The atmosphere of decentralized finance (DeFi) is ripe with specific use cases for specialized purposes. The concept of decentralized autonomous organizations (DAOs) is certainly relevant to conversations about DeFi, but it doesn’t necessarily fit the DeFi box – its potential applications are just too big to be relegated to just decentralized finance.
Decentralized (or distributed) autonomous organizations are more of a model of governance than a specific use case within the blockchain-powered financial product sector. DAOs are now taking specific forms, many of which are DeFi products. But the concept of the DAO can be applied in many different sectors of society in the future.
What is a decentralized autonomous organization (DAO)?
As we usually do when it comes time to explain blockchain-related concepts, we’ll get the term “decentralized autonomous organization,” or DAO, to the core of the term by breaking it down into simple English terms. Per Oxford languages, decentralizing something is “transfer (control of an activity or organization) to multiple local offices or authorities instead of a single one. Something that is decentralized is therefore defined by shared power over a system.
A task or system that is autonomous, according to Merriam Webster, is one that is “undertaken or implemented without outside control” while “existing or [being] able to exist independently ”. An organization is a type of administrative or functional structure. Therefore, a decentralized autonomous organization is one with distributed, non-central control that can exist independently without outside intervention, while having an organized structure. Decisions in these systems are, at least in theory, made by the participants.
DAOs adhere to these principles, but they specifically refer to systems built on blockchain technology. Networks of computers, known as nodes, run protocols built into self-executing smart contracts to keep the system functioning as intended.
How DAOs Work
The blockchain element of DAOs explains the “decentralized” aspect of these autonomous organizations. Blockchains are composed of nodes that decentralize every transaction. Rather than having a single computer handle 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 distributed, and thus 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 are executed when pre-specified conditions arise. Suppose a buyer enters a purchase request in a blockchain system. A salesperson then enters a sales request and all nodes in the system verify the legitimacy of the transaction. A smart contract then releases the money to the buying party, crediting the seller’s account to reflect the transaction. Due to the power of smart contracts, no human intervention is required once they are triggered. Therefore, the whole system remains autonomous.
Smart contracts can also regulate voting processes that determine how a DAO is managed. When such autonomous smart contracts are built into a decentralized, blockchain-powered platform with a specific organizational purpose, you have a DAO.
What is the purpose of a DAO?
The specific purpose of a DAO depends on the DAO you are referring to. As this series aims to explain the world of decentralized finance, we will focus on DAOs as they relate to the DeFi sector. The organization may exist to help users transfer cryptocurrencies across blockchains, or to serve some of the most popular DeFi use cases, such as crypto lending or yield farming.
You could argue that any cryptocurrency, if it has a decentralized organizational structure, is a DAO. Cryptocurrency transactions are generally executed through smart contracts, are intrinsically linked 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 cryptocurrency these days refers to a DAO, they are likely referring to something more specific, and generally something built on the Ethereum blockchain.
Ironically, decentralized autonomous organizations require that human participation be of some value, and it is not like this all the way 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 the token, and the more participants can be rewarded for their efforts by owning increasingly valuable native tokens from that DAO.
Once a DAO is funded, launched and running, decisions about its material function (where, for example, will network generated funds be invested) become a democratic process among stakeholders. This crystallizes the decentralized nature of a DAO, or at least a DAO functioning as it claims. At this point, a DAO can continue to fulfill its purpose, whatever that purpose may be.
What is the current state of DAOs?
These decentralized organizations are largely used to conduct financial transactions for the time being. They allow users to borrow crypto, lend crypto for interest (and in some cases additional tokens), buy and sell crypto. Use cases continue to emerge, but these are the most established DAO purposes to date. In the future, DAOs can manage elections, conduct real estate transactions, or control another sector of society. For now, they largely exist in the secretary of decentralized, cryptocurrency-related financing.
Some of the DAOs that have had the most success on paper so far, and the best known as a result are Maker, MetaCartel and Aragon. Maker is especially notable in the DeFi space for offering cryptocurrency lending services that have proven to be extremely popular. The concept of DAOs, still relatively young, will only continue to see a greater number of players in the markets and, with increased competition, hopefully better and better options for crypto-inclined consumers.
How do regulators view DAOs?
One problem always seems to emerge in talks about regulation and blockchain-powered, crypto-linked projects: fraud. If fraud turns out to be a significant problem within a sector, regulators may be in the picture sooner rather than later. But it seems that over time, DAOs are getting better at resolving kinks and providing self-government.
One of the first much-hyped forays into DAOs, originally called “The DAO”, was structurally flawed and fell victim to a hack. The damage: 3.6 million ETH tokens. Had “The DAO” been the last impression DAOs left, regulators might be inclined to dive in and protect investors from the kind of mismanagement that would result in the absconding of 3.6 million ether courtesy of fragile security protocols .
But it was not the last impression. While time will tell to what extent regulators become involved in the DeFi space in general and in particular with specific DAOs, for now it appears that DAOs in the decentralized financial sector are doing a quality job protecting their investors’ assets and generally be reliable.