DAO Explained

Decentralized Finances’ significant strength is its permissionless and decentralized nature, meaning no centralized structure controls any part of the blockchain’s operation. 

These features don’t only benefit finance-related matters; they also apply to the issues in governance. A Decentralized Autonomous Organization (DAO) is an example of such decentralization of the blockchain that deals with other types of activities, including but not limited to, decentralized venture funding, operations with IoT-enabled devices, and activities needing an autonomous execution.

What is a DAO

Decentralized Autonomous Organizations (DAO) describe a set of rules that govern a network and provide incentives for participants in the consensus. DAO’s are considered decentralized as no central, single authority holds more power than the overall majority. On top of this, the decision is not centralized but rather automated using some set of rules that include complex mathematics and game theory. These rules are built to benefit the network and the participants in a fair manner. Overall, this system aims to improve centralized government models marred by several bureaucratic layers, hierarchies, and an agent-participant problem.

The DAO use case is found in the fact that contracts are enforced in a code, or a smart contract, that forms a set of rules agreed upon by all participants, which all members must abide by. This eliminates the error of human intervention for decisions that are crucial for the longevity of the protocol. DAO’s take care of the agent-principal dilemma, a type of situation that allows an agent to make certain decisions or actions on behalf of another person.

The dilemma arises when agents act in selfish interests, the agent may disregard the principal’s benefit without the principal being aware that he/she is being taken advantage of. What causes this type of problem is the information asymmetry between the agent and the participant, which has a power dynamic that favors the agent.

How DAOs Work

DAO’s are built to mimic a company’s structure where rules and regulations are created using open source codes and enforced by smart contracts. The rules here are decided collectively by the token holders. Unlike traditional systems, there are no hierarchies; however, to ensure the network’s strength, DAO’s typically have incentives programmed for the set of users who participate in the governance structure. Usually, after the codes are written and programmed, DAOs would enter a funding phase, which is used later to incentive the network participants. By owning and locking a certain amount of tokens(cryptocurrencies) during the funding phase, participants are allocated voting rights that equate to the number of their holdings.

Decentralize Autonomously Corporation (DAC)

DAO is the principal factor behind the rise of the Decentralized Autonomous Corporation (DAC), a type of company that uses the DAO approach to making company decisions in a more democratic, trustless, decentralized, and autonomous manner. The first type of DAC to ever exist in the blockchain is Bitshares, an eCommerce company started by its founder Dan Larimer. This protocol enables transactions between consumers and manufacturers without human involvement. Dan Larimer first proposed the concept of ”Decentralized Organized Enterprise” in an article published on September 7, 2013. An idea that, incidentally, was implemented in Bitshares in 2014 and EOSIO in 2018.

In the DAC, all finance-related transactions are entered into the blockchains public ledger, making them immutable, irreversible, decentralized, autonomous, and implemented without human interference.

Bitcoin

Bitcoin is the first crypto coin that uses a DAO structure to secure its network through rewarding participants who take part in its organization, called a proof-of-work consensus mechanism. Transactions are successful when miners reach a consensus, solving tricky mathematical puzzles; in return for their efforts, they are rewarded in BTC. This system is guided by a set of rules that rewards legit work done and punishes offenders.

Ethereum “The DAO”

The Ethereum network operates as a decentralized venture fund based on open-source code. This network runs without a typical management structure, disregarding a board of directors associated with traditional business setups. This didn’t come without a considerable cost as vulnerabilities in the code resulted in hackers’ exploitation, causing the first-ever hard fork of the Ethereum blockchain. This split Ethereum into two blockchains, Ethereum & Ethereum Classic, making the funds obsolete.

The Weakness of DAO's

Legal: There are still uncertainties of DAO’s legal status as the law does not yet recognize them. Participating in this type of venture requires accepting the risks associated with it, as claims of loss can not be legally pursued, resulting in its classification as a high-risk investment option. This opens up the opportunity for legal misunderstandings with local regulations.

Hacks: Unless the hash rate is high, like in Bitcoin, which requires a large amount of capital and electricity, a low hash rate coupled with a motivated exploit could result in a 51% attack. 

Final Thoughts

Although DAO’s enhance the trustless, decentralized, and autonomous nature of the blockchain, a fault still exists in its governance’s centralization. Many argue that it does not fit correctly with the true spirit of decentralization with the possibilities of 51% attacks - a situation arising where a malicious participant can allocate a significant portion of the hash rate to disrupt transactions. As blockchains continue to innovate, we can expect a much more technologically advanced DAO system that addresses these issues. This system should continue to expand the limitless opportunities of crypto. Fingers crossed!

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