Decentralized Autonomous Organizations (DAOs) in Decentralized Finance (DeFi)
This article is the third issue of Overtheblock.io DeFi Series, which represents an extensive and ongoing effort to understand and map the innovation potential of Distributed Ledger Technologies (DLTs) in the financial sector.
From hierarchies to networks
We are witnessing a historical period characterized by profound changes in many aspects of our lives. One of these concerns the structure of norms and actions that define how people interact with each other. When we talk about organizations, we are also speaking of decision-making processes, which lead to different kinds of managerial practices and results.
In the previous articles of Overtheblock’s DeFi Series (Introduction to DeFi and DeFi cross-chain analysis), we discussed the difference and coexistence of centralized and decentralized ecosystems in the provision of financial services. We analyzed the innovation blockchain and Distributed Ledger Technologies (DLTs) are introducing in many socio-economic contexts, with a specific focus on the financial industry, highlighting the introduction of a disruptive novelty in organizational terms for the execution of financial services.
Specifically, blockchain has enabled a new breed of viable alternatives to centralized and hierarchical governance structures showed in Figure 1 (i.e., top-down managed organizations), promising a solution to two problems that generally affect traditional governance structures: the principal-agent dilemma and the high transaction costs of coordination [1]. While the second issue is relatively straightforward to comprehend, since the intermediated nature of any service provided within a centralized ecosystem, the first one is more complex to grasp. Specifically, it refers to the situation in which an agent, who acts on behalf of a principal, has an incentive to behave following his/her interest, which may be different from that of the principal, creating an opportunity for moral hazard (i.e. misaligned behaviours). In this context, blockchain technology proposes a unique solution to these issues, proposing a new way to align individuals’ incentives while diminishing the transaction costs by automating the transaction rules and procedures.
This article explores a new frontier of business organization paradigm based on blockchain and defined as Decentralized Autonomous Organization (DAO). Particularly, it analyzes the nature of these new organizations, focusing on their appearance and future perspectives in the financial industry. More specifically, within the Decentralized Finance (DeFi) environment, we put under the lens three use cases. The aim is to present the multifaceted nature of DAOs which may take different shapes and forms depending on the rule settings and the processes to which the paradigm is applied.
DAOs in DeFi
DAOs are non-hierarchical organizations governed by goal-seeking communities united by purpose and rules that operate through cryptographic routines (see Figure 2). Taking advantage of blockchain technology, DAOs provide public access to their network, relying on the internal stakeholders’ contribution on a voluntary basis. Therefore, it is on the community that DAOs base their functioning.
DeFi, instead, is a decentralized financial system composed of decentralized applications (dApps) based on public blockchain infrastructures like Ethereum and Eos [2].
On the opposite side of the spectrum, Centralized Finance (CeFi) generally works in a framework where transparency is absent. Indeed, people have to trust institutions to manage and execute services without observing the behind-the-stage actions needed to carry out a task. In turn, these actions generate costs that translate into high transaction fees, considering the long value chains that characterize the organization of centralized institutions and the multiple levels of intermediation needed to perform tasks.
Moreover, there is a sizeable market not served by existing centralized institutions [3], consisting of unbanked people who are excluded from accessing the most basic financial services for various reasons, such as ethnicity, financial conditions and geopolitical positions. Therefore, in centralized contexts, the traditional financial industry has created an environment where the incentives of the three main stakeholders involved (i.e., shareholders, employees and customers) are strongly misaligned since often their interests do not point in the same direction.
By leveraging decentralization, DeFi provides permissionless access to various financial services performed through the execution of smart contracts, thus eliminating or reducing intermediation and enabling transparency. Within the same framework, DAOs represent innovative business ventures arranged with automation at the center and humans at the hedges, characterized by internal capital used to reward certain individuals’ activities [4]. Consequently, although DAOs present avant-garde organizational attitudes, they heavily rely on hiring individuals to perform tasks that the automation cannot.
In this vein, the innovation potential of DAOs within the DeFi ecosystem is twofold:
1. From the technological point of view, DLTs make available an auditable and immutable ledger that contains the history of stakeholders actions and,
2. From the governance and organizational standpoint, DAOs give access to a decentralized environment where incentives are aligned among the different stakeholders. Simultaneously, the hierarchical arrangements of traditional institutions are partly or totally replaced by a system of incentives that drives users’ interest towards the benefit of the community so that the stakeholders’ behaviour aligns with the goal pursued [5].
The result is an ecosystem composed of decentralized organizations able to provide access to a broad spectrum of financial services eliminating most of the barriers to entry and thus fostering financial inclusion.
DAOs use cases analysis
The analysis presented below focuses on three DAOs: MakerDAO, Swissborg and Uniswap. Each venture adopts a peculiar approach with respect to the implementation of the DAO paradigm.
In terms of value proposition, MakerDAO offers a borrowing & lending solution leveraging the DAI stablecoin and a set of digital assets as collateral through the over-collateralization of digital assets (e.g., BTC, ETH). Swissborg, instead, offers a wealth management solution optimizing transaction rates and providing simplified access to a plurality of DeFi platforms. Finally, Uniswap provides exchanging services for ERC20 tokens (i.e., tokens issued on the Ethereum blockchain that apply the same standard).
Each DAO applies different governance rules that define the degree of decentralization of the platform and, in turn, the respective implementation model. Table 1 benchmarks the three DAOs along four key dimensions: financial service offered, governance model adopted, role of the community, decentralization approach implemented. MakerDAO and Swissborg show a multiple governance layer, while Uniswap applies a simple but strongly innovative on-chain protocol that makes it the most decentralized DAO among the three.
MakerDAO and Uniswap represent two decentralized applications (dApps) that leverage blockchain technology to implement different financial services (i.e., borrowing & lending and exchanging, respectively). On the other hand, Swissborg has created an “extended organization” composed of a core team plus a community of contributors that may be leveraged on a number of processes such as marketing, community management, new products development and testing. This organization allows users to manage their own wealth (held in the form of digital assets), respecting the fundamental blockchain principles of fairness, accessibility, transparency and trust. Indeed, it is not a decentralized application (dApp) but, rather, a platform that provides access to financial services based on blockchain technology by adopting a hybrid approach leveraging the advantages of both DeFi and CeFi.
The three solutions derive important value drivers that highlight the differences between CeFi and DeFi. In particular, decentralized ecosystems enhance actors’ alignment in terms of incentives. Since the three use cases leverage the same technology (even if in different ways), the following value drivers are common to all three solutions: near-zero rent extraction, cost efficiency, transparency, ease of use for widespread accessibility.
In turn, by applying different governance rules, each use case reaches different outcomes with respect to the financial services provided. The main principle shared by the three use cases concerns the disruption of the traditional financial industry by creating an ecosystem based on trust, fulfilment and inclusiveness.
[1] Shermin, V. (2017), Disruptive governance with blockchain and smart contracts, Strategic Change, 26(5), 499–509.
[2] Elev8, 2020, Centralized vs. Decentralized Finance | How Does DeFi Stack Up?, Retrievable at link.
[3] Aithority, 2020, Can Blockchain Bank The Unbanked?, Retrievable at link.
[4] Ethereum Blog, 2014, DAOs, DACs, DAs and More: An Incomplete Terminology Guide, Retrievable at link.
[5] Freni, P., Ferro, F. and Moncada, R., Tokenization and blockchain token classification: a morphological framework. In: 2020 IEEE Symposium on Computers and Communications (ISCC), Retrievable at link.
Please cite as:
Moncada R., Ferro E., (2020) Decentralized Autonomous Organizations (DAOs) in Decentralized Finance (DeFi), Overtheblock Innovation Observatory, https://medium.com/overtheblock/decentralized-autonomous-organizations-daos-in-decentralized-finance-defi-f02acee4bf2a
OverTheBlock is a LINKS Foundation’s initiative carried out by a team of innovation researchers under the directorship of Enrico Ferro. The aim is to promote a broader awareness of the opportunities offered by the advent of exponential technologies in reshaping the way we conduct business and govern society.
We are chain agnostic, value-oriented, and open to discussion.
