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

What Is a Decentralized Autonomous Organization (DAO)?

A decentralized autonomous organization (DAO) is an organizational structure with no central governing body. DAOs, which were popularized by blockchain enthusiasts. have members who share a common goal of acting in the community's best interests. They are completely transparent and make decisions using a bottom-up management approach.

How DAOs Work

Digital currencies are decentralized, so they aren't controlled by one institution like a government or central bank. Rather, they are divided among different computers, networks, and nodes. This inspired a group of developers, and they developed the idea for a decentralized autonomous organization in 2016. It was meant to promote oversight and management like a corporation but under a collective group of leaders and participants that acts as the governing body.

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

Members could call for a vote on a proposal, which would be broadcast to voting members. The smart contract would tally the vote. This may be automated, as it would require altering the blockchain's coding. Regardless, the outcome 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 with 100 tokens of the DAO could have twice the weight of voting power over a user with 50 tokens.

The theory is that users with a larger investment 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 or 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 can vote on how to use those funds. For example, some DAOs that are intent on acquiring rare non-fungible tokens (NFTs) can vote on whether to relinquish treasury funds in exchange for assets.

Advantages and Disadvantages of DAOs

Advantages Explained

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. 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.
• Enables participation: Individuals within an entity may feel more empowered and connected 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.
• Votes are publicly viewable: 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 are publicly viewable. This incentivizes actions that will benefit voters' reputations and discourages acts against the community.
• Encourages 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.
  

Disadvantages Explained

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:

• Voting can take time: 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 can vote. This might require a much longer voting period, especially considering time zones and priorities outside the DAO.
• Members must be educated on the process: A DAO must educate members about 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. While DAOs bring a diverse group of people together, it's often challenging for those people to learn how to grow, strategize, and communicate.
• May be inefficient: 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 issues: 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.

Example of a 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, a paper was published that addressed several potential security vulnerabilities, cautioning investors from voting on future investment projects until those issues had been resolved.

In June 2016, hackers attacked The DAO based on these vulnerabilities. The hackers accessed 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 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.