What is a DAO in crypto?
Regulations define what is permissible and what is not for corporate entities of all types. These governance rules may exist as private agreements like shareholder contracts between business owners. The law can also mandate the enforcement of such agreements as corporations have only been able to act via people or corporate entities in the past.
However, the enforcement of rules causes two fundamental issues: the parties do not always follow the rules nor is mutual consent always given prior to the execution of such regulations. So, who gets impacted the most?
The stakeholders with minimal or no power to participate in governance decisions or the ones with no authority to spot problems are prone to financial mismanagement and loose money. Is there any solution to this problem?
Indeed, there is a remedy for the above issues called decentralized autonomous organizations (DAOs). But, what is the purpose of a decentralized autonomous organization?
Among the benefits of DAOs is transparency, a solution to the Principal-Agent problem (more on this later). But, what is a DAO?
The distributed ledger technology called blockchain and smart contracts are at the heart of the DAO ecosystem, where governance rules are written, automated and enforced using software, and the participants oversee contributed funds, eliminating the need for third-party involvement.
Users must first join a DAO by purchasing its native cryptocurrency to become a member. Decentralized autonomous organization examples include DASH, Augur, MakerDAO and virtual worlds like Decentraland. However, BitShares, a virtual e-commerce network, was the first successful DAO. Bitshares was dubbed a decentralized autonomous company, a term invented by Dan Larimer (the company’s founder).
Furthermore, the DAO (investor-operated venture capital firm) was the first decentralized autonomous organization founded on the Ethereum blockchain by Slock.it in 2016. However, the DAO was exploited due to the discovery of a coding flaw, which resulted in the attacker taking $70 million in Ethereum (ETH).
This guide will explain what a DAO in blockchain is, how decentralized autonomous organizations work, the types of decentralized autonomous organizations, why DAOs are important and how to create a decentralized autonomous organization.
How do decentralized autonomous organizations work?
Smart contracts are used to construct the DAO’s rules, which are set by a core team of community members. These smart contracts are evident, verifiable and publicly auditable and lay the groundwork for the DAO’s operations. They allow any potential member to comprehend how the protocol will operate at all times fully.
The next step is for the DAO to work out how to receive financing and how to impart governance once these rules have been formally inscribed onto the blockchain.
A token issuance method is usually used to accomplish this, in which the protocol sells tokens to raise funds and replenish the DAO’s treasury. Token holders receive voting rights in exchange for their money, which are usually proportional to their holdings. The DAO is ready for deployment once funding is completed.
The “Solidity” programming language is used to create DAO code. Deployment on the Ethereum blockchain activates a DAO. A DAO’s code, once deployed, requires Ether (ETH) to engage in Ethereum transactions. A DAO cannot accomplish anything without ETH; hence, the first item of business for a DAO is to receive ETH. Following the deployment of a DAO’s code, ETH can be given to the DAO’s smart contract address during an initial creation phase stated in the code.
Once the code has been deployed into production, it can no longer be altered without a consensus obtained through a vote by members; that is, no specific authority has the power to change the DAO’s rules. It is entirely up to the DAO’s token holders to decide.
How do you start a DAO?
Follow the below steps for creating a DAO:
Build a strong foundation
The first step is to determine, in discussion with your peers, why DAO is required, what role it will play and how it will work. For a DAO to be developed, it involves human decision-making to identify the opportunity, maybe recruit co-collaborators, validate the need and sketch out the processes that can be automated and put into smart contracts.
Clarifying the goal with other DAO enthusiasts is of utmost importance to avoid any chances of disagreement in terms of DAO’s governance structure. Also, you need to have an encrypted wallet, which allows for transactions and storage.
Before investing in any business, the first question investors or funders will look at is the source of revenue. So, how does a DAO make money?
Dividends are the primary source of income for DAOs. DAOs make investments that help them earn dividends. DAO creators can also make money by persuading peers to invest in the DAO based on its business concept.
Determine ownership
After mutually agreeing on the DAO’s intent, the next step is to establish ownership for DAO’s members, which helps develop and grow decentralized autonomous organizations. A DAO can transfer ownership to its members in various ways because ownership is usually tokenized. The two standard methods used by DAOs are “airdrops” and “rewards.’’
With airdrops, tokens are distributed to members depending on their contributions and community behaviors. Rewards are bonuses paid to members who achieve duties and goals. Members gain ownership by earning native token-based rewards. Tokens can also be purchased through decentralized exchanges like Uniswap.
Establish a governance structure
In this stage, how decisions will be made once a DAO is set up are determined. “Token weighted voting” is the most common method used to establish decision-making rules. Voters are token holders, and each token represents one vote. Members submit ideas using a tool like Snapshot, then they vote based on the preferences of other members, and the outcomes are then executed automatically via smart contracts.
Set up rewards and incentives
Setting up rewards and incentives as the various benefits offered to DAO members and contributors builds trust. Native governance tokens are distributed to the members and contributors who have ever used the DeFi protocol under consideration. These tokens represent ownership rights, but they do not have any market value.
DAOs may also reward contributions with cryptocurrencies like ETH, Tether (USDT), or USD Coin (USDC) or even with titles and grades. After the DAO conceptualization phase ends, the reward structure can further be improvised.
Types of decentralized autonomous organizations
Depending on modus operandi, structure and technology, DAOs can be categorized into various types, as discussed follows:
Protocol DAOs
When tokens serve as a voting metric for implementing any changes in the protocol, such a governance structure represents protocol DAOs. For instance, MakerDAO has revolutionized the DeFi space with its DAI stablecoin.
Other examples include decentralized exchanges (DEXs) like Uniswap, which awards native governance tokens to liquidity pool contributors. The tokens can be used to vote for the DEX’s governance-related decisions.
Collector DAOs
Artists who use nonfungible tokens (NFTs) to create art rely upon collector DAOs to establish ownership of their art. Flamingo is an example of one such DAO. PleasrDAO, which lowers the restrictions to NFT investments, is an example of a Collector DAO.
Operating systems
Standalone platforms like Colony that organizations can use to create their DAOs are called operating systems.
Service DAOs
Projects like MetaverseDAO, which offers individuals and agencies a provision of talent hunting and supports acquisition models, are called Service DAOs.
Investment DAOs
Also called Venture DAOs, they allow capital pooling to democratize investing for various DeFi operations. Millennials support Investment DAOs because such DAOs are transparent and open to anyone globally. Krause House is an example of a venture DAO, which is governed by basketball fans to operate the National Basketball Association.
Grant DAOs
The community contributes monies to the grant pool and votes on funds allocation and distribution decisions in a Grant DAO. Innovative DeFi projects are funded using these DAOs, showing how decentralized communities are more flexible with funding than traditional organizations.
One of the most well-known Grant DAOs is Aave Protocol, which uses the Grants infrastructure to foster and grow its community of DeFi initiatives. Using this protocol, those with excess funds can lend, and those in need can borrow from the protocol’s members.
Entertainment DAOs
Entertainment DAOs offer decentralized fun, allowing creators to bring their innovation to life with control over its governance. For instance, Flufworld members can personalize 3D NFT Flufs (a collection of one-of-a-kind bunnies) and license them out.
Bored Ape Yacht Club (BAYC) will also launch its Entertainment DAO, allowing BAYC native token holders to vote on the creative decisions.
Media DAOs
Media DAOs allow product owners of content (i.e., readers) to contribute directly without involving advertisers for the native token as a reward in return for their contributions. For instance, Forefront offers oodles of opportunities to DeFi enthusiasts, including a crypto education hub and growth options for incubated projects.
Social DAOs
Collaboration platforms for social networking in the crypto space like Blockster are called Social DAOs. Such platforms offer digital democracy where everyone’s opinions are heard, and people can share their common interests.
Technology layer for DAOs
The base layer is the blockchain technology on which various protocols (not limited to Dash, Cosmos, Colony, Ethereum) are built. Companies like DAOstack and Aragon, which use solidity and might be called DAO software as a service (DSaaS) models, are on the platform level.
DAOs created on Aragon and DAOstack are deployed at the application level. However, it is not always required to use these platforms to develop DAOs as you can fork existing DAOs to create the one servicing your needs. DAOs, for example, are part of the layer-2 ecosystem established on top of Ethereum.
Within the DAO, cryptocurrencies and digital assets can be moved directly through a characteristic known as composability (a.k.a. money legos). Thanks to composability, protocols and applications can be picked and constructed in many combinations.
How much does it cost to start a DAO?
Because there is no set price for creating a DAO, the price depends upon the gas fees on the network at a time when you plan to create a DAO. For instance, if you choose to create a DAO on the Ethereum blockchain, you will incur gas fees, which is the cost charged by the network for loading the smart contracts onto the blockchain.
Approximately 0.2 ETH, with an average gas fee of 30gwei, may be charged. Additionally, you’ll have to file an annual report every year, which costs $60 or more depending upon your business operations.
How to create a DAO on the Aragon network?
To create a DAO on Aragon, follow the basic steps below:
- Acquire some ETH. As mentioned in the above section, to create an Aragon DAO, you’ll need at least 0.2 ETH.
- Transfer your ETH to your Web3 wallet.
- Once you’ve received your ETH, go to https://client.aragon.org/, click Connect Account, and choose your wallet provider from the drop-down menu. Until your wallet is connected, click through the approval process.
- To build your DAO, go to “Create an Organization” and follow the instructions.
DAOs tension triangle
The tension triangle in a DAO can be seen as a delicate balancing act between three unique but equally crucial components: voice, exit, and loyalty. The extent to which a DAO respects the individual’s sovereign character is the extent to which it permits them to leave.
An individual is all about the freedom to participate in decision-making. Individuals can select when to join and exit a DAO and whether or not to participate in and vote on all other DAO choices (i.e., utilize their voice).
It corresponds to the concept of free will. The DAO-specific design space-related with voice is called a governance mechanism. Governance involves participating in protocol-related decisions and improving the DAO by being engaged. Boosting governance necessitates strengthening the voice and decreasing exit incentives.
Governance (voice)
The legal structure, membership, purpose, operations, off-chain and on-chain voting that enable the organization’s existence and destruction are all covered by governance rules.
Individual (exit)
Individuals who believe in self-government and the common good and are willing to do things for themselves are often referred to as individuals. However, they want individual rights to be respected. Registered or unregistered corporations that function under the sovereignty of their territories and are legally treated or classified as individuals can also be included in the definition.
Decentralization (loyalty)
Decentralization is an amalgamation of technological and political elements to develop a belief system that defines the characteristics of those who choose to join the DAO. When all else is equal, whether participants in a DAO will tilt towards voice or leave is determined by loyalty.
Decentralization and the people and their motivations behind the DAO are vital variables impacting the project’s trustworthiness. Furthermore, every DAO’s degree of decentralization is different, and it is determined by its capabilities, purpose and participation costs.
Why do corporations need governance?
When one person or central entity (the agent) makes choices and executes plans on behalf of another person or entity (the principal), the Principal-Agent dilemma arises, just as in traditional organizations.
When agents act in their own best interests in ways that may be at odds with their principles, it leads to moral hazard problems. Public corporations’ recent and widespread share buybacks to enrich agents disproportionately through incentives, at the expense of the corporation’s long-term health, is one example of this behavior.
As a result, DAOs must be organized so that management is appropriately motivated to function for the long-term benefit of the DAO and all of its stakeholders. Otherwise, they risk supporting the Principal-Agent problem, which has become widespread in many businesses. Therefore, governance is needed for the public good!
Even if record keeping is the only function leveraging blockchain technology via a digital registry for DAO governance, this is still a significant gain in openness over conventional infrastructure. Nonetheless, if proxy advisory services directly counsel individual investors and provide oracle services to smart contracts (for smart votes) to automate individual voting, individual voting decisions on corporate matters can be executed more efficiently.
DAOs vs. traditional organizations
The following table outlines the differences between DAOs and traditional organizations:
What are the various DAO governance challenges?
DAOs encounter various issues from time to time, and the most common ones are explained in the sections below:
Governance systems
A decentralized governance mechanism consisting of thousands or millions of people making mutual decisions is a must for all DAOs. As a result, managing the dissemination and communication of information and findings to all members is a DAO’s most significant problem.
Master nodes empower centralization
Those who own the most tokens are called master nodes and are weighted higher in governance choices. In principle, it solves the loyalty issues as stakers or nodes who own the most tokens stand a chance of losing more due to poor governance decisions. Large swaths of the network, however, are underrepresented.
As a result, the network becomes more centralized, with decisions being taken by the disproportionately powerful minority. Quadratic voting and conviction voting are two voting systems that aim to mitigate the issue.
Quadratic Voting is a way of communal decision-making in which a participant not only votes for or against an issue but also communicates their strong feelings about it. Similarly, conviction voting is a revolutionary decision-making mechanism that funds ideas based on the community’s aggregated preferences, which are expressed in real-time.
Shadow voting
A token holder without an economic stake in the protocol casts a shadow vote by borrowing a governance token to vote and then returning it to the lender, making the DAOs less resilient.
For instance, the attacker creates a flash loan without incurring any interest payments or carrying the cost of capital is an example of shadow voting.
Decentralized cartels or dark DAOs that buy on-chain votes in an obfuscated manner are other examples of manipulating governance mechanisms. In the best-case scenario, the attacker is compelled to pay interest over a long period, capital carrying costs, or subject their collateral to penalties.
As protocols do not control second-market interest rates, they can influence the “cost of governance” by adjusting the length of time it takes to complete the voting process. Any system in which a token can control governance exposes the voting process to conspiracy and bribery around crucial decisions.
Within a DAO, this is one of the most critical attack routes. Therefore, for a DAO to be a successful, well-functioning and robust entity, cartel-like conduct must be addressed in the rulebook from the start.
Future of DAOs
The average person is unlikely to work for a corporation in the future. Instead, people will earn money in unconventional ways, such as by learning new skills, making art, playing video games or curating information.
The networks that grow around crypto protocols, which are emerging as new ways of coordinating, quantifying, implementing and rewarding contributions, are enabling this novel future of work.
This transition is already starting to open up passive income opportunities for individuals, and it’s leading to an increasing transfer of value capture from corporations to people participating in crypto networks as individuals, such as in DAOs.
DAOs will eventually supplant the old governance approach. Moreover, they are no longer just an optimistic notion, even though they are still in their early stages of development. This is because DAOs are transparent businesses that manage billions of dollars in assets and invent new methods for contributors and network participants to make money.
DAOs are becoming more common, and now is an exciting time for industrial and organizational experts to address this new phenomenon with new theory and empirical study. Also, brands must keep up with current developments that may impact how they interact with customers or vice-versa. While DAOs aren’t yet common, they appear to be gaining traction with many optimistic creators
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