How Do DAOs Really Work
Introduction to DAO
DAO is one of the most important yet misunderstood applications of Ethereum. It stands for Decentralized Autonomous Organization, which means an organization with (1) a group of participants with a common goal (2) governed by code that is decentralized, open and transparent. If the system is well designed, the organization will organically evolve toward achieving the common goal.
This is a mouthful of big words, and many people may be skeptical about the feasibility and efficacy of an entire decentralized organization operated by code as opposed to human. How will such an organization work, especially without human input?
In this article, I will unpack the definition in the first paragraph via several examples that illustrate the type of problems that DAOs can and are particularly equipped to solve. I will address various nuances and misconceptions around DAOs as we go. Hopefully by the end of the article, you will have a clear idea of how DAOs work, at least in the high level.
Example #1: DAO
The first example is a DAO that is literally called DAO(confusing, I know!), which is one of the earliest decentralized autonomous organization built on Ethereum. It is a decentralized venture capital fund.
Recall from the first paragraph the two things that an organization needs to be a DAO. In this case, the group of participants are investors who have the common goal of maximizing the returns on their funds, and the governance by code works as such:
The smart contracts (built on top of the Ethereum blockchain) will take votes from shareholders (people who hold DAO tokens) on which startups to invest in and how much. The more tokens a shareholder locks up, the more weight he has in the vote. Once the votes have been recorded, the smart contracts will automatically allocate the funds based on the vote results.
Participants can be sure that the vote results are fair because every line of code is transparent and immutable on the blockchain.
How does this differ from a traditional venture capital fund?
Traditional venture capital funds have the principal-agent problem, which is when the agent (board of directors in this case) takes actions on behalf of the principal (investors who have money in the fund) but the agent’s actions are more incentivized by his self-interest than that of the principal’s. In other words, the board of directors do what is best for themselves as opposed to what is best for the investors. In DAO, investors directly vote on projects that they want based on how much stakes (tokens) they hold.
However, while DAO was a good proof-of-concept, it failed because of vulnerabilities in its code, which were exploited by hackers to steal more than $50 millions worth of Ether. The failure illustrates that while the open-source nature of DAOs makes it transparent to the community, it also exposes DAOs to attacks by hackers. In fact, the hack was so influential that it directly led to a hard fork of Ethereum: Most of the Ethereum community agreed to roll back the blockchain to a previous state to undo the attack, while the rest rejected the rollback and insisted that code is law. The former group is known as Ethereum (ETH) today while the latter is known as Ethereum Classic (ETC).
Example #2: MakerDAO
While DAO failed, DAOs are definitely not just an abstract concept as of today. Perhaps the most well-known example of DAO is the MakerDAO (sometimes just called Maker) project, which currently has a thriving and rapidly growing ecosystem. People from the MakerDAO project have the common goal of creating a stablecoin, DAI, that “can be used by anyone, anywhere, anytime”.
The governance involves decisions on a variety of Risk Parameters (such as what collateral can be used, how much debt can be issued, and fees) that ensure the stability of DAI and is done via voting by MKR holders. A detailed introduction to MakerDAO is beyond the scope of this article and be read here, but a helpful analogy is that if MakerDAO is like a company, DAI is the product, the Risk Parameters are features of the product, and MKR holders are the shareholders of the companies who vote on how to adjust the product’s features.
Essentially, 1 DAI is collateralized by 1 USD worth of ETH, and MKR holders vote to make a series of decisions to ensure that the price always stays stable and DAI fully collateralized. In centralized organizations, decisions like these are made by board members and executives. Or if a company is public, you may be able to vote by holding stocks (ownership in the company). In MakerDAO, anyone who owns MKRs can vote on decisions.
Similar to how stock holders (who use Robinhood as their broker) can easily participate in certain votes via the Robinhood front-end, in MakerDAO, voting is done via the Maker Governance Portal, a user-friendly front-end to the smart contacts that make up the Dai Credit System (you can also vote by interacting directly with those smart contracts). To vote, you need to lock up tokens. The more tokens you lock up, the more voting power you have. Vote results are determined by the amount of MKR that votes for each proposal. For example, if proposal A has in total 700 MKR voting for it and proposal B has 300 MKR, proposal A would win with a 70% majority vote.
There are two types of voting in MakerDao: governance polls and executive votes.
Through governance polling, MKR holders will be able to seek soft consensus on the basic principles of the ecosystem, the first example of which was the Foundation Proposal that established the five core principles of MakerDAO.
Through the executive voting process, MKR holders vote directly on changes to the Dai Credit system. For example, if some shareholders decide that they want to increase the collateral required to borrow DAI to ensure the stablecoin’s stability, they simply put forward a proposal, and if the proposal passed the vote, the smart contracts will automatically increase the collateral requirement. The whole process is automated and no corruption is possible. The rules of governance are transparent and immutable on the blockchain, open to anyone who wants to examine them.
Example #3: Voting
As can be seen from the two previous examples, contrary to the common misconception, DAOs do not eliminate the need for human input, it is simply a more transparent, corruption-resistant, and decentralized way to ensure the integrity of a system that exists to serve the participants’ interests in the first place. In both DAO and MakerDAO, the participants themselves must decide on what to vote for, and the autonomous system simply ensures that their intentions are implemented with certainty — it is in some sense, a corruption-resistant democracy, which brings us to the third example which only exists in the conceptual phase right now.
Imagine a democratic nation where all the laws are recorded immutably and openly on the blockchain. A DAO can be used to automate the process of lawmaking. When a proposal is made, the citizens can directly vote from their cellphones through a front-end that connects to the smart contracts. Once the vote concludes, the laws are automatically changed based on vote results recorded on the smart contracts. There are no elected officials that can act contrary to what the people want; instead, the power lies entirely in the hands of the people. Regardless of whether you think this is a good idea, DAO can hence enable the most direct and honest form of democracy today.
Conclusion
We have seen a failed, a successful, a potential application of DAOs. Hopefully by now you have a better understanding of the concept. There are many other examples of DAOs — Bitcoin, to name one, where the common goal is an open economic system resistant to inflation and the system operates on code (as opposed to managers) that provide incentives to keep the network strong. Regardless, we are still in a very early stage of DAOs, and there will be many creative possibilities for what DAOs could evolve into down the road!
