The DAO that Can Be Owned Is Not the DAO
Lesson 22: Understanding the Essence of DeFi DAO-ism
The fish trap exists because of the fish. Once you’ve gotten the fish you can forget the trap. The rabbit snare exists because of the rabbit. Once you’ve gotten the rabbit, you can forget the snare. Words exist because of meaning. Once you’ve gotten the meaning, you can forget the words. Where can I find a man who has forgotten words so I can talk with him?
— Zhuangzi
DAO-ism, the decentralized autonomous organization (and not the ancient Eastern religion), is the belief that DAOs present a true innovation as a legal structure of management and governance.
This article explains the essence of this innovation and why DAOs cannot be collectively owned, as is often commonly believed. Ironically, the opening quote from Zhuangzi — who is one the central historical figures of Daoism (the religion) — helps to elucidate what’s so special about DAOs.
Let’s put it this way:
DAOs exist because of decentralized technology. Once you can go about your daily participation in a DAO and its corresponding ecosystem, you can forget the DAO.
Nonetheless, the key to going about daily participation in a DAO requires we understand why DAOs exist. The rabbit snare exists to catch the rabbit . . . by analogy, we might just have it wrong as to why the DAO exists.
Getting it right means remembering that DAOs change how we operate. We should not make the mistake of trying to fit them into existing paradigms of use and management. I include in this warning the hype about the democratic basis of DAOs, which tends to be overrated.
What is a DAO?
A Decentralized Autonomous Organization is an entity that governs projects and protocols on a blockchain network. DAOs can be used to govern mainnets, like Ethereum, or projects and applications on the mainnet, like Uniswap (a decentralized exchange).
DAOs may very well be the most significant legal innovation within the blockchain and financial space. This is because there is neither central ownership of the organization (as with a private corporation); nor is there a collective ownership of the organization (as with a co-op). The latter distinction is a bit more involved. Before unpacking it, there are three basic features of DAOs that need to be highlighted.
(1) Function
DAOs are fully autonomous because they are composed of smart contracts which execute actions when specific criteria or conditions are met. For example, if the DAO treasury reaches a certain amount, a smart contract can be put in place to trigger a transfer of funds to another account as a means of ring-fencing assets in case of the need for liquidity.
Ideally, DAO members would vote on which smart contracts ought to be in place; but initially, DAOs are usually governed in their nascent stage by a small group of people — e.g. its founders and advisors, who are responsible for getting the DAO to a self-sufficient level of operation and membership. Many DAOs will therefore have a threshold at which control of the DAO switches over from a small group of people to the community.
(2) Governance
DAOs are democratically organized. In principle each member has a vote on governance issues. There are different ways users of a protocol can become a DAO member and different ways in which voting power is assigned. The most common pathway is to use a native token as a governance token. When a user holds that token, they have the right to vote in any DAO decisions. For example, the amount of tokens one holds tends to translate into proportional voting power. So the more tokens one holds, the more votes one gets. Call this “token share voting”.
A more nuanced version involves tiered voting, where for example, token holders must accrue a minimum amount to reach a tier of membership at which voting rights are assigned. Tiered membership voting encourages more participation in the ecosystem to accrue governance tokens. This helps to ensure that only the most active members are voting on important issues. Call this “tiered token share voting”.
Governmentally, members of the community can propose voting issues under the expectation that the management team of the DAO will execute them. In principle, this sounds fair and democratic; but there can be many complications to this form of governance. Not all members vote. Voting power can be dominated by one or a few large token holders. Execution of a decision may not be clearcut and involve decision-making issues not originally considered in the voting initiative.
(3) Legal Implications
Because DAOs are autonomous and decentralized, they tend to displace the center of responsibility since they are run by smart contracts. Responsibility can be traced back to the human community who voted or put in place the smart contracts. But this tends to be problematic to trace and apply, especially when there is an enormous number of users. Can 5 million users be held accountable?
This question is problematic, and it means DAOs will have to work out a way in which they can maintain autonomy yet structurally account for responsibility in case any of the DAO’s actions (via smart contracts) or its products results in negligence.
One way of addressing this issue is by pairing a DAO with a corporate entity in which specific individuals are legally responsible for executing DAO governance. The type of corporate entity depends on the nature of the Web3 project.
The DAO that Cannot be Owned
Owning a DAO is like forgetting its original purpose or meaning. A truly decentralized entity has no owners, though specific individuals or entites may be charged with carrying out “the will of the DAO”.
Why DAOs are not like centralized private companies
One might be tempted to think that holding governance tokens is like owning shares in a company since tokens provide a similar type of voting power to common stockholders. The analogy helps to some extent since it highlights how tokens provide a stake of sorts in decision-making processes. However, unlike common stock, tokens do not represent a share of ownership. Token holders have no legal or contractual claim.
Moreover, governance tokens are utility tokens. This means that they are usually (but not always) awarded on the basis of performing some action in the DAO. In other words, they are participatory. Unlike stock, they are not bought in order to accrue value based on the labor of others (workers in the company).
To be sure, not all governance tokens operate in this manner. But in order to maintain a clear distinction between shares and tokens, current and future DAOs will need to ensure that they steer clear of any securities-like structures and practices.
Why DAOs are not like co-ops
Co-ops are organizations in which members and employees are both the users of the organization’s services and products and the owners of the organization. REI is perhaps the most famous co-op in the US. In the UK, “the Co-op” is a popular food market which offers other services, such as banking.
DAOs differ from co-ops in that:
- There is no entity that is owned, even though a DAO may be registered as a LLC or C-corp. So while a DAO will have a treasury, members of the DAO do not get a claim or share of that treasury. They do not own it in any sense; though they can vote on what to do with the treasury with respect to infrastructure, DAO investment, or even charity donation.
- While DAOs involve membership by way of holding governance tokens, use of a DAO’s services does not require membership; nor does it penalize non-members for use of services. To be sure, not all co-ops require membership and instead offer members a perk in addition to dividends in the company.
- Co-ops usually distribute dividends on an annual basis to its members. Because no one owns a DAO, there are no dividends to distribute. What tends to happen is that a successful DAO will mean its members benefit indirectly through a network effect — where more active users increase the value and utility of the services. Perks might be distributed as user rewards (think airline miles) in the form of a financial token bearing some exchange value.
What’s important to note is that because DAOs are both a legal and organizational innovation, their composition and distinctiveness will change as the regulatory landscape responds to their roles in the financial world.
The First DAO — “the DAO”
The DAO, a.k.a. Genesis DAO, was created by the Ethereum community in May 2016. What follows is mainly a summary of Samuel Falkon’s detailed account of the brief history of the DAO. Falkon also presents more of the interesting technical details of the DAO, which are herein omitted.
The main functions of the DAO were to allow people to send ETH in exchange for DAO tokens, where at one point the asset value of the DAO was over $250 million. According to Falkon, a second function was to
“allow anyone with a project to pitch their idea to the community and potentially receive funding from The DAO. Anyone with DAO tokens could vote on plans, and would then receive rewards if the projects turned a profit.”
Despite early success, the DAO was hacked on June 17, 2016. 3.6 million ETH was stolen at least temporarily. Fortunately, there was a lock on funds for 28 days which prevented the hacker from completing the steal. The Ethereum team initiated a hard fork in order to secure the funds and return them to the original owners.
The DAO was abandoned yet retained as Ethereum Classic, which then gave rise to the ETH mainnet, now known as ETH 1.0.
Another significant result of the DAO was that it brought blockchain finance to the attention of the SEC. Falkon refers to a July 25, 2017 report:
“Tokens offered and sold by a “virtual” organization known as “The DAO” were securities and therefore subject to the federal securities laws. The Report confirms that issuers of the distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws.”
This has, of course, proven crucial to the development of the existing and future landscape of cryptocurrency design, usage, and application.
Why DAOs Have Shift to NFT Raises?
Typical ways for DAOs to raise money include ICOs, IDOs, and IEOs (to be explained in a later lesson). Each is a type of event involving the minting and vesting of coins or tokens (I will use the terms interchangeably herein even though they have distinct meanings). One of the investor risks for buying such coins is being defrauded — e.g. by pump and dumps, rug pulls, or Ponzi schemes. In short, the coin itself represents the value of the project; and if that project is fraudulent then the coin essentially has no value (unless one can cash out before the project shuts down).
In contrast, NFTs can provide a few significant advantages by assuring the public of a project’s legitimacy and avoiding the problem of a project issuing equity-type securities (“Buy our coins! Make a profit!”).
Bonafide Investment
NFTs either representing real world assets — like artwork — or existing as digital images and art can be used by projects to raise capital by having investors purchase an asset that has value apart from the project itself. For example, if an investor buys part or all of a NFT representing Edward Hopper’s “Ground Swell”, then s/he does not have to worry about whether the project selling the NFT succeeds.
While coins tend to provide more incentive for investors with the prospect of a jump in their value, NFT-based raises can provide token or coin perks in the form of rewards. To recall a similar point made earlier: Projects can set tiers for NFT purchases, where the more one spends, the more one gets in terms of earning-power with respect to tokens. Tokens are, in this sense, rewards much like airline miles. The project then needs to work out how the rewards can be “cashed out”.
Avoiding Securities
The problem with coin raises is that they are arguably functioning as equity securities, where a purchaser is investing in a common enterprise (equity ownership) with the expectation of making a profit off the labor of others. Ironically, the idea that coins work like an equity security runs counter to decentralization where there is no ownership (only governance). Coins and tokens do not have to function like equity securities, but such a shift would require designing a tokenomics not based on value speculation and equity, and more on utility. (More on this in another article!)
So long as NFTs do not represent a part of the project itself — i.e. where purchasing a NFT is a matter of purchasing or owning the project, just as one would buy land — then NFTs can be used to raise capital without crossing over into securities. This is because one is buying an already extant asset, and not investing in a common enterprise.
While securities regulation may change to complicate the status of NFTs, so far the defense which has worked: the investor is just buying art.
Other Uses
NFTs can also be used to help a project’s tokens maintain their value by preventing early adopters from dumping their holdings once the coin price goes up. In effect, a NFT can function like a vesting instrument that locks coins for a specified period of time. Think here of NFTs acting like lock boxes.
This allows incredible flexibility for investors, since although the coins are vested, they can sell the NFT on a marketplace should they choose to. And because the value of the NFT is not directly related to the coin value and its supply (inflation/deflation), it means less harmful knock-on effects for the project. It’s sort of the best of both worlds.
How This Can Be Applied
Forget all the hype about the real innovation of DAOs being a form of democractic governance. Don’t get me wrong, democracy is a necessary component for an open society where information can flow freely and key decisions can be decided by the public. Informed debate about this information and decisions are integral to democracies, where specific institutions function to host and nurture the lifeblood of public reasoning.
DAOs, on most counts, aren’t very efficient democratically. Historically, most stakeholders don’t vote, and the decision-making process can be quite cumbersome in terms of expedition and being adequately informed. (Ok, so this means DAOs are like most democractic socieites!)
Having said that, the way to think about DAOs is in terms of how they fit legally within regulatory structures. Unlike corporations, there are no people or owners who can be held accountable. This puts the emphasis on how the decision-making process leading up to smart contract automation is executed.
This puts a different spin on how automation might be involved in providing access to utility and finance.
Who knows what the future will hold on this front. As Laozi once said, “The truth is not always beautiful, nor beautiful words the truth.”
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
If you found this helpful, Subscribe to The Art of the Bubble’s free newsletter.
Join us on Discord for live chat and daily updates.
