Doc's Daily Commentary

Mind Of Mav

DAOs: The Next Big Thing or Just Hype?

In November the auction of a copy of the original US-constitution captured global media headlines. Not because it was the only privately available copy of the 13 original documents to be sold, nor because of its 43 million USD price it fetched at a public sale at Sotheby’s. What caused most interest was that the second-highest bidder was neither a person, nor a company, but a so-called DAO. This acronym stands for decentralized autonomous organization, a blockchain-based organization governed solely by algorithms. Human managers have as little place in the DAO-design as do offices or articles of incorporation.

The ConstitutionDAO was able to raise close to 49m USD from more than 17,000 contributors and had become the first DAO Sotheby’s ever worked with. This raises many questions: How does a DAO work? Where did the concept come from? And where is it going?

A DAO is a means of independent protocol governance. Too abstract? Then think of it as a group of people who want to do business with each other, yet there is no trust between them. In most cases they have never even seen each other, nor do they know the real names of their business partners.

It could be any type of business that requires you to put up your own money (usually hoping to earn more). The goal of your joint venture could be to pool money to lend it and earn interest. Or the objective could be to buy a valuable piece of art and then resell it with a profit.

In all the scenarios you need to have a joint bank account and you need to agree on numerous rules that determine how the cooperation will work. For which things do you want to spend the money? How do you split the earnings? How do you incentivize others to support the network? What is the threshold of the risk you are willing to take? To which currency do you peg your token? You get the point.

There are literally thousands of such questions, but the beauty of a DAO is that once you have agreed on how to handle them, you can code this logic into a smart contract. Smart contracts are if-then scenarios that you can program onto a blockchain. They are the foundation of the DAO because it transforms all the ways you want your company to behave into code. Completely autonomously. No need for managers or operative staff. Human errors: gone. So are fraud attempts; code is incorruptible.

Does this mean you can sit back and watch the computer do the work while the cryptos are piling up in your wallet? Unfortunately, not quite. Once you have set up the basic mechanism, you need to do two things: Fill the treasury of the DAO and set a model for its governance. This is done via a token issuance, in which investors buy the tokens with another asset. In return, they are entitled to participate in voting on future changes and possibly in sharing the proceeds. Here each DAO has a lot of flexibility in how it is set up.

The birth and re-birth of DAOs

DAOs have been around since 2015, as first introduced by Dan Larimer, who had founded a number of important crypto-companies such as BitShares, Steemit and EOS. Yet DAOs really soared to prominence on Ethereum. That ended rapidly when in June 2016 the Ethereum chain suffered the infamous DAO-hack. A DAO organization that (confusingly enough) was also named DAO managed to raise a record 150 million USD from over 11,000 investors. The DAO’s purpose was to invest the raised capital into dApps (i.e. decentralized apps) to earn a profit for the investors. The smart contract code had a vulnerability, however, and attackers managed to drain ETH worth 50m USD from the DAO. Subsequently, the organization went out of business, Ethereum was split into ETH (Ethereum) and ETC (Ethereum Classic), and the concept of the DAO was considered scorched earth by many founders and investors.

The DAO had its large revival in the 2021 DeFi-summer, where billions of dollars flowed into Decentralized Finance (DeFi) applications, many of which were governed by DAOs. Simply put, DeFi includes a host of financial services that use blockchain technology and offer banking services without banks. DeFi applications range from decentralized crypto-exchanges (DEX) to autonomous lending platforms that collateralize users’ crypto-assets.

Driven by this success, other industries acquired a taste for DAOs too. Today, cultural DAOs are highly popular. For example people coming together to purchase digital art collections and displaying them in a virtual museum. Other DAOs are set up to manage the proceeds of the exploitation of intellectual property rights. Gamers use DAOs to share and sell in-game collectibles they have acquired. And applications such as MolochDAO pool money to provide grants to those advancing the Ethereum platform.

Reaching for the physical world

Had it been successful, the ConstitutionDAO would have marked a milestone and an important test as to whether a digital, autonomous organization is also capable of managing a physical good. So far, most DAOs have been handling other blockchain-based assets, whether it was crypto-collateral in the financial realm or NFT-secured digital art in the cultural world. Had the US Constitution been acquired by a DAO, it would have had to provide for the physical security of the document, the logistics of transferring it from one museum to the other, to negotiate with museums, and so on. These analogous tasks are not what DAOs were designed to do.

As the ConstitutionDAO has failed to secure the target asset, we will not see how this would have worked. Yet there is a somewhat similar project which has better chances of success: DuneDAO. Sci-fi lovers chipped in more than 700,000 USD worth of Ether to purchase the manuscript for Alejandro Jodorowsky’s unfinished adaptation of Frank Herbert’s classic sci-fi novel Dune. The manuscript had more than 3,000 illustrations and was supposed to be turned into a 15-hours movie. It was never shot due to budget restrictions, yet many classics such as Star Wars or Blade Runner were inspired by it.

The eventual manuscript sold for 3,2 million USD at Christie’s, but technically not to the DuneDAO. As it had failed to raise enough capital, one of the founders put up the rest of the cash on the group’s behalf. An attempt will follow to raise the rest of the investment via the DAO, so that ownership can pass to the autonomous organization. Just like with the ConstitutionDAO, investors buy governance tokens (in this case $SPICE . . . which is confusingly the same as one of our favorite STOs). Those give them voting rights on how to display the manuscript, not — and this very important — a fractional ownership right. The DAO remains the owner.

The DuneDAO project is additionally tricky, as the distribution rights do not come with the copy of the manuscript. A lot of creativity and legal consultation will be needed on how to display it — another test to see whether the interface between the DAO and the physical world works.

The link to the offline-realm highlights two key DAO-downsides

DAOs can be a great automatization driver, yet they also have some downsides. Two of them are particularly troubling.

The first is security. The 2016 DAO-hack was just the peak of the iceberg. Unlike the underlying blockchain mechanism, smart contracts are prone to attacks. They are very powerful, but that also means they are complex. And complexity means there is much room for mistakes. A study of close to one million smart contracts built on Ethereum found that 34,000 had significant vulnerabilities. That is 3,4%. Imagine your bank telling you there is a 3,4% chance the money from your savings account is drained. Not really a convincing selling argument, is it?

There are ways to mitigate those risks, for example by having independent auditors, e.g. Consensys’ Diligence, check the contracts. Slashing the risks will take DAOs a long way, but risk will never be completely eliminated.

And this leads us to the second major DAO-downside: Liability and their legal status more broadly. In most jurisdictions a DAO has no legal standing; it is not an entity provisioned for in the law. This causes trouble in terms of liability, but also in more mundane, everyday needs of an organization. How to sign a purchasing contract off-chain? How to do your tax-declaration? And what if you do manage to purchase the US Constitution, borrow it to a museum and don’t get it back? Can a DAO sue the museum?

Another not so banal question: Without being a person or legal entity, can an autonomous organization obtain property rights? What happens if it goes out of business? Who’s the heir of the assets and the treasury? The number of such questions explodes once you step into the world off the chain.

The state of Wyoming could be a good indicator on how legislators might interpret DAOs. Wyoming will vote on a bill that stipulates that DAOs are a form of Limited Liability Company (LLC) with some specifics. If token-holders are treated like shareholders this definitively brings clarity, but it also kills much potential of a DAO.

Are DAOs the organizational model for the future?

As always when I venture a look in the future, I like to start with recent figures and trends. The explosion of DAO-investments in the last months is stunning. In September 2021, 14bn USD worth of assets were under management by the 20 largest DAOs. In June the same year it had been 6bn USD. There are almost 1m DAO members now, five times more than back in June.

Lately, there is a lot of talk about a possible crypto-winter, in which the market capitalization of cryptocurrencies falls precipitously. Such a scenario could definitively reverse the investment trend, but some advances that were made are irreversible.

One of them is the growing diversity. Growing diversity in terms of business models and DAO-purposes, but at the same time growing technical diversity. In the past it was almost beyond question that a DAO should be built on Ethereum and that its governance tokens should be issued on the ERC-20 standard. Today, alternatives such as Solana are rising. They are promising lower costs and an extreme leap in chain efficiency. Solana can perform up to 50,000 transactions per second as compared to Ethereum’s 15. Not 15 thousand, just 15. This is certainly also ramping up the pressure on Ethereum to speed up their projects for increasing transaction efficiency.

There is more good news. No other impeding trend will aid the proliferation of DAOs in the coming years as much Central Bank Digital Currency (CBDC). As of this year, 86% of central banks actively work on digital versions of their currency. I have written here about the significance of a blockchain-based digital Euro. CBDCs are so crucial, because for the first time they merge the benefits of fiat currency with blockchain technology on a national and supranational scale. Thanks to the smart contract capability of fiat money built on distributed shared ledgers, money becomes programmable and thus the possible reach for DAOs grows. The more money is already on the chain, the easier it is to build and operate DAOs.

While there is no doubt that DAOs might go through boom and bust cycles akin to those of cryptos and early web applications, the idea will last. And over the long-term it will gain traction in many areas, as we see blockchain technology powering more and more of the world’s infrastructure.


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