest at the user end to do so would lead to a decrease in participation.
One comment on the MakerDAO forum described that rational “self-interest” would always trump reality in a rather ingenious way.

This is the sad reality of participating in governance. Not everyone can take the time to fully understand all proposals, and many DAO members will ignore their voting rights due to lack of time or interest.

There can also be a lack of understanding around the human mind itself when applied to cryptography. People tend to feel that just because humans want to move away from centralised systems to an ecosystem where they have as much power as their counterpart, they will be willing to put in a hundred times more effort to ensure that the ecosystem remains intact.

However, we must understand that we cannot decentralise humanity. We have been programmed to want to have someone “in power” to make key decisions for us, because we are too busy with other things to do it ourselves.

The crucial distinction to be made here is the fact that, despite having representatives who can then make key decisions. Because everything would be codified, it would ensure that every DAO agent has a say in the decision. No human being can alter the infrastructure.
For all its claims, a DAO is not as decentralised as it hopes to be. Even in the best possible scenarios, there can be a concentration of power within a few hands, which can then influence the decisions made by the DAO. And all this is possible only because the central stakeholder in a DAO is a human being.

Final thoughts
You might think it is hypocritical of me to keep saying that DAOs have immense potential, after writing that it is impossible to decentralise humanity.

However, DAOs have this great potential because they solve human problems through the use of code. If the main rules of a DAO are written in code, then they cannot be manipulated. No one can change the smart contract where those rules are written. This immutability (along with the transparency that blockchain brings) is enough to cement the position of DAOs within the larger crypto ecosystem as genuine replacements for hierarchical organisational structures, systems where those in power freely change the rules to suit their own self-interest.

Moreover, the potential use cases for daO are truly limitless. A DAO with (potentially) 1M members can be a DAO with (potentially) 1M members.
In the end, I would like to leave you with a personal thought. A DAO seems like a panacea that cures all our problems, but we must remember that it is almost impossible to change human nature. Humans are programmed to want to fight each other to get to the top. Evolutionarily, a society where everything is always the same has never existed. And I doubt it ever will.

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