What Are DAOs And How They Work?
DAOs are gaining a lot of traction in the blockchain space. They are a crucial building block for the next version of the Internet — Web 3.0. But what is a DAO and how does a DAO work? We will answer these questions and more in this article. This is also available as video if you prefer.
Background
The best way to understand a new concept is by relating to something we are familiar with. So, in order to understand DAOs let’s start with a concept we come across everyday.
Organisations, or more informally clubs. Suppose you are part of a Football club. To promote the club, all the members contributed some money to the club’s fund. When the club gets big enough it will naturally have a management structure with roles like manager, treasurer etc. The management is expected to lead the club and they have access to the club’s fund. You have to trust them to be honest and use the money only to promote the interests of the club. The future of the whole club relies heavily on the integrity and ability of these few people. The key here is trust — something that’s broken all too often these days. This is where DAOs can help!
Why Do We Need a DAO
Well, in this example, if you use a DAO to run the club, you don’t need to trust anyone else in the group, just the DAO’s code, which is 100% transparent and verifiable by anyone. DAO will facilitate coordination among the members to achieve the goals of the group.
What Is a DAO
At its core, a DAO is a smart contract. A piece of code which defines the rules of how the organisation should run. Unlike traditional organizations, there is no hierarchy to DAOs. To align interests of the organization with that of its members, DAOs incentivize their users to achieve their goal. A key distinction from traditional organisation is that the control is decentralised.
How DAOs Work
Forming a DAO typically involves the following steps.
Establishing a cause
First you need a reason to form a DAO. It can be anything that brings people together. For example, things like forming a:
- Charitable trust: People from around the world donate money to the trust and the group can decide how they want to spend donations.
- An Investment fund or simply
- Giving the users the rights to govern an organisation
Once the purpose is established and the rules of how the DAO runs are written into smart contracts. They typically enter a Funding phase.
Funding phase
Any who wishes to be part of the DAO can contribute to the DAOs fund and the DAO will issue tokens proportional to the size of their contribution. These tokens will give you voting rights to steer the direction of the DAO. This is similar to how companies issue shares today except DAOs are more decentralised. At the end of the funding phase, the DAO is considered live and operational. Moving forward, all key decisions surrounding the organization are made through governance.
Governance
All users who own the DAO tokens vote on proposals. The weight of their votes will be proportional to the share of tokens they hold. So, if the DAO issued a total of 1000 tokens and you hold 100 of them, your vote will carry a 10% weight. When a consensus is reached, the result of the vote can be automatically actioned by the DAO’s code.
How Are DAOs Being Used Today?
Here’s an overview of the DAO landscape. Pretty much every reputable dApp or protocol uses a DAO structure. UniSwap, Aave, Curve are all popular protocols with Billions of dollars at stake, controlled by DAOs. MolochDAO is funding the development of public infrastructure related to Eth 2.0. People are also using DAOs to invest together — for example, if you want to buy an NFT from the BAYC collection, the cheapest one is 83 ETH (nearly 300,000 USD) — even if you have that kind of money, it’s a lot of risk for most people. So, instead you could form a DAO, pool funds from people, and buy a few NFTs through the DAO. This way, you can diversify your collection and have fractional ownership of many expensive NFTs. Social DAOs like Gitcoin are providing grants to fund builders and creators for their work. Personally, I hope to apply for a Gitcoin grant if this channel gets enough traction. So, you would do me a huge favor by hitting that subscribe button.
Benefits
There are several benefits to using a DAO to run an organisation. Such as:
- Transparency: Since all actions of a DAO are public, this builds trust with the community.
- Decentralisation: DAOs eliminate the need for central hierarchies like management boards.
- Strong Community: People in a DAO community feel valued and often more engaging because they have a say in the future of the organisation.
Downsides
It’s not all sunshine and rainbows though. DAOs have their share of downsides too.
- Bugs in code: Exposes them to risk of hacking. In fact the first ever DAO, called The DAO, was hacked and 3.6 million ether were stolen from the DAOs fund. That’s over $12 billion at today’s prices!
- Delays from voting: Given the decentralised nature of DAOs, each proposal needs to be voted on by the community and that can take a few days to weeks. While this is good under normal circumstances, this is a big issue when developers want to fix a critical bug but need the community approval. In the case of The DAO, a fix was available but the community couldn’t reach consensus in time to apply the fix. And the result was a devastating hack!
I want to finish on a positive note. Most DAOs today are basically copies of well tested DAO frameworks. They run on minimal code that went through a lot of scrutiny so there’s less scope for bugs. If you find DAOs that align with your values, I think it’s worth being part of that community — after all, we are all working towards building a better world.
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