This article aims to provide an overview of Decentralized Autonomous Organizations (DAOs) in the cryptocurrency space. It references smart contracts and blockchain technology. If you are unfamiliar with DeFi, do read our introductory article to DeFi before reading this article. 

What Are DAOs?

DAOs, or Decentralized Autonomous Organizations, are community-based collectives governed by a specific set of transparent rules known as smart contracts. Instead of having a central point of leadership, DAOs adopt a community-led system where each member owns the right to propose and vote on critical decisions involving the organization’s future such as treasury allocation, technical upgrades, and future development of each project.

To become part of a DAO and gain voting rights, users have to hold its native token. This framework of distributed rights incentivizes members to place the organization’s best interests before their own, by voting for proposals which will benefit the DAO’s future.

How Do DAOs Work?

The rules of a DAO are written into smart contracts, which lay the foundational framework for its operation. Smart contracts are lines of code programmed to automatically execute an action when certain conditions are fulfilled. These rules are usually set by founding members of the DAO, and can be audited by the public due to the transparency of their code.

DAOs usually fund their treasury through the issuance of their native token, which can be exchanged on Decentralized Exchanges (DEXs). Token holders are allocated voting rights in proportion to their token holdings.

The DAO a.k.a Genesis DAO

The first ever DAO created was known as The DAO, or Genesis DAO. It was founded by a few members of the Ethereum community in 2016. During its initial creation phase, users could send Ether (ETH) to The DAO’s wallet address in exchange for DAO tokens, which could be used to vote on plans, proposals, and potential project funding. Shortly after the launch, an attacker exploited a loophole in The DAO’s smart contract code, making away with a total of 3.6 million ETH. This attack led to the DAO hard fork of the Ethereum network, giving rise to Ethereum Classic (ETC). This infamous exploit is now etched in crypto history, providing invaluable lessons on the importance of blockchain security.

Why Do DAOs Exist?

The fundamental aspects of a DAO align strongly with Web3 ethos: decentralization and autonomity. With a governance framework that revolves around their community, DAOs were created with the goal of running and developing blockchain projects from the ground up. Unlike traditional corporate structures, every member of the organization can have more equal rights compared to having a figurehead or board of directors.

Advantages of DAOs

1. Decentralization and Autonomity

Without a single or select group of leaders governing the collective and making decisions, DAOs allow individual community members to have a say in decisions regarding the organization’s future. With the shared vision of the DAO’s success, community members can combine efforts to vote for proposals benefitting the DAO as a whole, and allowing for self-governance.

Learn more about governance in DeFi here!

2. Transparency

DAOs are run by specific sets of rules known as smart contracts which help to automate and facilitate on-chain processes when certain pre-requisites are fulfilled. Due to the open-source nature of blockchain technology, smart contracts are fully transparent and can be viewed by anyone on the net. This means that the smart contract codes governing DAOs can be publicly audited in order to prevent hackers from exploiting any flaw or loophole in the system. The transparency of DAOs also ensures that community members are accountable for their proposals and actions in the organization.

Disadvantages of DAOs

1. Security

The transparency of smart contracts is a double-edged sword. Since the code is freely accessible to the public, it poses a threat to the security of DAOs. This is because malicious attackers could inspect the smart contract code for vulnerabilities and loopholes to exploit them for money. As mentioned above, the first ever DAO was exploited for 3.6M ETH. Because DAOs are completely governed by smart contracts, they are exposed to huge security and smart contract risks.

2. Concentrated Votes

Even though all DAO members are eligible to vote on proposals and decisions, not everyone has equal voting power. Since voting power is proportional to the amount of tokens held, members holding a small amount of tokens have limited voting rights. This poses the question of whether a DAO could be fully decentralized. Whales or big stakeholders holding a large number of native tokens can dominate the votes, making it unfair for other community members. In June 2022, Solana protocol Solend put out a community proposal to take over a whale account to prevent implosion through a potential liquidation. The proposal received 97.5% voting approval, but 90% came from a single wallet.

3. Inefficient Decision Making

In order for a proposal to be passed, there has to be a voting procedure. This may not be the most efficient way of decision making in times of emergency, where actions have to be taken promptly. It is difficult to get all community members to vote on plans and proposals in a short period of time. On top of voting procedures, there are also transaction times which have to be accounted for. Overall, it is difficult to make decisions in a short amount of time with the consensus of the entire community.

The Future of DAOs

In theory, DAOs are incredible organizations centered around culture and community, which resonates deeply with the Web3 ethos. Due to their transparency and distribution of power, a strong case can be made for why they could replace existing traditional hierarchical structures. With the ability to rally strong-knit and dynamic communities around a common purpose, DAOs seem to be perfect for DeFi and NFT projects. However, there are several practical shortcomings to governing a project on code. Many Web3 builders and developers are still trying to balance the intervention between man and machine in order to successfully make DAOs work. Furthermore, there is insufficient legislation and regulation of these unconventional collectives at this point in time. This makes the mainstream adoption of DAOs a long road away. With the appropriate regulatory framework and technical improvement, DAOs hold great potential in reimagining traditional hierarchical structures in the Web3 world and beyond.

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Disclaimer

This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up to date or accurate.