What is DAO? A Guide for Professionals

What is DAO? A Guide for Professionals

What are Decentralized Autonomous Organizations (DAO)?

Decentralized Autonomous Organization (DAO), also called as the Decentralized Autonomous Corporation (DAC) is an establishment or organization whose protocols are designed via digital codes, controlled by the shareholders and not regulated by the central government. They guarantee a democratic structure with all its decisions managed by all the members irrespective of hierarchy.

They run autonomously on a blockchain, by using cryptographic technology for its smooth execution. Due to its decentralized nature, the operations remain unaltered in a case of systemic failure. Bitcoin is considered to be the first application of the decentralized autonomous organization (DAO).  The DAO eliminated the need for a trusted third party in financial transactions as decisions are based on pre-defined code and smart contracts.

How does DAO work?

For a DAO to function, it needs a set of rules on which it will operate, and these rules are smart contracts that are essentially computer programs. The members of the DAO are represented by addresses owned by humans, robots or even another DAO. These members are then each designated with tokens that depict the shares of the DAO and the votes for a particular decision. So, the members of the organization use token to either spend or reward certain activities within itself. Another benefit from gaining a token is owning a vote in decision making ultimately impacting the way DAO operates.

After the DAO is stationed, it becomes fully autonomous and independent, meaning no user can tamper its operation. Blockchains and smart contracts help reduce the cost of management which in the case of a third party could be huge. Since the interests of all the stakeholders are aligned because of the one binding factor viz. the token, there seems to be one common goal for everyone. The members of the group are not bound by any legal contracts or entities instead of protocols written in software. To execute a proposal, the majority has to vote in favor of it to become serviceable. Users can exchange funds with anyone in the world without requiring an intermediary.

Features of DAO

  • Decentralized – The fact that an organization could eliminate corruption of any form due to the exclusion of third-party access is solved as DAO is decentralized.
  • Smart Contracts – As stated earlier, smart contracts enable DAOs to be effective. Since the rules are coded, therefore making it hard to infringe the DAO.
  • Trusted Timestamping – After the protocols are laid out, and funding is complete, the DAO can’t be changed not even by its creators. The integrity is well preserved, which might be subjected to modification if traditional organizations come in the picture.
  • Blockchain Technology – The transactions exchanged are transparent, incorruptible, and immutable because of this advancement. Blockchain equips DAO to be decentralized and independent.
  • Open-Sourced – After being deployed, the DAO gets autonomous and allows any user to access the codes(open-source). One even has access to the transactions on any blockchain.

The DAO Attack

In 2016, the German start-up Slock.it launched ‘The DAO’ a specific DAO which was a medium to exchange capital funds on the Ethereum blockchain. Investors were given 100 tokens for 1 Ether that they spent, which would eventually give them voting rights for a particular project. The token holders can become contractors by choosing the projects they want to invest in. By the mid of May people started to invest in the DAO and made it the largest crowdfunding in history. They managed to raise around $150 M, significantly more than the creators had expected. On June 12th, Stephen Tual, one of the creators, reported a “recursive bug call” that had been observed but claimed no funds in the DAO were at risk.

The creators instituted a ‘split-function’ which was aimed to aid the minority from the suppression of majority in a decision-making process. This property enabled users who voted against a proposal to redeem their funds in case they didn’t want to be a part of it. The redeemed funds could split into a child DAO which has the same properties a parent DAO.

A hacker detected a fault in this strategy and drained approximately a third of the funds of the DAO. The new child DAO possesses characteristics similar to the parent DAO which implies it can’t be accessed during the funding period, which is for 28 days.  Failure of the DAO had negative implications on the Ethereum network and cryptocurrency.

To solve the malfunction, the creators had two approaches, either to ignore the misfortune and to let the situations be as it is or exercising a two-step process, a soft fork followed by a hard fork. A soft fork makes only one blockchain valid as participants the update. On the other hand, in a hard fork, both the old as well as new blockchains exist simultaneously. The proposal of using a soft fork was later dismissed due to the security concerns it raised. Bagging majority votes, the hard fork was accepted to solve the problem.

The unforked blockchain was sustained as Ethereum Classic, therefore, splitting the Ethereum into two different blockchains, each with its cryptocurrency. With this approach, the investors were able to retrieve all their funds. The mining approach of the Ethereum network was changed from the Proof-of-work system to the Proof-of-state concept.

 Challenges related to DAOs

  1. On the contrary to traditional organizations built in a top-down manner, which require a lot of management for coordination and enforcement of a process, all the stakeholders in DAO exercise the same power.
  2. DAOs provide an operating platform to people from across the globe to be subjected to different authorities to make their legal decisions or judgment as there is no central governing system and just self-enforcing code. A barrier to the adoption of DAOs is its uncertain governing prospect.
  3. The risk of coordinated attacks poses a threat to the DAOs. The codes remain unchanged once deployed in the blockchain and are open-sourced so anybody can access it there lies a possibility of tampering the system and exploiting it for their gains.
  4. There is no ‘corporate veil’ protecting the shareholders, from the decisions that lead to financial liabilities caused due to the actions taken by the DAO.

Advantages of DAO

Each stakeholder can influence a decision proposed in the DAO. Since DAO eliminates the conventional hierarchical management, all proposals are placed in front of everyone and not certain privileged people, therefore, giving a fair opportunity of judgement by the entire organization.

Every user knows what they’re setting their feet into, meaning the stakeholders are aware of the protocols that are pre-defined before they invest. Thus, eradicating any external management.

The most significant advantage being transparency, as all decisions are posted on the public register. The financial transactions, as well as the rules recorded in the blockchain, are fully preserved and are available for review to anyone. So, they know how to spend funds and can track how those funds are spent.

Disadvantages of DAO

The most evident drawback of the DAO can be witnessed from the hack, how “The DAO” lost almost a third of its share due to security issues. The vulnerability in the code which let hackers spot the bug and rightfully extract the money out as they were technically “following rules”. The unstoppable code presents a problem because no one can change it.

Institutions like Massachusetts Insititute of the technology believe giving the masses a choice to take such critical financial decisions a bad idea and unlikely to produce any good results. The world isn’t aware of these technologies, and hence participants may not make effective decisions.

There is no legal framework yet, so DAOs are non-operational in the real world of finance.

Examples of DAOs

  • Dash – It is an open-source cryptocurrency that is run by a set of users called “masternodes”. Transactions are instant and untraceable.
  • Augur – A prediction market platform created on the Ethereum blockchain. It settles the predictions in 2 stages: market stage and arbitrary market stage. Users trade shares between one another in the market stage and the result is decided in the arbitration stage.
  • Aragon – It is an open-source software which uses Ethereum smart contracts for decentralized peer to peer networks.
  • Moloch DAO – It is Collectively used to generate funds through the development of public infrastructure instead of private benefits.

Conclusion

Offering growth to community-based decision-makers, the DAOs permit organizations to escape the dependency on the traditional institution. It allows resolutions to be in favor of the whole society and does not focus on individual benefits. I believe there’s still scope for growth as it is an emerging establishment and would hopefully allow us to eliminate the corrupt systems.

Read about Security Tokens: Here

Read about Defi (Decentralized Finance: Here

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