DAOs: what are these new forms of organization in the crypto-asset sector?
Collectively owned and managed by their members, DAOs are native organizations in the crypto-asset industry that rethink traditional decision-making models within a group of people. In this article, Adan comes to explain the concept of DAOs, their history, the key use cases attached to them and their risk management and regulatory issues.
Decentralized autonomous organizations (DAOs) are communities established on blockchain networks that belong to their members without centralized management.
They allow their users to contribute to various causes with other like-minded people without trusting a benevolent leader to manage funds or operations. Thus, a DAO does not inherently have a hierarchical system and does not expose a person of power (e.g. the CEO) to the risk of spending or manipulating funds. Instead, blockchain-based rules embedded in the code define how the organization operates and how funds are spent.
Once formed, a DAO is managed by its members, often through the use of governance tokens. These offer certain rights that influence the direction of a protocol. This could include technical features such as new products, but also non-technical proposals: marketing, funding of events to educate.
Generally speaking, the exercise of this influence can take two forms:
#1 – Governance token holders can propose changes via a proposal submission process;
#2 – and if certain criteria are met and the proposal is put to a vote, governance token holders can use their tokens to vote on the proposed changes. Most proposals today are voted on Snapshot – an off-chain voting platform that allows DAOs to vote easily and without gas charges.
To date, the key DAOs are used for governance of decentralized finance protocols – see article here.
How it works
The infrastructure of a DAO is mainly built around a smart contract. The smart contract defines the purpose, operation and governance rules of the organization and secures the group’s cash flow. Once the smart contract is online on the network, no one can change it, except by voting.
Thus, DAOs can take many forms beyond simple for-profit and non-profit organizations. DAOs can be formed to manage a specific project, a blockchain, and even potentially a nation-state.
While DAOs primarily claim to offer more transparency and efficiency, decisions can be made relatively quickly among network participants, creating increased activism within the crypto-asset industry. This is because members of these organizations can share their expertise and opinions on member communication channels (e.g. Discord or Telegram), improving community knowledge and the prospects for more informed decision-making.
The term “DAO” was first used by Vitalik Buterin – co-founder of Ethereum – who suggested the term decentralized autonomous organizations (DAO) to describe the “holy grail” of organization types, an “entity that lives on the Internet and exists autonomously, but also relies heavily on hiring individuals to perform certain tasks that the automaton itself cannot do.”
In May 2016, a few members of the Ethereum community announced the creation of the first DAO, called The DAO , which quickly became one of the biggest spectacles in the Ethereum blockchain community. Prior to its launch, the DAO had an initial creation period in which people could send Ether to a single wallet address in exchange for DAO tokens on a scale of 1 to 100. The DAO eventually raised 12.7 million Ether ($150 million at the time, or $44.4 billion in today’s valuation). Essentially, the platform would allow people to pitch their ideas to the community and receive funding for its implementation. However, the experiment proved to be short-lived when The DAO was hacked a month after its launch.
But this major event for the crypto-asset industry did not slow down the adoption process of these new organizations as today, there are over 10,000 DAOs with ever-diversifying use cases.
These organizations create decentralized communities sharing a common goal, with many potential applications.
The potential categories of DAO can include a multiplicity of use cases. Below is a non-exhaustive list.
Risks related to DAOs
Although DAOs present multiple opportunities for the non-profit sector, these still emerging organizations also carry new risks, mainly technological – see article “The DeFi and the emergence of new risks”. Thus, to better understand this decentralized ecosystem, it seems necessary to study and mitigate these risks.
One of the major risks to which the DAO is exposed is the hacking of the smart contract. Indeed, the amount of funding that these “automatons” actually store is constantly increasing while their complexity is also seriously increasing. This sometimes leads to costly bugs and exploits, which can jeopardize the sustainability of a DAO. Indeed, there are many times when hackers have used flaws related to the development of a smart contract to subtract and liquidate decentralized applications. The best known example is The DAO case – See “The DAO: post mortem” written by Simon Polrot, January 24, 2017.
To mitigate these risks of flaws, several control methods have been developed such as audits or formal verifications.
The decentralized governance offered by DAOs exposes protocols to governance risks such as the risk of inequality and takeover by whales, the risk of governance asymmetry or the risk of conflicts of interest.
In this respect, delegation can alleviate certain problems by solving the coordination problems of small holders, by aligning incentives and by allowing activism to flourish. Indeed, smallholders cannot personally judge every decision, which are often very complex and require both technical knowledge and knowledge of the philosophy of the protocols – instead, they can delegate their vote to trusted community members.
Faced with these governance risks, some projects have tried to mitigate them:
1/ First via limited governance, which can be understood in two forms:
By limiting governance to specific changes. For example, governance would only allow changes to the distribution of tokens and fees. This is for example the case of Uniswap.
Or by providing for limited governance mechanisms where over time governance can no longer modify the essential contracts of the protocol (Governance Minimization). This is for example the case of Reflexer
2/ There are also temporalized governance systems that take a certain period of time after the outcome of the vote: this allows users who voted “no” and who are no longer convinced by the value proposition of the protocol to find an alternative for example.
3/ A DAO can also make the votes consultative, allowing to support and give more legitimacy to the orientations and choices taken by the development teams.
Other models attempt to completely disassociate themselves from classic governance systems:
Proof-of-Humanity (POH) is a truly egalitarian voting mechanism ensuring that no member can vote more than once. It is a system that is resistant to hacker attacks and offers new ways of governance. To log in, simply connect a self-hosted portfolio and fill in the required information to submit your profile. A successfully registered profile requires a number of advanced levels of verification, including taking a video including a speech and a clearly displayed Ethereum address on paper.
A DAO may also consider implementing a so-called ‘reputation’ system: using a reputation-based voting mechanism to make decisions. In this case, a community member with a relatively higher reputation value will have more influence in the organization. This system is notably developed by DAOstack. In the end, this reputation system aims to help DAOs maintain and work towards a set of collective preferences or goals. To this end, the protocol is designed to help reputation flow to users who pursue the collective goals of the DAO, away from users who do not.
There is also proof of participation, which allows you to demonstrate that you have, for example, voted or not voted on a proposal, contributed to such and such work.
Finally, there is quadratic voting, which aims to make voting fairer by assuming that the binary “yes” or “no” outcome of a governance proposal is not always representative of the debates that took place. A well-known example of the use of quadratic voting is Gitcoin.
Regulatory issues in France related to DAOs
In addition to the tax issues already discussed in this paper, one of the fundamental problems with DAOs in France is that they are not a recognized and established legal structure in France. However, this does not mean that DAOs cannot have a legal entity. In this respect, one of the key risks for participants in a DAO in France is the recharacterization as a de facto company.
De facto companies are a legal concept in which individuals act as partners without having drafted a statute and registered the company. The de facto managers did not necessarily want to create a company – or at least were not aware of it. While there is no precedent in France for treating a DAO as a de facto company, an equivalent case could be made with the Ooki DAO case in the United States when the Commodity Futures Trading Commission (CFTC), in September, brought legal proceedings against the Ooki DAO accusing it of operating without having complied with the obligations related to the regulated status of Futures Commission Merchant (FCM). Faced with these risks of requalification, some DAOs in France have chosen to structure themselves via the associative model – to find out more, see Cryptoast’s article “Structuring a DAO to the test of French law – What are the legal issues? “by Stéphane Daniel and Daniel Arroche (d&a partners), Gabriel Rebibo, William Piquard and Pierre Laurent (Atka), Paul Frambot (Morpho), Vincent Danos, Adrien Husson and Jean Krivine (Mangrove) and Philippe Honigman (Mangrove and dOrg), all members of Adan.