Emerging distributed ledger technologies and blockchain have sparked various innovations, new organizational structures, and social forms. One of the most intriguing inventions is the emergence of decentralized systems, including decentralized autonomous organizations and their subclass, decentralized autonomous corporations. This article introduces these concepts and sheds light on the past, present, and possible future of these decentralized implementations.
Index Terms: DAO, DAC, decentralization, autonomous, smart contracts
Since decentralized autonomous organizations - DAOs - have emerged worldwide, each of these words has been interpreted in various ways, leading to different definitions and use cases of DAOs that focus on other characteristics. The idea has evolved around the issues that arise when people share a common goal and use a blockchain to make decisions transparently and efficiently.
What is a DAO?
DAOs can be described as an open-source blockchain protocol governed by algorithm-driven smart contracts that can execute decisions based on information without a central decision-maker and hierarchical management. The consensus protocol of a DAO is based on smart contracts on the blockchain, which are essentially self-verifying protocols programmed to execute automatically when certain conditions occur.
Everyone agrees to abide by the rules when they participate, and if those rules are violated, DAO funds are blocked, and no one can use DAO. In theory, DAO guarantees that all participants abide by the rules, thus enabling an efficient, self-sustaining organization.
The characteristics of DAOs
Each word preferred to describe the acronym ‘DAO’ forms a comprehensive parallel meaning for the characteristics of DAOs, which are explained below:
- DAOs are decentralized.
DAOs are decentralized because they are not organized hierarchically and do not concentrate power in centralized management. The novelty of DAOs lies in their ability to coordinate large numbers of people while avoiding the cumbersome nature of hierarchical structures.
The defined protocol rules or predefined smart contracts guide the behavior of network participants and perform automated consensus. In this way, a DAO can no longer be controlled by a single party but is managed by a community of participants. Moreover, due to its open-source nature, any member of DAO can view historical data, such as transactions and changes in the log, which enables DAOs to be more democratized, transparent, and fairer systems of organization.
- DAOs are governed by autonomous algorithms.
The rules and specific actions of DAO are embedded in smart contracts that are executed by themselves based on the behavior of the protocol. There is also no need to interpret these program rules, as they are executed automatically when certain conditions occur.
For example, a DAO with its internal capital can automatically buy and sell cryptocurrencies based on specific smart contracts with programmatic conditions. The autonomy of DAOs is enabled by smart contracts, which are self-executing contracts with situations written as code and then deployed on blockchain networks. DAOs can own capital and sell data, generating potentially powerful revenue.
- DAOs are organizational structures.
A DAO is a virtual organization with a certain number of members who collectively decide on governance issues. The decision process of this virtual organization does not have any explicit hierarchy, although weights of votes can be varied depending on reputation (reputation-based voting) or stake a member has.
Members of a DAO are connected by a common goal and network incentives tied to consensus rules, rather than a formal contract that is more commonly seen in traditional corporate structures. These consensus rules are entirely transparent and written in the open-source software that drives the organization. Because DAOs operate without borders compared to conventional businesses, they can be subject to different jurisdictions.
A DAO, as a virtual organization, can carry out processes such as allocating capital, executing certain decisions, punishing harmful behavior, and distributing rewards. They can also interact with each other and trigger smart contracts in decentralized applications.
These functions mentioned above provide a flexible structure that allows many communities to adopt DAO and program it for their purposes by encoding their bylaws, rules, or policies into smart contracts. So far, people have created DAOs that fund and manage projects such as stablecoins, venture capital funds, decentralized cryptocurrency exchanges, meme buying cartels, etc.
Even though the possibilities for DAO are limitless, they still lack customization and scaling capabilities compared to “traditional enterprise”. The DAC may be better suited to meet the expected needs of a traditional enterprise, such as managing payroll or insurance.
What is a DAC?
The importance of DAOs at the time of this writing can be traced back to the earlier concept of a decentralized autonomous corporation - the DAC - which emerged a few years after the introduction of Bitcoin in 2008.
The first touch of DACs was by Daniel Larimer, the founder of Bitshares, in 2013 in a series of articles. In these articles, DACs are being described as being companies run by an incorruptible set of business rules implemented by publicly auditable open-source software run by stakeholders in their computers.1
At the time, the DAC concept was used informally in online forums, with the terms “decentralized” and “distributed” autonomous companies used interchangeably. The term was more widely adopted and publicly discussed, notably by Vitalik Buterin on several websites. The term was inherently associated with corporate governance and very restrictive for many blockchain-based projects with a more general purpose. Thus, several alternatives to the term emerged, leading to the generalization of DAOs as a replacement for DACs. Although the two terms are sometimes used interchangeably, DAO and DAC differ primarily in motivation to participate, as the term can be interpreted differently today.
Vitalik Buterin proposed the concept of DACs in 2014. According to his definition, decentralized autonomous corporations/companies are a subclass of DAOs, and the “shares” in a DAC entitles the holders to continuous income that depends on the success of the DAC. Thus, holders of a DAC share would be entitled to “a share in its profits, a share in its growth, and/or a say in its governance.”2 In this way, DAC behaves more like a traditional corporation paying dividends than DAO, which acts more like a nonprofit structure. Although there seems to be a difference between DAC and DAO in terms of paying dividends, the distinction may lose effectiveness in some cases. This is because simply by participating in the ecosystem of DAO rather than providing investment in DAO, participants are also incentivized by rewards in the form of native asset tokens that help them work towards a common goal.
At this point, Buterin suggests further discussion, pointing out that “since all DAOs contain internal capital that can be owned, and the value of this internal capital can easily increase as the DAO becomes more successful/popular, a large portion of DAOs will inevitably be DAC-like to some degree.” Since the definitions and applicable regulations are still in the gray area, to further analyze the differences between these two business models, an assessment of economic reality is considered to differentiate the motivation for participation. Like the Howey test, it is important to determine whether dividends/profits or governance are the primary motivations for participating in these ecosystems.
Although Buterin presented the definition of DAC in 2014, there has not been much discussion about DACs since then until the Metis Protocol. The Metis DAC is a governance structure that helps manage and promote autonomous and decentralized communities. This governance structure is different from DAOs because DAOs focus solely on voting and governance. In contrast, Metis DACs are designed to function as operational enterprises with business-related tasks such as payroll, marketing, communications, and insurance. With all of these capabilities, Metis DACs are poised to be a hub for the Web3 economy and various business structures. As with any significant technology breakthrough, Metis DACs will be phased in starting in Q1 2022.
The potential future use cases could be many with DACs. A DAC could be set up by a vending machine manufacturer to be placed in public places. Those who buy would pay with their cryptocurrency, and the money from the various vending machines around a block would be deposited into the DAC fund. The DAC then distributes the funds to vendors who fill the vending machines when products are sold, so the value is transferred immediately.
Use cases of DAOs
In contrast to the limited examples of DACs, there happens to be more internalized use cases for DAOs, including but not limited to the following:
- Building communities with DAOs
Social communities formed through DAOs are also on the rise. Friends With Benefits, or $FWB, is a well-known Discord community of cultural crypto enthusiasts. In the early days, members could purchase $FWB tokens to access the server. At this writing, prospective members can still purchase $FWB tokens. Still, the existing community collectively votes on who can join next to its music discovery platform, startup incubator, and online crypto news publication. Another example is Komorebi Collective, a DAO that finances women and LGBT crypto users. So far, building a community is one of the most potent tools that DAO can enable.
- Wide range of applications and incentives
Protocol DAOs manage crypto protocols, investment DAOs that make venture investments, collector DAOs that purchase NFTs such as FlamingoDAO and PleasrDAO, etc. DAOs also offer their participants various incentives for rewards in return for actions such as playing, learning, working, contributing, creating, etc.
- Primary use cases for DeFi
DAOs are currently used extensively in DeFi, which is inherently decentralized. Defi refers to any number of new financial applications and transactions based on the blockchain. DeFi allows crypto holders to conduct virtually any transaction - from trading cryptocurrencies to owning a crypto wallet to making predictions about current events - without a central financial authority. Therefore, the relationship between DAOs and DeFi is symbiotic, providing a much simpler coordination mechanism for members’ finances and guiding them toward the mission of network participants. The explosive growth of decentralized financial protocols has led to DAOs becoming more popular as of 2020, with many yield farming and decentralized exchange platforms (DEX) such as compound.finance, yearn.finance (YFI), and Uniswap (UNI) relying on DAOs for their management.
- Compliance with securities laws
For several reasons, most crypto projects are moving to incorporate this type of governance function into their tokenomics, usually as one of the tokens of their dual token structure. The most common one is to promote a token to be more widely used/utilized (by giving it voting rights and governance participation rights) and not be a securitized token to comply with securities laws.
- Manipulation Risks
DAOs are likely to be labeled as flat hierarchies, relying on its entire community to make decisions regarding governance issues rather than relying on a central authority. While this is the case, according to the project’s preferences, some participators have more say than other due to their voting rights pro-rata to their holdings of governance tokens of the project.
The problems DAOs face
- DAOs do not have a defined regulatory framework
The regulatory environment for DAOs is entirely uncertain, which poses risks for participants. There is limited guidance directly applicable to issues that DAOs face, particularly regarding the distribution of governance tokens. For example, in the U.S., DAO token holders could be considered holding interests in pass-through entities, resulting in taxable income in various solutions. It remains to be seen how the different jurisdictions will shape the regulatory framework for these new types of organizations. Nevertheless, DAOs have been recognized by proactive jurisdictions such as the State of Wyoming in terms of tokenization of shares. It should be noted that a continued uncertain regulatory landscape could be a significant barrier to the adoption of DAOs and the potential they offer.
- Potential points of centralization
Decentralization should be viewed as a range/area rather than a state. DAOs enable a more significant number of participants to collaborate than ever before. Still, the governance rules outlined in the protocol may always bear the risk of representing a point of centralization.
- Security Considerations
DAOs have gained momentum since the concept was first introduced in 2015 by Slock. It and expanded in 2016 by ‘The DAO.’ The DAO is a decentralized venture capital that planned an open system where anyone could submit an idea. The members could vote on whether or not to allocate funds for certain investments. After a few rounds of funding, about 3.6 million ETH were stolen due to security vulnerabilities in the code (―recursive call bug), also known as ‘the DAO hack’.
The desirable characteristics of DAOs (decentralization, immutability, trustlessness) inherently introduce significant performance and security drawbacks. These drawbacks introduce a host of risks; thus, security considerations must be a high priority when implementing a DAO-based solution. As seen in ‘The DAO hack,’ since there is no possibility of correcting codes even after detecting a bug, the only possible solution which was implemented in this case was the ‘hard fork.’
As discussed earlier, DAOs govern several niche aspects that make them highly suitable for a wide range of possible self-sustaining formations. With decentralized technologies, more democratic and collaboratively managed systems are expected. In addition, the openness of these crypto economies will allow people to participate in different DAOs and crypto networks in various industries and sectors. Therefore, it is expected that more organizations (such as nonprofits, startups, and beyond) will form as DAOs, and more self-actualizing groups will adopt DAOs to manage and mix different income streams and ownership returns. While the idea is compelling, there are still important issues that need to be addressed. In particular, legacy systems need to be replaced in favor of these democratic structures to properly harness the potential of decentralized autonomous organizations and their continued emergence in the Web 3.0 paradigm.
- Stan Larimer, 2013, Bitcoin and the Three Laws of Robotics, Let’s Talk Bitcoin (2013) at https://letstalkbitcoin.com/bitcoin-and-the-three-laws-of-robotics
- Vitalik Buterin, 2014, DAOs, DACs, DAS and more: An incomplete terminology guide. Ethereum Blog6 (2014), 2014 at https://blog.ethereum.org/2014/05/06/daos-dacs-das-and-more-an-incomplete-terminology-guide/