According to deepdao.io, in January 2023, there were over 10,000 DAOs with 91k decisions made through 8.1M votes cast. It’s worth noting that the voting and decision making has significantly dropped in the last months. The reason, which is both known and unknown, won’t be a topic of this article, however will be weighed upon later.
At this point, it is evident that DAO, as an offshoot of decentralization, is here to stay. However, one of the major issues currently plaguing the adoption of DAOs across and beyond is the abstruseness with DAO governance and the lack of regulatory clarity, which have been extensively discussed in my podcast.
In this article, I discuss the DAO governance and legal concerns that seem to restrict the wide adoption of DAOs.
A DAO (Decentralized Autonomous Organization) is a novel organizational structure devoid of hierarchy, where the members hold the decision-making power and have the ability to directly influence the future of the project. DAOs employ the use of smart contracts, which are a set of codes that make the interaction and execution autonomous and trustless. Members of the DAO use their tokens or NFTs to vote on proposals and reach a consensus to execute the objectives of the project.
DAOs bring a new way of organizing, where the voice of many matters more than the voice of one (or a few). One of the strong tenets that DAOs thrive on is decentralization. DAOs move to eliminate the centralization and hierarchy that comes with managing the affairs of an organization through C-level executives and Board of Directors. Instead, the executive power is distributed across a larger number of members through blockchain technology that enables execution that is highly independent of human involvement.
The Significance of DAOs: Embracing Decentralized Autonomy.
DAOs, as decentralized organizations, change how we think, live, work and build, and encourage inclusivity.
Tired of the usual prejudices, limitations, tyranny and wanna-be democracies, decentralization brings a change. It brings back the sovereignty that no longer belongs to us, where we are required to consent to the centralized mechanisms because it enables us to do simple things like buy food in a supermarket, or own a house, or even travel. Decentralization is not a new movement or a new politics to gain popularity. It’s a mindset. It’s how we view the world and the way we build that world. It’s a better future.
We live in a world where our personal information is sold for targeted ads, where mainstream media feeds us with the information (or misinformation) which they need us to believe and hides the things they don’t want us to know. We live in a bubble of the colors of our flags, where it's difficult to jump into a different bubble as we either don’t have passports that rank high enough, or we are not privileged enough. The world belongs to the monied, to those who have, and to the privileged.
Decentralization changes that. In this environment, one asks what you can do, what your skills are and what you want to do; rather than where you come from, what schools you went to or what god you believe in. DAOs as decentralized organizations enable an environment where anyone who has a device and internet access can get involved, contribute, earn and change their (unprivileged) future.
DAOs promote human and financial inclusion by opening up many opportunities for people to get funded, to invest and make a profit. They allow the masses to be builders and creators, and provide a space for all skin colors, genders and religions to be seen as equals, rather than as insignificant workers.
DAOs build a decentralized community-based environment where members are the ones with the decision-making power. They can freely voice their opinion, put out proposals, and have direct influence on the project’s and their own future. The success of the organization is not defined by hierarchy and the power of a few; the strength of a DAO is defined by the people and its ability to empower people to be involved and be inspired to participate.
Opposing the dishonesty and lack of trust in the centralized world, DAOs offer a great level of transparency amongst members owing to blockchain being fully transparent and highly immutable. Further, the smart contracts make the DAO autonomous, trustless and highly independent of human involvement.
In the regular world, we are often deprived of the ability to truly know how the tax we paid is actually used, and whether it’s really spent for making our lives, cities, schools, and roads better. Contrary to that, any use of DAO funds is visible on the blockchain, and in case of any misuse - members have the ability to flag it and alarm the rest of the community.
Lastly, decentralization allows access to a bigger pool of talents, and we all well know - the main strength of every industry is the talent building it.
Can Decentralization Solve the Problem of Human Nature?
Despite the many advantages that DAOs bring, they do not come without challenges. Looking back, the first DAO was launched in 2016 and two months into existence, the great hack happened, causing a large portion of the funds to be drained. Despite its success at first, it left a bitter taste with the community as it was displayed how vulnerable smart contracts can be. Even though the majority of the funds were recovered with the hard fork, it divided the community. This showed that blockchain as a technology does offer a new way of organizing and funding, however, it’s not immune to human nature and completely immutable.
Decentralization empowers the crowd and removes the reign of the “select few,” but at what cost for the project? The decisions made by the community decide the future of the project which begs the question, can a large decentralized community of people make a decision that is good for the project?
In the centralized world, we go by the assumption that those who call all the shots have the necessary skills and expertise to run the business, however in DAOs that is usually not the case. Not every community member has enough knowledge, experience and expertise to vote on each and every decision that is relevant to the project.
As a way to solve that, liquid governance allows members to delegate the votes to the “chosen” contributors - those that the community believes have enough expertise to make the right decision. But again, that doesn’t come without any risks. By delegating our votes to the “expert”, we trust one person which defies the very important trustless characteristic of the DAO and increases risk of centralization. Even worse, there is always the risk that the person we trust is in fact corrupted, and may vote for something that serves their best interest, but not of the DAO?
In many DAOs that have the weighted voting system, the voting power depends on the amount of tokens one holds, so the well-known “whale danger” comes into play. On one hand, it is vital to reward those who invested more of their resources in the DAO as a way to recognize their support and contributions; but on the other hand, we don’t want to centralize by empowering the few, and discouraging the mass community by creating an environment where their “voice is too small, and the vote insignificant”.
So, how do we protect the governance and keep the contributors happy? In the episode with Eagle we discussed two options: firstly, implementing the total cap on how much voting power one can use to vote, however this raises the question whether it is fair towards someone who has invested more resources into the project? Another solution might be to have a mechanism that is triggered when the majority of the community votes option 1, but the whale votes for option 2. The difference in the number of votes prevails and the decision depends on what the community wants. This also agrees well with the premise of quadratic voting.
You can often hear explanations of DAOs voting as a democracy, and to be honest whenever I hear that, I get goosebumps and feel like screaming. You may wonder why and the answer is simple - democracy can be easily corrupted. We have learned on so many different occasions that direct democracy is never direct, and it always ends up resorting to “let’s choose representatives”, and we all know how that story goes…
Many argue that the 1 wallet - 1 vote solves the whale and liquid (centralization) governance issue. It may seem so at first, however, it really doesn’t. It simply requires one to create more than one wallet, which can be used to cast many votes. So you end up getting many baby whales acting as one big whale. Blockchain makes the voters’ identity anonymous, and it doesn’t tell us who’s behind the vote. A way to solve this problem is to KYC each and every holder/wallet to prevent this type of hijack. Khm, khm, big fat no.
Are these the only voting issues DAOs face? Unfortunately, not.
DAOs Aren’t Fake. People Building DAOs Are.
Regardless of which voting system a DAO adopts, the lack of community engagement usually takes up first place in the line of challenges DAOs are facing. Despite the decentralization and the “everyone’s voice is heard” incentives, the members often do not exercise their voting power. One would think that the ability to decide the future and growth of your investment itself would be quite a push to be actively involved, but it’s not the case. Members are often not as engaged and not as responsive to the DAO’s needs. The “why” keeps popping up in an attempt to understand the reason.
The first “official” DAO was launched in 2016, it was a success and a failure at the same time, and until recently DAOs weren’t as popular. Fast forward to 2023, there are over 10,000 registered DAOs, and probably even more in existence. This happened because “DAO” became the buzz word. We do know that buzz words and hype helps in raising funds, but do we really know what happens after the funds are raised?
Many of these wanna-be DAOs aren’t real DAOs as they are often heavily centralized, built on airdrop communities and “to-the-moon” campaigns. And those who stayed after the hype do not feel heard, they join community calls to listen to the few, and are asked to merely vote on logo colors. They didn’t come to a DAO for that. They came to be heard, to be involved, have a say, and vote on things that matter.
That’s where you lose even the small portion of the interested community. You can’t build fake, and expect the real.
Is it only the fault of the hype and buzz though?
It’s not.
The community migrates from the Web2 mindset, which creates an environment where their voices do not matter and are not used to being heard. They need to learn that their voices are heard, and re-learn the significance of their opinion.
I often hear from founders “I can’t have the community decide on these matters because they don’t know”. This is another scream. If your community does not know your project, or is unable to decide what is good for the project and they do not understand how DAOs operate, you failed big time. Do us all a favor and go back to Web2.
The Web2 mindset is difficult to change, we have been raised in this manner, lived it for so long, and are still living it. We live on constant crossroads of Web2 and Web3 where we battle with the dragons of both. It can’t just go away overnight.
Education is the key. Trust is built by educating, by giving people a place to ask questions, by empowering their voice, and by showing them their voice is as important.
What Are the Offchain DAO Challenges?
The novelty and complications of Web3 stir a lot of controversy and fear. We usually fear things we don’t understand, or even worse - we tag them as a scam without understanding the basics.
Crypto has had the reputation of a “new way to finance terrorism, drugs, and launder money”, however, no one talks about how many wars, deaths, and human trafficking the dollars and euros have financed.
We do know that everything that is not centrally controlled, raises a lot of concerns with the regulators as they are really worried about protecting the consumers and ensuring their safety.
But, why is it difficult to regulate DAOs?
One of the major challenges the regulators face is how to regulate a decentralized organization that has no jurisdiction, doesn’t have a central management, and allows anyone to get involved? How to tax an organization with no flag attached to it, which also has its own currency? Do we even want them to get to this answer?
You can think of a DAO as a “chat group with its own cryptocurrency and significant financial means”. In order for that “chat group” to do anything with that money, let’s say pay for a vacation, buy a house, or maybe a US constitution, they need to have a connection with the traditional financial system. DAOs as DAOs are largely invisible to the law, and that makes it difficult for them to enter into any sort of contracts, open a bank account, pass KYC/AML/CFTC requirements, or pay for a domain or a server.
So, should DAOs be regulated?
It’s a question that has different answers, but if we are looking into the future and seeing DAOs as a new way of organizing, we really need to think twice before saying anything.
DAOs cannot survive only on member investments and member-based funding forever. It’s simply not sustainable with the market fluctuating constantly and the ongoing expenses. So, it's necessary to have a business model and a revenue source that can support the scale of the DAO.
Going back to the example of the chat group - if the chat group is able to acquire funds, regardless of the size of the funds, if they are not put to use, it just ends up being a loud chat group and people start to leave as there’s too much spam.
To do business, earn revenue, and grow, you need to be able to communicate with the traditional world via a bank account. But, how can an organization without legal identity, no legal standing and jurisdiction, open a bank account?
That's an even more difficult question to answer.
Some have tried. Wyoming, in 2021, was the first to recognize DAOs as decentralized autonomous organizations. It was a small step for regulators, but a huge step for the community. It showed that the regulators and “(current) people in power” do understand the advantages this industry brings. Unfortunately, the regulations are more of a “DAO” and “LLC” words pasted together, still, a huge step forward. The Marshall Islands followed, Tennessee too. Across the world, there are several jurisdictions that are DAO-friendly and can offer the needed protections and limited liabilities.
Why is that even important? DAOs are often confused for general partnerships which are simply put, a business arrangement of two or more people who equally share profits, losses and liabilities. Meaning, one bad actor in the DAO, can put everyone involved at risk resulting in unlimited personal liabilities.
Does having a legal entity centralizes the DAO? It does if you use that entity as an excuse for centralization. Centralization happens with governance and operations. The legal wrapper is a tool to protect the community, the founders, and the project, until we have a better solution.
Are all risks mitigated if a DAO is incorporated and the project has legal protection? Unfortunately not. Having that LLC surely mitigates many of the legal risks, however, it doesn’t mitigate the risks of greedy and corrupt founders. Once an LLC is registered, the DAO assets do not belong to the community anymore, they belong to the LLC. Fortunately, several jurisdictions mitigate these risks as well. But we still have a long way to go.
Conclusion.
With any new technology, there is always risk and resistance in mass adoption. The same applies to decentralization and DAOs. There are many advantages in moving to a decentralized environment, but they also come with many challenges, like regulatory clarity, trustable and smooth operations, and returns for the community . There are even hindrances when it comes to regulating the DAOs from the point of view of the regulators due to the novel organizational structure.
Embrace the Rise of DAOs with me and embark on a journey into the intricate realms of DAOs, Web3, and decentralization. To delve deeper into this remarkable space, I invite you to listen to my podcast, DAO Today, where we passionately explore its inner workings, challenges, and potential. Tune in to engage with insightful discussions that navigate various aspects, with a particular focus on the legal and regulatory challenges shaping this industry. Listen now!
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