What is a DAO and how does it work?
The acronym DAO stands for Decentralized Autonomous Organization. In simple terms, a DAO is an organization that is governed by computer code and programs. As such, it has the ability to function autonomously, without the need for a central authority.
Members of a DAO are not tied by any formal contract. They are rather bound together by a common goal and network incentives tied to the consensus rules. These rules are completely transparent and written in the open-source software that governs the organization. Since DAOs operate without borders, they might be subject to different legal jurisdictions.
As the name implies, a DAO is decentralized and autonomous. It’s decentralized because no one entity has the authority to make and enforce decisions. And it’s autonomous because it can function on its own.
Once a DAO is deployed, it cannot be controlled by a single party but is instead governed by a community of participants. If the governance rules defined in the protocol are designed well, they should steer actors towards the most beneficial outcome 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 know or trust each other.
DAOs and the principal-agent problem
DAOs tackle a problem in economics called the principal-agent dilemma. It happens when a person or entity (the “agent”) has the ability to make decisions and take actions on behalf of another person or entity (the “principal”). If the agent is motivated to act in its own self-interest, it may disregard the interests of the principal.
This situation allows the agent to take risk on behalf of the principal. What deepens the problem is that there might also be information asymmetry between the principal and the agent. The principal might never know that it is being taken advantage of and has no way to make sure that the agent is acting in their best interest.
Common examples of this problem occur with elected officials representing citizens, brokers representing investors, or managers representing shareholders.
By allowing a higher degree of transparency enabled by blockchains, well-designed incentive models behind DAOs can eliminate parts of this problem. Incentives within the organization are aligned, and there is very little (or no) information asymmetry. Since all transactions are recorded on a blockchain, the operation of DAOs is completely transparent, and, in theory, makes them incorruptible.
The common goal in the case of Bitcoin is storing and transferring value without a central entity coordinating the system. But what else could DAOs be used for?
On top of that, these innovations introduced a subset of DAOs called Decentralized Autonomous Corporations (DACs). A DAC may provide similar services to a traditional company, for example, a ridesharing service. The difference is that it works without the corporate governance structure found in traditional businesses.
Ethereum and “The DAO”
What issues are DAOs facing?
The regulatory environment surrounding DAOs is completely uncertain. How different jurisdictions will create the regulatory framework around these new types of organizations remains to be seen. However, a continually uncertain regulatory landscape could be a significant barrier to the adoption of DAOs.
The desirable properties of DAOs (decentralization, immutability, trustlessness) inherently carry significant performance and security drawbacks. While some of the potential organizations that can spring up as DAOs are undoubtedly exciting, they introduce a lot of risk that isn’t present in traditional organizations.
Points of centralization
It’s arguable that decentralization isn’t a state, but rather a range, in which each level is suitable for a different type of use case. In some cases, full autonomy or decentralization might not even be possible or make sense.
DAOs allow organizations to break free from reliance on traditional institutions. Instead of a central entity coordinating participants, governance rules are automated and steer actors towards the most beneficial outcome for the network.