Everything You Need to Know About Decentralized Autonomous Organizations (DAOs) — The DeFi Series
The sphere of decentralized finance (DeFi) is ripe with specific use cases serving specialized purposes. The concept of decentralized autonomous organizations (DAOs) is certainly relevant to conversations about DeFi, but it does not necessarily fit into the DeFi box — its potential applications are simply too great to be relegated to decentralized finance alone.
Decentralized (or distributed) autonomous organizations are more of a model for governance than a specific use case within the blockchain-powered financial product sector. DAOs now take specific forms, and many of them are DeFi products. But the concept of the DAO may, in the future, be applied in many different sectors of society.
What Is a Decentralized Autonomous Organization (DAO)?
As we tend to do when it is time to explain blockchain-related concepts, we will get to the heart of the term “decentralized autonomous organization”, or DAO, by breaking it down in simple English terms. Per Oxford Languages, to decentralize something is to “transfer (control of an activity or organization) to several local offices or authorities rather than one single one.” Something that is decentralized, therefore, is defined by shared control of power over a system.
A task or system that is autonomous, according to Merriam-Webster, is one that is “undertaken or carried on without outside control” while “existing or [being] capable of existing independently”. An organization is some type of administrative or functional structure. Therefore, a decentralized autonomous organization is one with distributed, non-central control that is able to exist independently without outside intervention while having an organized structure. Decisions in these systems are, at least in theory, made by its participants.
DAOs adhere to these principles, but they refer specifically to systems that are built on blockchain technology. Networks of computers, known as nodes, execute protocols built into self-executing smart contracts in order to make the system function as intended.
How Do DAOs Work?
The blockchain element of DAOs accounts for the “decentralized” aspect of these autonomous organizations. Blockchains are composed of nodes that decentralize each transaction. Instead of a single computer handling tasks such as security checks, financial transactions, and other essential processes, blockchains rely on a network of independent-yet-connected nodes. In this way, all aspects of a blockchain are dispersed, and therefore decentralized. This decentralized system of nodes also facilitates democratic governance by stakeholders.
Smart contracts provide autonomy to a DAO. These contracts are programmed, algorithmic protocols that execute when pre-specified conditions arise. For example, say a buyer inputs a purchase request in a blockchain system. A seller then inputs a sale request and all nodes in the system verify the legitimacy of the transaction. A smart contract then releases the funds to the purchasing party, crediting the seller’s account to reflect the transaction. Because of the powers of smart contracts, no human intervention is required after they are set in motion. Therefore, the entire system remains autonomous.
Smart contracts may also govern voting processes that determine how a DAO is run. When such autonomous smart contracts are built into a decentralized, blockchain-powered platform with a specific organizational purpose, you’ve got a DAO.
What Is the Purpose of a DAO?
The specific purpose of a DAO depends on the DAO which you are referring to. Because this series is meant to explain the world of decentralized finance, we’ll focus on DAOs as they pertain to the DeFi sector. The organization may exist to help users transfer cryptocurrencies across different blockchains, or to serve some of the most popular DeFi use cases such as crypto lending or yield farming.
One could argue that any cryptocurrency is, if it has a decentralized organizational structure, a DAO. Cryptocurrency transactions are generally executed by smart contracts, are intrinsically tied to blockchain technology, and function within some sort of organizational structure. This seemingly checks all the boxes of what makes a DAO a DAO. However, when someone who knows their crypto refers to a DAO today, they are likely referring to something more specific, and generally something that is built on the Ethereum blockchain.
Ironically, decentralized autonomous organizations require human participation to have any value, and in this way they are not completely autonomous. These organizations also generally require a native token to reward users with when they participate in the DAO. The more human participants in a DAO, the more legitimate its purpose, the more valuable its token, and the more participants may be rewarded for their stake through ownership of increasingly valuable native tokens of that DAO.
Once a DAO is funded, launched, and active, decisions about its material function (where will funds generated by the network be invested, for example) becomes a democratic process among stakeholders. This crystallizes the decentralized nature of a DAO, or at least a DAO that functions as it purports to. At this point, a DAO can go on to fulfill its purpose, whatever that purpose may be.
What Is the Current State of DAOs?
For now, these decentralized organizations are largely used to execute financial transactions. They allow users to borrow crypto, lend crypto for interest (and in some cases, additional tokens), purchase, and sell crypto. Use cases continue to emerge, but these are the most established DAO purposes to date. In the future, DAOs may administer elections, execute real estate transactions, or govern some other sector of society. For now, they exist largely in the secretary of decentralized, cryptocurrency-related finance.
Some of the DAOs that have the most on-paper success to date, and the most notoriety as a result, include Maker, MetaCartel, and Aragon. Maker is particularly notable in the DeFi space for providing cryptocurrency lending services which have proven to be massively popular. The concept of DAOs, still relatively young, will only continue to experience a greater number of players entering the markets and, with increased competition, hopefully better and better options for crypto-inclined consumers.
How Do Regulators View DAOs?
One issue always seems to come up in conversations about regulation and blockchain-powered, crypto-linked projects: fraud. If fraud proves to be a significant issue within a sector, the regulators may poke their heads into the picture sooner rather than later. But, it appears that DAOs are getting better at working out kinks and providing self-governance over time.
One of the first widely-hyped forays into DAOs, the originally-named “The DAO”, was structurally unsound and fell victim to a hack. The damage: 3.6 million ETH tokens. Had “The DAO” been the last impression left by DAOs, then regulators might be inclined to swoop in and protect investors from the sort of mismanagement that would result in 3.6 million Ether being absconded with thanks to vulnerable safety protocols.
But, it was not the last impression. Though time will tell the extent to which regulators get involved in the DeFi space generally and specific DAOs particularly, it appears for now that DAOs in the decentralized finance sector are doing a quality job of protecting their investors’ assets and being generally trustworthy.