Decentralized Autonomous Organization (DAO)

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What Is a Decentralized Autonomous Organization (DAO)?

A decentralized autonomous organization (DAO) is an emerging form of organizational structure with no central governing body and whose members share a common goal of acting in the best interest of the entity. Popularized by blockchain enthusiasts, DAOs make decisions using a bottom-up management approach.

Key Takeaways

• A decentralized autonomous organization is an entity structure in which token holders participate in the management and decision-making of an entity.
• A DAO does not have a central authority; instead, power is distributed among token holders who collectively cast votes.
• All votes and activity through the DAO are posted on a blockchain, making all actions of users viewable.
• One of the first DAOs, the DAO, was an organization created by developers to automate decisions and facilitate cryptocurrency transactions.
• A DAO must ensure security is prioritized, as exploits can leave a DAO drained of millions of dollars of its treasury savings if they store it in cryptocurrency.

What Is the Purpose of Decentralized Autonomous Organizations (DAOs)?

One of the major features of digital currencies is that they are decentralized. This means they are not controlled by a single institution like a government or central bank but instead are divided among a variety of computers, networks, and nodes.

Inspired by the decentralization of cryptocurrencies, a group of developers came up with the idea for a decentralized autonomous organization, or DAO, in . The concept of a DAO is to promote oversight and management of an entity similar to a corporation. However, the key to a DAO is the lack of central authority; the collective group of leaders and participants acts as the governing body.

How DAOs Work

DAOs rely heavily on smart contracts to function. These scripts generally automate the group's decisions when the required number of votes is reached. If the group votes on a proposal and it fails, the smart contract doesn't execute anything. For example, imagine a cryptocurrency was governed by a DAO. A faction of members wanted to change how a blockchain's tokenomics worked. This could be an increase in the circulating supply of coins, burning a select amount of reserve tokens, or issuing rewards to existing token holders.

Members could create a proposal and call for a vote, which would be broadcast to all members with voting rights. They could vote, and the smart contract would tally the vote. This type of change might or might not be automated, as it would require altering the blockchain's coding. Regardless, the outcome of the vote would determine the direction the blockchain would take. If the vote was about spending tokens from the treasury on a certain project, the smart contract could automate the transfer of tokens to the entities working on the project.

Voting power is often distributed across users based on the number of tokens they hold. For example, one user that owns 100 tokens of the DAO could have twice the weight of voting power over a user that owns 50 tokens.

The theory behind DAOs is that users who are more monetarily invested in the DAO are incentivized to act in good faith. For instance, imagine that a DAO member owns a majority of the organization's voting power (a majority of the tokens). This user could act in bad faith; however, if the DAO is programmed to penalize bad actors, the user will jeopardize the value of their holdings.

DAOs often have treasuries that house tokens that can be issued in exchange for fiat. Members of the DAO can vote on how to use those funds; for example, some DAOs with the intention of acquiring rare NFTs can vote on whether to relinquish treasury funds in exchange for assets.

ConstitutionDAO

In , ConstitutionDAO was formed to attempt to buy a copy of the U.S. Constitution. Though the DAO failed to acquire the asset, it proved that a collection of like-minded individuals could form and pursue such endeavors.

Benefits of DAOs

There are several reasons why an entity or collective may want to pursue a DAO structure. Some of the benefits of this form of management include:

• Decentralization: Decisions impacting the organization are made by a collection of individuals as opposed to a central authority that is often vastly outnumbered by their peers. Instead of relying on the actions of one individual (CEO) or a small collection of individuals (Board of Directors), a DAO can decentralize authority across a vastly larger range of users.
• Participation: Individuals within an entity may feel more empowered and connected to the entity when they have a direct say and voting power on all matters. These individuals may not have strong voting power, but a DAO encourages token holders to cast votes, burn tokens, or use their tokens in ways they think are best for the entity.
• Publicity: Within a DAO, votes are cast via blockchain and made publicly viewable. This requires users to act in ways they feel are best, as their votes and decisions will be publicly viewable. This incentivizes actions that will benefit voters' reputations and discourages acts against the community.
• Community: The DAO concept can encourage people from all over the world to seamlessly come together to build a single vision. With just an internet connection, token holders can interact with other owners wherever they may live.
  

Limitations of DAOs

Not everything is perfect regarding DAOS. There are some severe consequences to improperly setting up or maintaining a DAO&#;here are some of the limitations DAOs face:

• Speed: If a public company is guided by a CEO, a single vote may be needed to decide a specific action or course for the company to take. In a DAO, every user is given an opportunity to vote. This might require a much longer voting period, especially considering time zones and priorities outside the DAO.
• Education: Similar to the issue of speed, a DAO has the responsibility of educating members regarding pending activities. It's much easier for a single CEO to make decisions on company developments, as DAO token holders may have varying educational backgrounds, understanding of initiatives, incentives, or accessibility to resources. A common challenge of DAOs is that while they bring a diverse group of people together, that diverse group of people must learn how to grow, strategize, and communicate.
• Inefficiency: Partially summarizing the first two bullets, DAOs run a major risk of being inefficient. Because of the time needed to educate voters, communicate initiatives, explain strategies, and onboard new members, it is easy for a DAO to spend much more time discussing change than implementing it. A DAO may get bogged down in trivial, administrative tasks due to the nature of needing to coordinate many more individuals.
• Security: An issue facing all digital platforms for blockchain resources is security. A DAO requires significant technical expertise to implement; without it, voting and decision-making may be compromised. Trust may be broken, and users may leave the entity if they can't rely on its structure. Even if multi-sig or cold wallets are used, DAOs can be exploited, treasury reserves stolen, and vaults emptied.

DAOs

Pros

• A variety of individuals can collectively come together to act as a single entity.

• More individuals have a voice in the planning, strategy, and operations of the entity.

• As votes on the blockchain are publicly-viewable, tokenholders are naturally incentivized to act more responsibly.

• Members of a DAO may feel empowered to collaborate with like-minded individuals with similar goals within a single community.

Cons

• It can take longer for decisions to be made as voting participants may be distributed across time zones.

• There may be a burden to educate users as the collective voting population are diverse with varying ranges of education and knowledge.

• Severe exploits such as theft of treasury reserves are possible if the DAO's security is not properly established and maintained.

DAO Example: The DAO

The DAO was an organization designed to act as a form of venture capital fund based on open-source code without a typical management structure or board of directors. The DAO was built using the Ethereum network.

The DAO launched in late April thanks to a month-long crowd sale of tokens that raised more than $150 million in funds. At the time, the launch was the largest crowdfunding campaign ever recorded.

Why Did The DAO Get Disbanded?

By May , the DAO held a large percentage of ether tokens (up to 14% of the total circulating amount), according to reporting by The Economist). At roughly the same time, however, a paper was published that addressed several potential security vulnerabilities, cautioning investors from voting on future investment projects until those issues had been resolved.

Later, in June , hackers attacked the DAO based on these vulnerabilities. The hackers gained access to 3.6 million ETH, worth about $50 million at the time. This prompted a massive and contentious argument among DAO investors, with some individuals suggesting various ways of addressing the hack and others calling for the DAO to be permanently disbanded. This incident also figured prominently in the Ethereum hard forking that took place shortly thereafter, resulting from a community vote (of sorts) initiated by Ethereum developers.

What Are Some Criticisms of the DAO?

According to IEEE Spectrum, the DAO was vulnerable to programming errors and attack vectors. The fact that the organization was charting new territory regarding regulation and corporate law likely did not make the process any easier. The ramifications of the organization's structure were potentially numerous: investors were concerned that they would be held liable for actions taken by the DAO as a broader organization.

In July , the Securities and Exchange Commission (SEC) issued a report stating that The DAO sold securities in the form of tokens on the Ethereum blockchain, violating U.S. securities law.

The DAO also operated in murky territory regarding whether or not it was selling securities. Further, there were long-standing issues regarding how The DAO would function in the real world. Investors and contractors alike needed to convert ETH into fiat currencies, which could have impacted the value of ether.

Following the contentious argument over The DAO's future and the massive hacking incident earlier in the summer, by the fall of , several prominent digital currency exchanges, such as Kraken, de-listed The DAO's token, marking the effective end for The DAO as it was initially envisioned.

What Is a Decentralized Autonomous Organization (DAO)?

A DAO is a decentralized autonomous organization, a type of bottom-up entity structure with no central authority. Members of a DAO own DAO-issued tokens and can vote on initiatives for the entity. Smart contracts are implemented for the DAO, and the code governing many DAOs' operations is open-source or publicly auditable.

What Is a DAO and How Does It Work?

A DAO is an organization of people that uses blockchain technology to improve traditional top-down management structures. Instead of relying on a single individual or a small collection of individuals to guide the entity's direction, a DAO intends to give every member a voice, vote, and opportunity to propose initiatives.

Are Decentralized Atonomous Organizations Legal?

DAOs are legal in most jurisdictions. However, their actions must be carefully evaluated to ensure compliance with existing regulations in the geographies in which they operate.

The Bottom Line

Decentralized autonomous organizations (DAOs) are entities using blockchains and tokens to democratize governance to those with voting rights. Members of DAOs decide the direction of the organization and govern how it is run. The intent behind DAOs is to remove centralized control and give decision-making abilities to all users rather than leaving it up to a centralized group or person.

What is a DAO?

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Decentralized Autonomous Organizations (DAOs) are blockchain-based communities that are designed to bring a new, more open and democratic management structure to businesses and other collaborative projects in web3. So far, DAOs have formed to run several different types of organizations, including businesses, nonprofits, investment schemes, and more. DAOs are designed to operate without centralized leadership, and the parameters of their decision-making powers and processes are often determined by the smart contracts governing the project in question.

When a DAO is formed, founders frequently mint a governance token, which is a type of crypto asset that may entitle the holder to DAO membership and a certain amount of voting power on DAO decisions &#; typically the more tokens someone holds, the more votes they have. DAO tokens are typically initially distributed to the project&#;s management, users, backers, and other stakeholders, but can then be bought and sold on secondary markets like any other cryptocurrency. DAO holders may also submit project proposals, which are then voted on by the rest of the group.

While some would contend that Bitcoin was the first DAO, DAOs as we know them today began as smart contracts on the Ethereum blockchain. Similar DAOs are now built on other open-source blockchains, too. They are designed to run autonomously through smart contracts, where organizational policies are codified and executed once pre-defined criteria are met. In this article, we&#;ll discuss:

How do DAOs work?

What do DAOs do?

DAOs raise capital for projects and initiatives by creating and selling governance tokens. When an individual acquires the DAO&#;s governance token, they may gain membership and voting rights, but can also delegate their voting responsibilities to another member. There are several types of DAOs associated with projects ranging from investing to grant-making to entertainment, but most DAOs have tasked themselves with governing  DeFi protocols.

DAO projects have had varying degrees of success. For instance, AAVE, currently one of the largest DeFi protocols, lets borrowers and lenders interact without needing a centralized intermediary, and is one of the largest DAO-governed projects operating. By contrast, ConstitutionDAO&#;s project raised over $40 million to bid for a rare copy of the U.S. Constitution at a Sotheby&#;s auction, but was ultimately outbid by a billionaire.

Key features of DAOs

DAOs strive to be virtual, transparent, democratic, and autonomous. Given that all processes happen online, members rarely, if ever, meet in person. Much of the discussion around decisions take place publicly, on platforms like Discord or on governance forums where voting also takes place &#; we can look to AAVE&#;s as an example. 

Reinforcing their transparency, DAOs operate with a flat organizational structure that affords all members ownership and participation in decision making. As mentioned earlier, the more governance tokens a person owns, the more votes they have. Last year we analyzed the distribution of ten major DAOs&#; governance tokens. Across several, we found that less than 1% of all holders have 90% of the voting power. While many of today&#;s DAOs may not be upholding the principles of decentralized power they profess, they have the potential to become more decentralized over time, and their transparent decision-making processes hold much promise.

How do DAOs govern?

In the vast majority of cases, DAO members holding governance tokens vote on key decisions, which are then executed by smart contracts. Let&#;s look at Lido DAO as an example. Lido DAO governs Lido Finance, a DeFi protocol offering liquid staking for Ethereum and other tokens. Holders of Lido&#;s governance token, LDO, can vote on key decisions affecting the protocol&#;s operations and allocation of resources. For instance, here&#;s a recent vote that was passed and enacted to modify the Lido Finance Node Operator&#;s Registry, setting the maximum number of validators that a particular node operator was permitted to operate as part of the Lido Finance network. The DAO also accumulates service fees from Lido and puts those funds toward research and development, liquidity mining incentives, and protocol upgrades.

As for its proposal process, members publish all ideas on Lido DAO&#;s research forum, soliciting community feedback to improve plans or hear objections. If a proposal is well-received and feedback is quickly incorporated, it will move forward seven days after the initial posting on the research forum. The proposal is then put to a consensus vote on Snapshot, a decentralized voting system. Again, as is the case with DAOs, the more LDO tokens a voter has, the more decision-making power they possess. Members have seven days to vote, voting can&#;t end on a weekend, and it must be completed at least 24 hours prior to on-chain execution. For any proposal to pass, at least 5% of the total token supply must vote for it. 

From there, the proposal moves to Aragon, a DAO framework for on-chain voting. Because the DAO may entertain many ideas at once, proposals are usually combined into a package &#;to reduce operational burden and voter fatigue.&#; Voting on Aragon lasts 72 hours and is split into two phases: the first 48 hours are when members can vote both for and against a proposal. The last 24 hours represent the objection phase, when a member can vote against a proposal or switch their vote from for to against. For a vote to pass, it needs more than 5% of the total token supply to vote &#;Yes&#;, and more than 50% of the tokens used to vote &#;Yes&#; as well. Provided this occurs, the smart contract executes and the proposal is implemented. The above flow represents Lido DAO&#;s main governance path, but there are alternative methods like an emergency track for voting on pressing issues, or the usage of committees to streamline routine governance operations.

While DAOs strive for decentralization and democracy, individual DAOs vary in how closely they adhere to those principles. In the vast majority of cases, DAO members vote on key decisions in processes similar to what we&#;ve described above. However, depending on how the DAO&#;s smart contracts are set up, the organization&#;s leadership may be able to execute certain actions without community involvement through the use of multisig wallets. For instance, while Lido DAO votes on almost all decisions, it still has multisig wallets in place that leadership can use to, for example, pause the protocol in an emergency situation.

Benefits of DAOs

One of the biggest benefits of DAOs is their democratic foundation. Fundamentally, all that&#;s needed to be part of a DAO is a single governance token and an internet connection, allowing individuals anywhere in the world, regardless of background, to work together on large-scale projects making real financial impact. In a sufficiently large and decentralized DAO, no single person can make a decision affecting the entire organization on their own as everyone has the opportunity to vote on proposals. 

Given that these votes are logged on the blockchain, decision-making is transparent, which can motivate members to vote in a more altruistic way that both benefits the community and builds on their reputational capital. This feature of DAOs reinforces ownership and accountability across the organization.

Another benefit of DAOs is their egalitarian structure: members can submit a proposal for a project or an amendment to a protocol. Some organizations require token holders to have a minimum amount of tokens while others don&#;t. All members can see all proposals and share their feedback, too. In this way, everyone is more personally invested in the DAO&#;s success.

What are the biggest DAOs?

As of this publication in April , the top three DAOs by governance token market capitalization are Uniswap, Lido DAO, and the Ape Foundation. The Uniswap Foundation is the DAO in charge of managing Uniswap, the world&#;s biggest decentralized exchange (DEX), and launched its UNI token in September . The Ape Foundation governs ApeCoin, a DeFi protocol for community-led projects around art, gaming, and entertainment.

Top 10 DAOs by governance token market capitalization

DAO Project Token Market Capitalization Project focus

Uniswap Foundation

Uniswap

UNI

$3.4 billion

DEX

Lido DAO

Lido

LDO

$2.1 billion

Liquid staking protocol

Ape Foundation

ApeCoin

APE

$1.5 billion

NFTs, metaverse, and entertainment in web3

Arbitrum Foundation

Arbitrum

ARB

$1.5 billion

Layer 2 blockchain on Ethereum

Internet Computer

Service Nervous System

ICP

$1.4 billion

Web3 infrastructure blockchain

Aave

Aave Liquidity Protocol

AAVE

$1 billion

Lending protocol

BitDAO

BitDAO

BIT

$1 billion

Web3 project funding

Curve.fi DAO

Curve

CRV

$778 million

DEX

Synthetix

Synthetix

SNX

$691 million

Derivatives liquidity protocol

MakerDAO

Dai stablecoin

MKR

$677 million

Smart contract platform

 

The future of DAOs

As DAOs proliferate, services to support them are growing, too. Platforms like Aragon provide user-friendly software that assists with DAO creation and management, no coding required. Open-source projects like DAOstack offer similar capabilities. 

Some governments are working to support DAO innovation, too. On March 1, the state of Utah passed the Decentralized Autonomous Organizations Act, a bill allowing any DAO formed in the state that&#;s not registered as a for-profit or non-profit entity to be treated equivalent to a domestic limited liability company. The law goes into effect in and the state of New Hampshire is entertaining similar DAO legislation. It will be interesting to see if other states follow suit and Chainalysis will keep an eye on these developments. In the meantime, if you&#;re interested in diving deeper on DAOs and other web3 topics, download our State of Web3 Report.

This material is for informational purposes only, and is not intended to provide legal, tax, financial, or investment advice. Recipients should consult their own advisors before making these types of decisions. Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information herein. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with Recipient&#;s use of this material.

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