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What Is DAO: Explaining How Decentralized Autonomous Organizations Work
What is DAO_
Cryptocurrency
07.09.2021
Updated 12.03.2022
14:39

Traditional commercial and non-commercial institutions are created the way that a small group of leaders controls them by taking key actions for structure development. This applies for both private and governmental institutions. Nevertheless, this approach requires credibility on the part of other organization members and consumers, while the centralization allows hiding and forging data.

The blockchain technology has opened a new opportunity for creating fundamentally new systems and organizations capable of being autonomous and operating with no need to interfere in their work. These systems do not have a central governing body, and the control over their work is concentrated in the hands of a community. From this article, you will find out what DAO is, how decentralized autonomous organizations are formed, and what advantages they offer to companies and institutions.

What Is DAO?

DAO (Decentralized Autonomous Organization) is a decentralized autonomous organization, which is controlled by a program code and does not require having a centralized node that would run the ecosystem. DAO operates regardless of users, i.e. autonomously.

The precondition for creating DAO was a blockchain platform Ethereum launched in 2014. The Ethereum network is based on smart contracts – programs using which it is possible to execute safe deals with no participation of intermediaries. The platform was Turing-complete, which allowed to create the autonomous decentralized apps (DApps), such as exchanges (DEX) and DAO.

The first platform based on the principles of a decentralized autonomous organization was launched in 2016 and was named The DAO. However, a similar mechanism was implemented back in 2015 in a Dash protocol using the masternode system and providing an opportunity to vote. The aim of The DAO was to create a decentralized business model for commercial and non-commercial organizations. The project has become one of the most successful crowdfunding campaigns, having gathered $150 billion dollars from ICO.

Practically right after the launch of The DAO, hackers broke into the platform and withdrew about $50 billion dollars in ETH cryptocurrency. This situation proved fatal for the platform, and in September 2016 it was closed being excluded from the list of platforms.

After The Dao incident had happened, Ethereum developers deployed a hardfork to restore the lost funds in the initial contract. The original blockchain continued to exist under the name Ethereum Classic.

How Does DAO Work?

All the alterations aimed at improving the work of a decentralized autonomous organization are made to source code by developers. Nevertheless, the community itself takes the decision about what changes should be approved or rejected: everybody who owns the platform tokens may use them to vote for an update.

If the majority votes for the suggestion, then the community reaches a consensus, and the improvement is taken into work. This approach corresponds to the principles of decentralization. Voting is stimulative because the holders are rewarded for participating in it. Accepted alterations and transaction records are placed in blockchain and are stored there, which makes the DAO business model transparent for the community.

In order to understand the DAO system better, its structure may be compared to the government. But instead of parliamentarians who manage the processes, this role is taken by the autonomous program, and all the information is added to blockchain and is open to the community. Otherwise, the structures are pretty similar: users vote for the changes and, in fact, decide which direction the platform will develop.

One more key distinction is that there is no hierarchy in DAO. All the network participants have even rights. In other words, a decentralized autonomous organization possesses one-level architecture, while traditional organizations have a multi-level one. DAO is based on economic mechanisms aimed at stimulating all its participants, and to implement them, the developers apply game theory.

How DAO Solves Principal-Agent Problem

The principal-agent dilemma is one of the most widespread economic problems that traditional companies and institutions cannot resolve. The essence is that a legal or natural person, being an agent, may take a decision on behalf of the third party, which is a principal, without agreement or notifying this party. This creates an opportunity to ignore the principal’s interests.

As a result, it allows risky actions on behalf of the principal and creates information asymmetry between the parties. It means that the principal does not know if the agent acts for personal or common interests.

DAO partly resolves this issue due to the transparency, since all the information is stored in blockchain, and it cannot be changed or forged, providing a chance to get rid of the information asymmetry.

Features of DAO

  1. Decentralization. Decentralization provides for equal rights of all participants – that is why no central node can make decisions without having received preliminary approval of the community. The community manages the platform, and the blockchain rules must be defined in such a way to guide users to the most efficient result in the blockchain network.
  2. Transparency. DAO platforms are open-source, which allows conducting an external audit of the blockchain; besides that, any developer may take part in the development of the network.
  3. Autonomy. The program fully provides the functioning of the ecosystem, excluding any manual control over its work. It eliminates the need to depend on intermediaries that may affect the deal.
  4. Speed of reaching consensus. All deals are stored in the blockchain, so counterparties do not need to keep the records as well as complete a complex chain of bureaucratic procedures. It will allow companies and institutions to reduce financial expenses and simplify and accelerate business processes.
  5. No need for trust. DAO allows individuals and legal entities to interact with each other openly without the need to trust other participants of the deal. Thus, parties can easily reach common goals without worrying that the other party may try to violate the conditions or deal rules.

Examples of DAO

In fact, Bitcoin protocol may be considered the first implementation of the DAO architecture, even though its work is more primitive. Bitcoin meets the main principles of decentralized autonomous organization: decentralization and autonomy. The network participants are stimulated with rewards to contribute to its safety and reach a consensus between the nodes. But Bitcoin system possesses limited functionality, providing a chance to only store and transfer BTC cryptocurrency. In addition to that, Bitcoin lacks interoperability – a possibility to interact with other blockchains or, to say it in other words, interchain compatibility.

Platforms created directly as DAO expand the blockchain functionality and provide a chance to execute a number of various operations: an exchange of cryptocurrencies and tokens without centralized intermediaries, transfer of intellectual property rights, monitoring of supply chains, creation of decentralized venture and hedge funds, and creation of social networks that would stimulate content makers with rewards, and many other things.

For instance, DAO may coordinate and optimize the supply process, starting from goods’ manufacturing and finishing its realization, including the work of IoT devices. Using the principles of autonomous decentralized organization, it will be possible to control smart cities in the future.

Evolution of smart contracts. The problem with smart contracts is that the ecosystem is closed; that is why the data exchange with external sources over the Internet is not possible. This issue was resolved with the help of blockchain oracles that receive the data from the external world and then transmit it to the blockchain, which allows the creation of autonomous crypto exchanges, prediction markets, and betting platforms.

A list of the most popular DAO platforms

Where to find DAO platforms

A full list of blockchains operating on the DAO basis is available in the appropriate section of Coinmarketcap.

Current DAO Problems

Although there are evident advantages, decentralized autonomous organizations have not gained popularity among private companies and governmental structures yet. This derives from a number of problems that need to be solved before DAO approaches mass adoption.

Regulation Problems

DAO has got an undefined regulatory status. Currently, governments have not formulated specific legal rules to regulate decentralized autonomous organizations.

Economics

In some cases participating in voting may prove problematic for the community, which provides big players the right to influence the protocol’s work. For instance, the BitShares holders faced this kind of problem when it turned out that they had lacked time and energy to vote. The Ethereum users might have faced a similar situation when the transaction costs (payments for Gas) reached several dozen dollars due to a high network load.

Efficiency

The principle of decentralized management, which DAO is based on, is not always efficient. Sometimes full autonomy may bring no benefit or even be useless.

Centralized systems may end up more efficient, but their users sacrifice their rights because they cannot interfere in the operation and they have to trust the management. Besides that, the initial rules set out in the protocol serve as a centralization point for the whole ecosystem.

Vulnerability

Behind the putative safety of decentralized platforms, many points of vulnerability are hidden, which is not the case with traditional companies. Autonomous systems are fully operated by the program code that can be attacked by hackers – just like it happened with a notorious platform The DAO, from which cybercriminals had stolen one-third of the funds of the whole turnover.

Conclusion

Decentralized autonomous organizations allow creating democratic private or government structures that will be openly ruled by the community and interact with each other safely.

The autonomy will help to reduce operating expenses, simplify most processes, and speed them up making organizations more efficient. One of the main problems, except for cybersecurity, is creating effective rules of consensus in decentralized protocols, which affect their functioning.