What Is a Decentralized Autonomous Organization (DAO)?

A decentralized autonomous organization (DAO) is an emerging form of legal structure that has no central governing body and whose members share a common goal to act in the best interest of the entity. Popularized through cryptocurrency enthusiasts and blockchain technology, DAOs are used to make decisions in a bottom-up management approach.

What Is the Purpose of Decentralized Autonomous Organizations (DAOs)?

One of the major features of digital currencies is that they are decentralized. This means they are not controlled by a single institution like a government or central bank, but instead are divided among a variety of computers, networks, and nodes. In many cases, virtual currencies make use of this decentralized status to attain levels of privacy and security that are typically unavailable to standard currencies and their transactions.

Inspired by the decentralization of cryptocurrencies, a group of developers came up with the idea for a decentralized autonomous organization, or DAO, in 2016. The concept of a DAO is to promote oversight and management of an entity similar to a corporation. However, the key to a DAO is the lack of central authority; the collective group of leaders and participants act as the governing body.

How DAOs Work

DAOs rely heavily on smart contracts. These logically coded agreements dictate decision-making based on underlying activity on a blockchain. For example, based on the outcome of a decision, certain code may be implemented to increase the circulating supply, burn of a select amount of reserve tokens, or issue select rewards to existing tokenholders.

The voting process for DAOs is posted on a blockchain. Users must often select between mutually-exclusive options. Voting power is often distributed across users based on the number of tokens they hold. For example, one user that owns 100 tokens of the DAO will have twice the weight of voting power over a user that owns 50 tokens.

The theory behind this practice is users who are more monetarily invested in the DAO are incentivized to act in good faith. Imagine a user who owns 25% overall voting power. This user can participate in bad acts; however, by doing so, the user will jeopardize the value of their 25% holding.

DAOs often have treasuries that house tokens that can be issued in exchange for fiat. Members of the DAO can vote on how to use those funds; for example, some DAOs with the intention of acquiring rare NFTs can vote on whether to relinquish treasury funds in exchange for assets.

Benefits of DAOs

There are several reasons why an entity or collective group of individuals 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 that is often vastly outnumbered by their peers. 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.
• Participation. Individuals within an entity may feel more empowered and connected to the entity 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 is best for the entity.
• Publicity. Within a DAO, votes are cast via blockchain and made publicly viewable. This requires users to act in ways they feel is best, as their vote and their decisions will be made publicly viewable. This incentivizes actions that will benefit voters' reputations and discourage acts against the community.
• Community. The concept of a DAO encourages people from all over the world to seamlessly come together to build a single vision. With just an internet connection, tokenholders can interact with other owners wherever they may live.
  

Limitations of DAOs

Not everything is perfect regarding DAOS, though. There are severe consequences to improperly setting up or maintaining a DAO. Here are some limitations to the DAO structure.

• Speed. 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. With a DAO, every user is given an opportunity to vote. This requires a much longer voting period, especially considering time zones and priorities outside of the DAO.
• Education. Similar to the issue of speed, a DAO has the responsibility of educating a lot more people in regards to pending entity activity. A single CEO is much easier to keep in charge of company developments, while tokenholders of a DAO may have ranging educational backgrounds, understanding of initiatives, incentives, or accessibility to resources. A common challenge of DAOs is that while they bring a diverse set of people together, that diverse set of people must learn how to grow, strategize, and communicate as a single unit.
• Inefficiency. Partially summarizing the first two bullets, 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 much more individuals.
• Security. An issue facing all digital platforms for blockchain resources is security. A DAO requires significant technical expertise to implement; without it, there may be invalidity to how votes are cast or decisions are made. Trust may be broken and users leave the entity if they can't rely on the structure of the entity. Even through the use of multi-sig or cold wallets, DAOs can be exploited, treasury reserves stolen, and vaults emptied.

DAO Example: The DAO

The DAO was an organization that was designed to be automated and decentralized. It acted as a form of venture capital fund, based on open-source code and without a typical management structure or board of directors. To be fully decentralized, the DAO was unaffiliated with any particular nation-state, though it made use of 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 of all time.

Why Did The DAO Get Disbanded?

By May 2016, the DAO held a massive percentage of all ether tokens that had been issued up to that point (up to 14%, according to reporting by The Economist). At roughly the same time, however, a paper was published which addressed several potential security vulnerabilities, cautioning investors from voting on future investment projects until those issues had been resolved.

Later, in June 2016, hackers attacked the DAO based on these vulnerabilities. The hackers gained access to 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 hard forking of ethereum that took place shortly thereafter.

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 in terms of regulation and corporate law likely did not make the process any easier. The ramifications of the structure of the organization were potentially numerous: investors were concerned that they would be held liable for actions taken by the DAO as a broader organization.

The DAO operated in murky territory about whether or not it was selling securities, as well. Further, there were long-standing issues regarding the way that the DAO would function in the real world. Investors and contractors alike needed to convert ETH into fiat currencies, and this 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 token, marking the effective end for the DAO as it was initially envisioned.