Decentralized autonomous organizations, or DAOs, are entities with no central leadership.  The entire community makes decisions regarding the organization’s governance from the ground up, and a blockchain enforces a specific set of governance rules. 

DAOs are born and live on the internet, owned and managed by their community members.  Their built-in treasuries are only accessed by member approval.  Decisions are made through proposals with a group vote that is made during a defined period.

A DAO does not have a hierarchical management structure and can have multiple purposes.  Organizations such as charities, software subscribers, freelancer networks, and venture capital firms can all be set up as DOAs.

How do DAOs work?

The decision-making of DAOs is from the ground up.  The group’s members are the owners of the organization.  While there are several ways to participate in a DAO, it is usually through ownership of a DAO’s token. 

DAOs operate through the use of smart contracts.  These bits of code automatically execute when defined criteria are met.  While smart contracts are a component of several blockchains, Ethereum was the first widespread use of them.  Smart contracts define a DAO’s rules and regulations.  Stakers of a DAO’s tokens will receive voting rights and can influence the operation of the organization by proposing new changes to governance.

This model of staking can prevent the spamming of proposals, and the proposal will only pass if a majority of stakeholders approve.  The determination of “a majority” will vary between DAOs, (>50%, >=50.01%, >=60%, etc., different parts of a DAOs governance may have different levels of a majority) and is specified as part of the DAO’s smart contracts.  The model also makes DAOs fully autonomous and transparent being built on open source blockchains where anyone can review their code.  The DAOs built-in treasury can be audited at any time because the records on the blockchain indicate all financial transactions. 

The Three Steps to a DAO Launch

1. Creation of Smart Contracts Phase– A developer or group will build the foundational smart contract/s of the DAO. Which, once launched, can only be changed through the governance system that is first defined in the initial smart contract.  This means that the foundational contracts must be thoroughly tested to ensure proper functionality and essential details are not overlooked. 
2. DAO Funding Phase– Once the foundational smart contracts are created and tested, the DAO must choose its path to funding and its governance. The most common model chosen for fundraising has been through the selling of a DAO’s tokens, and the token holders will be given voting rights proportional to the number of tokens owned.
3. Blockchain Deployment Phase– Once the DAO’s system has been set up, it will be deployed on the chosen blockchain. From deployment, the stakeholders will decide the organization’s future and the DAOs creators, from phase one, lose their project influence except for the tokens they own from their work or that they purchase in phase two. 

What is the benefit of DAOs

DAOs are internet-native organizations and provide several advantages over traditional organizations.  The first and most important is that their structure means a lack of trust is needed between the members of the DAO.  While a legacy organization requires trust from all members, especially investors, and they can partially gain trust through mechanisms to build confidence in the people behind it, with DAOs, only trust in the public code is needed. 

The code is tested extensively before the DAO launch, and being publicly available, can be audited at any time.  Once launched, actions of the DAO are approved by the governance procedures and are also verifiable. 

Though they have no hierarchical structure, DAOs can still succeed in tasks and are under the control of their token holders.  Any stakeholder can propose an idea, and the group will consider decline, approve, or improve and then approve a proposed idea.  Internal disputes can be solved with voting that is in line with the smart contract governance rules known by all. 

Pooling funds by the DAOs investors gives anyone a chance to invest in an early-stage startup or a decentralized project that they believe in, letting them share the risk and gains that come out of the project. 

DAOs Solving the Principal-Agent Dilemma

The Principal-Agent Dilemma is a conflict that results between the Principal, who is a person or group, and the Agent, who is a person or group making decisions and acting on behalf of the Principal.  DAOs can solve this dilemma through their code. 

The Principal-Agent Dilemma is best explained with an example.  The Agent (a CEO, Insurance Agent, or Lawyer) may not work in the way that is in line with the goals and priorities held by the Principal (shareholders, insurance buyer, or clients) and instead act in a way that is in their (the Agent’s) own self-interest.

The Agent may also take excessive risks, while the Principal will end up bearing the burden of these risky actions.  An Agent trader may use highly leveraged investments hoping to get a bonus, but the Principal will be responsible for the downside. 

Image courtesy of Ethereum.org

The DAO’s code and community governance prevent these issues.  Stakeholders (Principals) choose to join a DAO and should do so after understanding its governance.  The Agent is a combination of the organization’s/community’s tokenholders whose interest aligns with the DAOs success and the code of the smart contracts that make up the DAO, which are known by all and can punish malicious acts that are against that self-interest.

The DAO and Its Scandal

“The DAO” (we’ll use a “The” to differentiate) was one of the first DAOs, launched in 2016, and was acting as a venture capital fund.  The native “DAO” token owners would profit from the organization’s investments, and the organization was seen as a revolutionary project with $150 M worth of Ether (ETH) invested. 

A few days after The DAOs source code was released, developers realized that malicious actors could drain it of funds.  A proposal was made to fix the bug, but an attacker utilized the weakness and stole $60 M worth of ETH from The DAO’s crypto wallet.  The project had about 15% of all of the ETH in circulation invested in it and was a huge blow to all DAOs and Ethereum. 

A soft fork was proposed by Vitalik Buterin (the Ethereum co-Founder) to blacklist the attacker’s address preventing the moving of funds.  The attacker, or their representative, claimed that the funds had been obtained “legally,” following the rules of the smart contract, and was ready to take legal action against anyone trying to seize the funds, also threatening to bribe Ethereum miners with the stolen funds to prevent a soft fork attempt. 

A hark fork was eventually the chosen solution rolling back the Ethereum history to before The DAO’s hack, reallocating the stolen funds to an additional smart contract where investors could withdraw them.  Anyone that disagreed with the hard fork solution became part of the newly formed Ethereum Classic (ETC) network.

Disadvantages of DAOs

The DAO structure is not a perfect one.  They are only a few years under their belts and being young, they have attracted criticism for lingering concerns about their structure, security, and legality.

Starting in 2016, the MIT Technology Review made its opinion known that trusting the masses with critical financial decisions was not good.  Since this initial publication, MIT has not publicly changed its view on DAOs. 

Because DAOs can be distributed and participated in globally, jurisdictional considerations have not been dealt with.  There is no global legal framework for DAOs, and any legal issues that arise will require any involved parties to contend with a complicated legal battle that will have various laws depending on the region that states it has the authority to make a judgment to regulate. 

In July of 2017, the US Securities and Exchange Commission (SEC) issued its report, stating that it had determined that The DAO had sold securities without the SEC’s authorization in the form of tokens on the Ethereum blockchain, and this action had violated US security’s laws. 

The hack of The DAO has raised security issue concerns showing that flaws in smart contracts are not easy to fix even after being identified, and this is made harder with a required group consensus to change them.

Summary

The Idea behind DAOs is a unique and useful one.  The benefits that a DAO can provide in the age of the internet are plentiful.  The Scandal of The DAO and the regulatory issues that have popped up show that DAOs are still in their early development stage, and several problems must be solved before they can become a more widely used structure for organizations.  Once these issues can be surpassed, DAOs will be valuable and possibly preferable for building trust in finance, philanthropy, and several other areas.

Disclaimer: The author of this text, Jean Chalopin, is a global business leader with a background encompassing banking, biotech, and entertainment.  Mr. Chalopin is Chairman of Deltec International Group, deltecbankstag.wpengine.com.

  The co-author of this text, Robin Trehan, has a Bachelor’s degree in Economics, a Master’s in International Business and Finance, and an MBA in Electronic Business.  Mr. Trehan is a Senior VP at Deltec International Group, deltecbankstag.wpengine.com.

  The views, thoughts, and opinions expressed in this text are solely the views of the authors, and do not necessarily reflect those of Deltec International Group, its subsidiaries, and/or its employees.