What is DAO and how does it work?
DAO stands for Decentralized Autonomous Organization. Simply put, DAO is an organization that follows computer code and programs. As such, it has the ability to function autonomously without the need for a central authority.
Using smart contracts, DAO can work with and execute commands based on external information. All without human intervention. The DAO is commonly run by a community of stakeholders, motivated through some particular token mechanism.
DAO transaction rules and records are transparently stored in a blockchain. The rules are usually decided by a vote of the parties involved. Typically, decisions within the DAO are made through proposals. As soon as a majority of stakeholders vote on the proposal (or as soon as they comply with some other rules set out in the network consensus rules), the decision will be implemented.
In some respects, the DAO functions similarly to a society or a nation-state, but in a bit more decentralized way. While traditional organizations work with a hierarchical structure and many layers of bureaucracy, DAOs have no hierarchy. Instead, DAOs use economic mechanisms to reconcile the interests of an organization with the interests of its members, usually through game theory.
DAO members are not bound by any formal agreement. Rather, they are united by a common goal and network incentives associated with consensus rules. These rules are completely transparent and are written in open-source software that governs the organization. Because DAOs operate despite the state borders, they may be subject to different legal jurisdictions.
As the name implies, DAO is decentralized and autonomous. Decentralized because no entity has the authority to take and enforce decisions. And autonomous because it can work on its own.
Once a DAO is deployed, it cannot be controlled by one party, but rather is managed by a community of participants. If the management rules defined in the protocol are designed correctly, it should lead the actors to the most favorable result for the network.
Simply put, DAOs provide an operating system for open collaboration. This operating system allows individuals and institutions to collaborate without having to get to know each other or trust each other.
DAO and the principal-agent problem
DAO solves a problem that is called the principal-agent dilemma in economics. It happens when a person or agent has the ability to make decisions and act on behalf of another person or entity. If the agent is motivated to act in his own interest, he does not have to take into account the interests of the represented party.
This situation allows the agent to take the risk on behalf of the entity. The problem is exacerbated by the fact that there may be information asymmetries between the subject and the agent. The entity may never know that something like this is happening and has no way of making sure that the agent is acting in his best interests.
Common examples of this problem occur in elected representatives representing citizens, intermediaries representing investors or managers representing shareholders.
By allowing a higher degree of transparency enabled by blockchains, well-designed stimulus models behind DAO can eliminate parts of this problem. The stimuli in the organization are consistent and there is very little (or no) information asymmetry. Because all transactions are recorded on a blockchain, DAO operation is completely transparent and theoretically makes them inviolable. Examples of DAO The Bitcoin network, although being quite primitive, can be considered the first example of DAO. It operates in a decentralized manner and is coordinated by a consensus protocol without a hierarchy between the participants.
The Bitcoin protocol defines the rules of the organization, while Bitcoin as a currency provides users with an incentive to secure networks. This ensures that different participants can work together to keep Bitcoin running, as a decentralized autonomous organization.
The common goal in the case of Bitcoin is to store and transfer value without the central entity coordinating the system. But what else could DAO be used for?
More complex DAOs can be deployed for a variety of applications. For example, for token management, decentralized hedge funds or social media platforms. DAOs could also coordinate the operation of devices connected to the Internet of Things (IoT).
In addition, these innovations introduced a subset of DAOs called Decentralized Autonomous Corporations (DACs). The DAC can provide similar services as for example a traditional carpooling company. The difference is that it works without a corporate governance structure, as is the case with traditional companies.
If we stick to this example we can imagine a car that owns itself and provides a ride as part of a DAC. This means that it could operate autonomously and carry out transactions with people and other devices. Thanks to the use of blockchain oracles, it could even trigger intelligent contracts and perform certain tasks by itself. For example, drive itself to a mechanic.
What problem do DAOs face?
Legality The regulatory environment around DAO is completely uncertain. How different jurisdictions will create a regulatory framework for these new types of organizations remains to be seen. However, a persistently uncertain regulatory environment could be a significant barrier to DAO adoption.
Coordinated attacks The desirable characteristics of DAO (decentralization, consistency, distrust) have, in essence, significant disadvantages in terms of performance and security. Some of the potential organizations, that may emerge as DAOs, pose a major risk that does not exist in traditional organizations.
Centralization points It has been proven that decentralization is not a state, but rather the extent to which each level is suitable for a different type of use. In some cases, full autonomy or decentralization may not be possible or will not make sense.
DAOs can enable cooperation to a wider range of actors than ever before, but the management rules set out in the protocol will always be a place of centralization. It can be argued that centralized organizations can operate with much greater efficiency, all this at the expense of the elimination of open participation benefits.
DAOs allow organizations to break out of trust that is often put in traditional institutions. Instead of the central body coordinating the participants, the management rules are automated and guide the actors towards the most favorable outcome for the network.
The Bitcoin network can be considered a simplified DAO and so far there are few other implementations. The key to designing good DAOs is to establish an effective set of consensus rules that address the complex issues of participant coordination. The real challenge facing the implementation of DAO may not be purely technological, but rather social.