How Does a DAO Work?
The specific design behind a DAO can vary from project to project, but let’s use DAOs on Ethereum as an example since that’s where much of this activity is taking place today.
For starters, the rules of a DAO are outlined in a smart contract published on the Ethereum blockchain. This smart contract will hold any funds owned by the DAO, and the rules on how those funds can be spent are also outlined in the contract.
Additionally, the DAO smart contract may also enable changes to a decentralized application related to the DAO. For example, DAO token holders may be able to vote on changes that could be made to how a decentralized exchange on Ethereum functions. However, in many cases on-chain voting is used to gauge DAO token holder sentiment on a particular change to a decentralized application rather than enabling the automated implementation of that change.
In general, the idea is that everyone involved in the DAO is able to make decisions collectively instead of operating in a hierarchical approach that is commonly found in traditional, corporate structures.
Bitshares and Decentralized Autonomous Corporations (DACs)
While DAOs are closely associated with Ethereum due to this being the first cryptocurrency network where the concept has gained popularity and notoriety, the early origins of the DAO concept can be found with Bitshares and the concept of decentralized autonomous corporations (DACs). Bitshares is a project that existed before Ethereum, and much of the hype around the Bitshares project at the time was around these DACs. The decentralized autonomous corporation term was eventually replaced by decentralized autonomous organizations due to legal concerns.
The idea with Bitshares was to create a decentralized autonomous bank of sorts. One of the main points of Bitshares was to create synthetic forms of the U.S. dollar that would be more decentralized that the centralized stablecoins that have become popular more recently. A user could put down a certain amount of BTS (the underlying token of the Bitshares system) as collateral to receive BitUSD, which was a token that was intended to track the value of the U.S. dollar.
This sort of system can be viewed as an early version of many of the sorts of decentralized finance (DeFi) applications that exist on Ethereum and other platforms today.
What "The DAO"?
In terms of DAOs on Ethereum specifically, “The DAO” was the first major attempt at creating such an organization and is also the most infamous project to ever exist in the space.
The DAO was a project that launched on Ethereum in 2016. It was able to raise $150 million worth of ETH via a token sale on Ethereum, but there was a vulnerability in The DAO’s associated smart contracts that led to a hacker stealing much of the funds held by this DAO. In response, the Ethereum blockchain was effectively hard forked to steal the funds back from the hacker and return them to those who were holding DAO tokens.
This entire situation shook the entire foundation of what Ethereum was supposed to be, as “code is law” was a common mantra in the community before this event. The backlash against this reversal of what happened on the blockchain led to the split of Ethereum into two separate networks, Ethereum and Ethereum Classic, despite the attempts by the Ethereum Foundation and other entities to dismiss the value of the original Ethereum chain (now called Ethereum Classic) where The DAO hacker was still in control of the funds they were able to obtain from the faulty smart contracts.
Decentralized Finance (DeFi) Stocks
These days, most DAOs are related to various DeFi projects on Ethereum and other platforms. For example MKR, is a governance token for the MakerDAO platform, which is used to create dollar-pegged ERC-20 tokens that are backed by collateral in the form of ETH and other tokens. Another example would be UNI, which is the governance token behind the Uniswap decentralized exchange.
While all of these DAO governance tokens behind DeFi projects are intended to grow in value as the DeFi apps increase in popularity, it’s important to look at the specific tokenomics behind each of these tokens to make sure that is actually the case. Bad tokenomics in some projects have led to situations where a decentralized app has become pretty heavily used without much additional value accruing down to the underlying token.
The Limitations of DAOs
It’s oftentimes difficult to find the real value proposition to the sorts of blockchain-based applications that are built more around buzzwords rather than real-world use cases. DAOs are yet another area of the cryptocurrency ecosystem where the term has become more than a buzzword than anything else. In many cases, something can be called a DAO or DeFi without actually having much to in terms of real decentralization.
As mentioned previously, the tokenomics behind a DAO’s token are extremely important, as simply referring to a particular project as a DAO does not mean that the token will necessarily increase in value as the application behind the DAO increases in popularity. Additionally, a DAO that has one or a handful of entities controlling the vast majority of the supply does not offer much in terms of decentralization. If one or a handful of token holders control the vast majority of the voting shares, then the level of decentralization achieved by the organization is more about theater than anything else.
Another potential issue with DAOs is they tend to add additional costs to the applications that are related to them. If someone were to fork the project related to the DAO and remove the fees or other aspects of the application that are supposed to provide value to the DAO’s token holders, then the value of the projects DAO token could collapse overnight. This is effectively what happened when the 0x Protocol was forked to remove to need to use a proprietary token associated with the platform. If you look at Ethereum itself as a DAO, then you could see a similar phenomenon eventually take place if people decide that they’d rather use something like RSK, which is a Bitcoin sidechain, instead of having to use a separate token, ETH, for gas payments.
It’s always important to remain skeptical of anything new in the Bitcoin and cryptocurrency space, as there have been plenty of bad ideas and outright scams implemented over the years. That said, it would make sense to continue to track the evolution of the DAO concept to see what level of value it can add to the entire ecosystem.