Introduction

Blockchain has fundamentally changed our financial system. However, properties such as trustlessness and immutability are not just for monetary applications.

Another application that may be disrupted by this technology is governance. Blockchain makes possible a whole new type of organization that can run autonomously without the coordination of a central entity. This article will introduce you to the forms of such organizations.

What is DAO? How does it work?

DAO is the abbreviation of Decentralized Autonomous Organization. Simply put, a DAO is an organization controlled by computer code and programs. Therefore, it is able to operate autonomously without the intervention of a central agency.

By using smart contracts, DAOs can process external information and execute commands based on them—all without any human intervention. DAOs are typically run by a community of stakeholders incentivized through some kind of token mechanism.

The rules and transaction records of DAO are transparently stored on the blockchain. These rules are usually decided by stakeholder vote. Typically, the way decisions are made in a DAO is through proposals. If a proposal is voted in by a majority of stakeholders (or satisfies another set of rules in the network's consensus rules), it will be implemented.

In some ways, a DAO operates similar to a company or a nation-state, but in a more decentralized manner. Traditional organizations would use hierarchical structures and many layers of bureaucracy, but DAOs have no hierarchy. Instead, DAOs use economic mechanisms to align the interests of the organization with those of its members, often through the use of game theory.

Members of DAO are not bound by any formal contract, but are bound together by common goals and network incentives, which are closely related to consensus rules. These rules are completely transparent and written in the open source software that governs the organization. Since DAOs operate without boundaries, they may be subject to different legal jurisdictions.

As the name suggests, DAO is decentralized and autonomous. It is decentralized because there is no single entity that makes and executes decisions. And autonomous because it can operate on its own.

Once a DAO is deployed, it cannot be controlled by a single party, but is governed by a community of participants. If the governance rules defined in the protocol are well designed, they should be able to guide participants toward outcomes that are most beneficial to the network.

Simply put, DAO provides an operating system for open collaboration. This operating system allows individuals and institutions to collaborate without having to know or trust each other.

DAO and principal-agent problem

DAO solves the principal-agent dilemma problem in economics. This occurs when a person or entity (the "agent") has the ability to make decisions and take actions on behalf of another person or entity (the "principal"). When an agent is motivated to act in his or her own interests, he or she may disregard the interests of the principal.

This situation allows the agent to assume risks on behalf of the principal. A more serious problem is that there may still be information asymmetry between the principal and the agent. The principal may never know that they are being taken advantage of and have no way of ensuring that the agent is acting in their best interest.

Common examples of this problem are elected officials representing citizens, brokers representing investors, or managers representing shareholders.

The carefully designed incentive model behind the DAO can partially eliminate this problem by allowing the blockchain to achieve a higher degree of transparency. Incentives are aligned within the organization and there is little (or no) information asymmetry. Since all transactions are recorded on the blockchain, the operation of the DAO is completely transparent and, in theory, they are immutable.

DAO example

Despite being a very primitive network, the Bitcoin network can be considered a DAO of the first example. It operates in a decentralized manner and is coordinated by a consensus protocol with no hierarchical relationship between participants.

The Bitcoin protocol defines the rules of the organization, and Bitcoin as a currency provides users with an incentive to protect the network. This ensures that different actors can work together to keep Bitcoin running as a decentralized autonomous organization.

Bitcoin's common goal is to store and transfer value without a central entity coordinating the system. But what other applications are there for DAO?

More complex DAOs can be deployed for different use cases, such as token governance, decentralized venture funds, or social media platforms. DAOs can also coordinate the operation of devices connected to the Internet of Things (IoT).

In addition to this, these innovations also introduced a subset of DAOs known as decentralized autonomous companies (DACs). DAC can provide similar services to traditional companies, such as ride-sharing services. The difference is that it operates without the corporate governance structure of a traditional business.

For example, a car that is autonomously owned and provides shared services as part of a DAC can operate on its own, transacting with humans and other devices. By using blockchain oracles, it can even trigger smart contracts and perform certain tasks on its own, such as going to find a mechanic.

Ethereum and "The DAO"

One of the earliest examples of DAO happens to be called " "The DAO". It consists of complex smart contracts, runs on the Ethereum blockchain, and is supposed to serve as an autonomous venture fund.

The DAO tokens are sold in the form of an Initial Coin Offering (ICO) and provide ownership and voting rights in the decentralized fund. However, shortly after launch, approximately one-third of the funds were siphoned off in the largest hack in cryptocurrency history.

The result of this incident was that Ethereum split into two chains after the hard fork. In one chain, the fraudulent transaction was effectively reversed as if the hack never happened. This chain is now the Ethereum blockchain. The other chain follows the principle of "program code is law" and is not affected by the fraudulent transaction and maintains its non-tampering characteristics. This blockchain is now called Ethereum Classic.

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What problems does DAO face?

Legal

The regulatory environment in which DAOs operate is completely uncertain. It remains to be seen how different jurisdictions will establish regulatory frameworks around these new types of organizations. However, the continued uncertain regulatory environment may be a significant factor hindering DAO adoption.

Coordinated attacks

The essence of DAO’s ideal characteristics (decentralization, non-tampering, and trustlessness) There are obvious performance and security flaws. The rapid growth of some potential organizations as DAOs is exciting, but they also bring many risks that do not exist in traditional organizations.

Points of centralization

It is debatable that decentralization is not a state, but is a scope where each level is suitable for a different type of use case. In some cases, full autonomy or decentralization may not even be possible or make sense.

Perhaps DAO allows participants to collaborate to a greater extent than before, but the governance rules set in the protocol will always be a focus of centralization. Some argue that centralized organizations operate more efficiently but forego the benefits of open participation.

Summary

DAO frees organizations from dependence on traditional institutions. Governance rules operate automatically, guiding participants toward outcomes that are most beneficial to the network, rather than a central entity coordinating participants.

The Bitcoin network may be considered a simplified version of the DAO, and there are currently very few other implementations. The key to a well-designed DAO is to develop an effective set of consensus rules to solve the complex coordination problems of participants. The real challenge in implementing DAO may not be purely technical, but social collaboration.

If you want to learn more about DAO, please check Binance Research’s report: "Theory and Practice of DAO".