With the rise of decentralized finance, or “defi,” comes an increased discussion of DAOs, a term used a lot in the crypto and blockchain space. DAO enthusiasts claim they’re the next step in a decentralized future, but what is a DAO, and how do they work?
What Is a DAO?
DAO stands for decentralized autonomous organization, which is a fancy term for a group of people who agree to abide by certain rules for a common purpose. Those rules are written into the code of the organization via smart contracts—algorithms that run when certain criteria are met.
Everyone agrees to buy into the organization, and it can have pretty much any purpose. There’s no central governing authority, hence the “decentralized” part. DAOs operate on a flattened hierarchy; that is, everyone has a stake and no one person owns or controls the entire thing the way a conventional CEO would.
DAOs operate totally online, and use blockchain technology as a ledger to record what goes on in the group, be that currency changing hands or decisions made. Examples of DAOs include everything from a group of crypto investors collecting NFTs called PleasrDAO to Friends With Benefits, a DAO acting as a social club/crypto publication/artist incubator.
Web3 advocates think DAOs are the next logical step in the business world, as all the major decisions of running a company can be divided among the whole organization and run automatically. In theory, this would eliminate bad or self-interested decisions made by conventional leadership.
To see what this might look like in action, imagine you have a shipping business. If that business were a DAO, there would be no governing board because everyone would have a say in decisions. Calculations like inventory replenishment, shipping costs, and demand for certain products would all be handled automatically by algorithmic smart contracts. The business would essentially run itself without the need for management.
How Does a DAO Work?
Sounds great, but how is it supposed to work? How does the system guarantee trust? When a DAO is first created, its rules are written into its code in the form of smart contracts programmed to run when certain actions take place. Everyone agrees to abide by the rules when they buy into the group, and if those rules are violated, its funds are locked and nobody can use the DAO. This, in theory, is how a DAO guarantees that everyone will follow the rules.
Every DAO has a built-in treasury to store its cache of digital currency that members can only access with approval by the group, and decisions affecting the group are made collectively during a set period. There are three steps to creating and launching a DAO:
- Creating the smart contract: The developers of the DAO code the smart contract(s) that will dictate the rules of the group and decide on the group’s purpose. This stage involves extensive testing of the code, because it can only be changed through group voting once the DAO is launched.
- Raising funds: DAOs run on their shared cache of currency, which has to be raised from its members. It’s here that people buy into the group if they support its mission, agreeing to purchase a certain amount of tokens in exchange for a stake. Governance rules can also be established in this phase.
- Launch: The DAO’s code is deployed onto the blockchain. From here on out, it can only be changed via collective voting by the stakeholders. The original developers no longer retain control of the project.
Since everyone shares the risk of the group, everyone has a vested interest in making sure it runs as effectively as possible. Group members also share the reward—if the group does well, its members get more currency and that currency increases in value within the DAO’s ecosystem. Those who buy in also share in the decision making of the group. New proposals have to be voted on and approved by a majority of stakeholders before being enacted.
In order to buy into the DAO, you must purchase whatever crypto token the DAO is written to run on. Most of the time it will be a token unique to the DAO. Friends With Benefits, for example, runs its entire ecosystem on the $FWB token. The smart contract-encoded rules of the DAO can include using that currency to buy things within the ecosystem, like NFTs, digital magazine subscriptions, or pieces of virtual land.
DAOs are built on open-source blockchains, so anyone can see what’s written into the code. If any member submits a proposal, or audits the group’s treasury, or takes any other action within the DAO, that action is recorded indelibly on the blockchain, keeping a transparent record. That transparency is also supposed to facilitate trust between members.
Can DAOs Work in the Real World?
While the DAO concept looks good on paper, and works relatively well within the niche world of cryptocurrency and defi, applying it to real-world corporations leaves something to be desired.
For example, an algorithm might know when to increase or decrease product cost in relation to demand, but how would it handle a factory explosion? A worker strike? These exceptions undermine the effectiveness of DAOs as AI can’t account for everything.
As Bob Greenlee, COO of Tusk Holdings, wrote for TechCrunch: “What if there is a strike or a fire at a manufacturer? It is hard to imagine a smart contract anticipating better than a human manager when it is safe to resume placing orders with them…there is a profound difference between solving for trust in transactions and creating trust in relationships, let alone in organizations or communities.”
DAOs also must contend with fraud and security issues. Some DAOs have raised an impressive amount of funds, only to pull the rug out from under investors’ feet. Others have found it can be difficult to guard those resources from cyberattacks. Friends With Benefits had to relaunch its token after a hack. If a breach happens, and that money is stolen, it’s gone for good. This is what happened to The DAO, the original decentralized autonomous organization, after it raised $150 million in Ether.
So, are DAOs the answer to the corporate world’s problems? Probably not. Most people who see any feasibility in their use seem to think the best solution would be a combination of the old and new. Greenlee writes that the idea might work if a system of smart contracts was overseen by human employees, but even then it could be messy. As with most concepts in the crypto world, they work well for their particular communities, but DAOs will likely need some work before they can be adopted at scale.
