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What is a DAO? Decentralized Autonomous Organizations explained
DAOs: What are they? How do they work? How can you get involved?
The advent of smart contracts has heralded numerous innovations. We owe the invention of 2 of the hottest investment trends to this groundbreaking technology – non-fungible tokens (NFTs) and decentralized finance (DeFi). Smart contracts have also given rise to decentralized autonomous organizations, or DAOs. If you've never heard of them, you're not alone. But they are slowly becoming the "next big trend" in crypto, so buckle up. DAOs represent a unique opportunity for normal people to collectively effect big changes in anything from business and politics to art and technology – as demonstrated by the recent attempted resurrection of Blockbuster.
DAOs may one day even replace traditional centralized business models and change the future of investing. Adoption is growing rapidly, with $2 trillion of the total cryptocurrency market cap currently managed by DAOs. Read on to discover exactly what a DAO is, how DAOs and their tokens work, how to invest in them and the pros and cons of this emerging crypto sector.
What is a DAO?
As its name suggests, a decentralized autonomous organization is an organization with no fixed leadership. It is collectively owned and managed by its members. All decisions are made from the bottom up via membership votes on proposals, while all rules are enforced and encoded through the blockchain. DAOs are built on open-source blockchains where anyone can view their code and all financial records can be audited.
The open-source code was created by Ethereum protocol engineer Christoph Jentzsch to eliminate the risk of human error or malicious intent among fund managers by placing decision-making power into an automated system. Designed to allow investors to send money from anywhere in the world anonymously, DAOs provide voting rights through the ownership of tokens.
Examples of DAOs
DAOs are predominantly used in the DeFi space to ensure applications are fully decentralized, with no single owner.
The Dash cryptocurrency is seen as the first true example of a DAO, as there is a governance mechanism that allows all token holders to vote on the use of its treasury. MakerDAO is another, with its software, its stablecoin and its prediction market platform Augur. Other examples include virtual worlds such as Decentraland, where users are incentivised to operate a shared virtual world and earn LAND tokens in exchange. With the growth and expansion of Web 3.0, the role of DAOs is likely to increase.
The asset class is not just limited to the metaverse and cryptocurrency space. ConstitutionDAO was formed in November 2021 to raise funds to purchase an original copy of the United States Constitution. The group managed to raise over $40 million in ETH from nearly 8,000 members but ultimately lost to a bid of $43.2 million. Despite the failure, the DAO garnered mainstream attention and showcased the power of DAOs as a source of crowdfunding.
DAOs can also exist as charities, accepting donations from around the world and collectively deciding how they are spent. Venture capital funds form another use case, with profits distributed among members, while grant funds can also take advantage of the new digital structure.
How do DAOs work?
As all decisions are made from the bottom up, all DAO members have voting rights for governance proposals. When certain criteria are met, smart contracts that encode the DAO's rules execute a chunk of code automatically.
There are numerous ways to participate in a DAO, the most common being owning the governance token. However, it's important to understand the ins and outs of a given community. One way is to check if a DAO has a Discord chat server, which serves as the go-to communication platform for DAOs and also now allows you to connect your Web 3.0 wallet.
DAO tokens explained
By owning the token associated with a particular DAO, members have voting rights on how its treasury is spent. Because the tokens can be traded on exchanges, they have monetary value. Members are incentivised to improve governance to entice investment and increase value. It's key to remember tokens do not represent stocks or shares in the manner of the traditional finance world.
3 popular types of DAOs
Protocol DAOs are built by a community that establishes governance rules for a service or blockchain protocol. Members can join and put forth proposals that are put to a vote. Each vote is based on the number of tokens held. Examples of protocol DAOs include Uniswap, Compound and Aave.
Investment DAOs work like a community fund. Every member of the DAO contributes a certain amount of cryptocurrency to purchase the native token, which is backed by the respective cryptocurrency. If a DAO is built on the Ethereum blockchain, the cryptocurrency needed to purchase the DAO token would be ETH.
Like protocol DAOs, these tokens give the holder voting rights. Different kinds of investment items can be incorporated, such as NFTs. Examples of investment DAOs include PleasrDAO, MetaCartel Ventures, Flamingo and Komorebi.
Sometimes, groups are started with like-minded people who have no specific goal at the outset other than an intention to form a collective. With these types of DAOs, membership is the key factor, which is purchased via the associated token. The most well-known example of a community DAO is Friends With Benefits.
Investing in DAOs
If you want to invest in a DAO, it's important to bear in mind it's not a get-rich-quick scheme and there are risks involved. Practise due diligence by doing research and assessing potential pitfalls to become an informed investor.
Here is a list of the 10 most popular DAOs and their associated tokens at the time of writing (February 2022) according to CoinMarketCap:
|DAO||DAO token||How to invest|
|Curve DAO Token||CRV||Buy CRV|
Pros and cons of DAOs
- Trust and transparency. Since DAOs are virtual, they have advantages over traditional organizations in that zero trust between parties, a core tenet of cryptocurrency technology, is required. Only the code, which is transparent and extensively tested before launch, needs to be trusted. Changes related to the code have to be approved by the majority of members, while internal disputes are solved by putting forward a vote.
- Shared risk. Because investors can pool funds through a DAO, they are able to invest in early-stage startups and share any risk that may come from these business ventures.
- A solution to the principal-agent dilemma. The principal-agent dilemma in finance refers to an instance when an agent takes excessive risk because the principal bears the burden. Members don't need to trust any agent acting on their behalf; instead, group incentives are aligned by shared stakes.
- Doubts over security and legality. DAO technology is still in its infancy, and concerns linger over its legality, security and structure.
- Smart contract flaws. The DAO hack brought to light issues of security and reliability in smart contracts, as coding flaws can be difficult to fix.
- No legal framework governs DAOs: DAOs can be distributed across numerous jurisdictions, so they don't fall under any overarching legal framework. Any legal issues that arise will straddle various legal systems.
The world of finance is constantly evolving. Over the past 2 years, technologies like DeFi, NFTs and DAOs have risen in popularity and adoption.
If the rapid ascent of Web 3.0 is anything to go by, the adoption of decentralized management innovations like DAOs is set to revolutionise business and investment models. However, like with any other financial matter, it's essential to perform due diligence before getting involved. While DAOs are important, the ultimate value is still held in the communities and projects they control.
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