V&IConcepts & Challenges

With the emergence of smart contract-capable blockchains, more and more communities have emerged in recent years that want to consolidate the opportunities associated with them into a new form of organization.

The Decentralized Autonomous Organization (DAO) has emerged as a new, innovative concept with the intention of no longer mapping entrepreneurial decision-making processes via a hierarchy, but rather via democratic decision-making processes embedded within code. In this blog article, we would like to look at the principle of DAOs and describe which forms currently exist as well as highlight the opportunities associated with this new form of corporate participation.

What are DAOs?

In the Web 3 world, a DAO is a blockchain-based system that enables participating actors to take over the management and control of a purposeful organization and determine its actions and development. The self-executing rules of this organization are stored in the form of smart contract code on the blockchain, thus ensuring the integrity and authenticity of the decisions.

The members of a DAO can participate in achieving the organization’s goals by making and implementing decisions on operative and strategic measures in a decentralized manner. Decisions are made with the help of the organization’s own governance token and are stored and executed immutably on the blockchain with the help of smart contracts. The smart contract platform on which most DAOs currently run is the Ethereum blockchain.

Generally speaking, DAOs can be described using the following characteristics:

Self-governing: A Decentralized Autonomous Organization is a self-governing entity run by a collective of actors who have come together to achieve a common goal.

Blockchain based: DAOs are blockchain-based and operate according to predefined, self-executing protocols that define how the organization arrives at decisions and allocates resources and rights.

Democratic: DAOs are a democratic entity based on voluntary contributions from participants, enabling decentralized decision-making processes and a non-hierarchical structure. This means that DAOs are (at least theoretically) never under the control of a central authority.

These characteristics of a DAO are ideal-typical and come in different shapes in practice. The DAO structure varies depending on the structure and goal of the decentralized organization as well as the underlying implicit and explicit community rules (written in code).

What types of DAOs exist?

With the emergence of the DAO concept, a variety of niche communities have formed that cover different areas of interest and topics. A DAO community can function both as a for-profit company and as a non-profit platform with an interest in academic research. Basically, DAOs pursue the goal of mapping the existing institutions of the real economy in the form of a decentralized form of organization and thereby streamlining the necessary administrative processes in a decentralized, rule-based and transparent manner with the help of blockchain.

Two different types of DAOs have emerged in practice:

Algorithmic DAOs aim to ensure the functionality of a code by focusing on ensuring and maintaining the functional flow of the system. Algorithmic DAOs include open-source blockchain systems and non-customizable smart contract protocols, which form a fully autonomous, self-sustaining system.

Participatory DAOs aim to enable decisions on the operational actions of the organization through participation and thus influence the development of the organization. What all of them have in common is the ability to use governance tokens to manage the treasury and optimize the smart contract functional capabilities.

Which DAO characteristics exist?

While algorithmic DAOs tend to secure the function of a system, participatory DAOs can have different characteristics and offer their members various rights and forms of participation. Different DAOs have been established over the last few years, each covering their own specialist areas and fields of application. Probably the best-known project on the Ethereum blockchain was “The DAO”, which resulted in the loss of a considerable portion of the Ethereum fund due to a security error in the protocol and ultimately led to a hard fork of the Ethereum blockchain.

However, the DAO concept did not die out after that. Instead, the initial mistakes were taken up and used as learning for the development of new DAOs.

Three superordinate categories of DAOs can currently be found in practice:

Venture & Investing DAOs focus on providing finance for start-ups and private individuals. This form of DAO belongs to the profit-oriented organizations, whereby the DAO community decides which projects should be financed with the DAO treasury.

Project DAOs, as the name suggests, focus on the implementation of projects or are responsible for the administration of protocols. These forms of DAOs act as community associations which oversee, support or promote innovative, social or scientific projects.

Decentralized Finance (DeFi) DAOs are organizations that focus on financial services. These DAOs manage Stablecoins, provide Lending Services or are responsible for the administration of Decentralized Exchanges

It should be emphasized that the distinction between these categories is not always clear. Project & Community DAOs can also have the intention of generating profit and could therefore also be assigned to the Venture & Investing DAO category.

What challenges do DAOs have?

In theory, DAOs offer many interesting use cases for democratizing the administration of an organization and ensuring that it is transparent and tamper-proof. Promising use cases have already been established in the Web 3 world, with projects continuously being funded.

In practice, however, the emergence of this type of organizational form raises a number of questions regarding implementation and integration into the real economy, particularly for the developers of the DAO. On the one hand, the creation of a DAO raises the question of how much human intervention should be allowed and to what extent the organization can act autonomously. The decision-making and management processes should be clarified and the operational implementation of decisions should be ensured. Both on the technical and the human side.

DAOs need to rely on a heterogeneous group of stakeholders who act in the interests of the organization in a benevolent manner. Incentives are needed to ensure the stability and sustainability of the organization. Both the supervising and the executing part need to be aware of the achievement of objectives and act in their interest. The success or failure of a DAO therefore depends closely on the actors involved, who share knowledge and information and want to ensure that the network is maintained.

A further challenge in the field of DAOs lies in determining the legal structure of the organization. It is not yet fully clear what legal form a DAO needs to adopt and how the governance token issued can be assessed for regulatory purposes. Especially in the case of DeFI tokens, it is possible that they will be treated as financial instruments and therefore DAOs and DAO tokens will be subject to the financial supervisory authority.

Outlook for the implementation of DAOs

The concept of DAOs is an extremely exciting, innovative but still very abstract field. The emergence of smart contract-enabled blockchains has created the possibility of streamlining and democratizing decision-making processes and storing them in a transparent and tamper-proof manner. Over the last few years, a large number of DAOs have emerged that monitor the security and development of technical systems as well as pursuing charitable or profit-oriented goals. All based on the blockchain.

In practice, however, DAOs face various challenges that need to be taken into account during the implementation process. On the one hand, it is important to ensure that the actors involved are offered incentives to participate in maintaining the network. On the other hand, procedural and legal aspects must be clarified in order to establish the economic-sociological framework conditions for the existence of the DAO.