DAO Governance Explained
DAOs or Decentralized Autonomous Organizations happen to be one of the most innovative blockchain-based concepts. The core philosophy is to create an organization that’s free from centralized control.
As the name suggests, DAOs have three core features:
Decentralization: Not governed by one single, centralized entity.
Autonomous: The DAO can automatically execute operations on its own without any intervention.
Organization: The DAO is governed by its own predetermined rules, like an organization.
Governance Tokens
Governance tokens are tokens that developers create to allow token holders to help shape the future of a protocol. Governance token holders can influence decisions concerning the project such as proposing or deciding on new feature proposals and even changing the governance system itself.
In many cases, the changes proposed, vetted and then voted on through on-chain governance accessed by using governance tokens are applied automatically due to smart contracts. In other cases, the team maintaining the project is tasked with applying the changes or hiring someone who will.
Who uses governance
A DAO’s trustless decision-making frameworks are generally intended to help make governance accessible to everyone, rather than a select few. More specifically, DAO governing bodies oversee the allocation of protocol resources and ensure the long-term viability of the projects they support.
While not every blockchain project utilizes a DAO, the growth of decentralized finance (DeFi) protocols has heightened the profile of blockchain governance, driving further investment. According to DeepDAO, DAOs oversaw more than $8.2 billion USD in digital assets as of Feb 2022.
One well-known example of a governance token is Maker (MKR). This token allows its holders to vote on decisions pertaining to the decentralized finance (DeFi) protocol that the decentralized stablecoin DAI runs on.
For example, MKR holders can vote to change the complex economic rules that govern the decentralized lending that allows DAI to keep its price stable. At the time that the text you are reading was being written, MKR holders were voting on whether the protocol’s debt ceiling should be raised.
Importance of DAO
Starting an organization with someone that involves funding and money requires a lot of trust in the people you’re working with. But it’s hard to trust someone you’ve only ever interacted with on the internet. With DAOs you don’t need to trust anyone else in the group, just the DAO’s code, which is 100% transparent and verifiable by anyone.
This opens up so many new opportunities for global collaboration and coordination.
What should DAO contributors know about governance
DAOs operate using smart contracts, which are essentially chunks of code that automatically execute whenever a set of criteria are met. Smart contracts are deployed on numerous blockchains nowadays, though Ethereum was the first to use them.
These smart contracts establish the DAO’s rules. Those with a stake in a DAO then get voting rights and may influence how the organization operates by deciding on or creating new governance proposals.
Once the rules of the smart contract are written onto the blockchain, the next step is to acquire funding. Since smart contracts require the creation and distribution of internal property like native tokens, which can be used for voting or incentivizing certain activities on the protocol. Individuals or entities interested in participating in the DAO’s growth can purchase the DAO’s native token which are cryptocurrencies tied to certain projects. Token holders are given voting rights proportional to their holdings and are able to own equity in the DAO to help shape the DAO’s future.
Once there’s enough funding for a DAO to kick-off, all of its decisions will be made by token holders through a consensus vote. As the DAO’s stakeholders, community members will then work towards the most beneficial outcome for the entire network. Beyond voting rights, members can also work for their DAOs where they can get governance tokens in return, including roles in token distribution and treasury management.
This model prevents DAOs from being spammed with proposals: A proposal will only pass once the majority of stakeholders approve it. How that majority is determined varies from DAO to DAO and is specified in the smart contracts.
Understanding governance within a DAO
DAOs are open-source, thus transparent and, in theory, incorruptible. All transactions of the organization are recorded and maintained on a blockchain. Interests of the members of the organization are — if designed correctly — aligned by the incentive rules tied to the native token. Proposals take the primary way for making decisions within a DAO, which are voted for by majority consensus of involved network actors. As such, DAOs can be seen as distributed organisms, or distributed Internet tribes, that live on the Internet and exist autonomously, but also heavily rely on specialist individuals or smaller organisations to perform certain tasks that cannot be replaced with automation.
Although some DAOs operate as independent protocols, the vast majority of DAOs share the following characteristics:
Tokenization: Many DAOs utilize blockchain-based tokens to represent voting rights. As a result, only token holders can participate in network governance.
Self-enforcement: DAOs utilize smart contracts that automate organizational rules. These smart contracts can greatly reduce — or even eliminate — the need for intermediaries that might compromise decentralized decision-making.
Autonomous automatization: A single smart contract is only capable of handling simple transactions. DAO frameworks must define a complex set of smart contracts that enable multi-party interactions — without human involvement.
Decentralized infrastructure: Although DAOs utilize decentralized governance, the underlying network must also exist on distributed infrastructure. Without adequate decentralization, governance can be exploited by those with significant enough computing power.
Transparent data: Blockchain immutability helps DAOs function successfully as decentralized governance mechanisms. Immutability helps protocols to communicate about organizational processes and data in a transparent manner.
Trust mechanism: Smart contract conditions and other protocol mechanisms codify a certain degree of trust into DAOs. As a result, a variety of agreements between network stakeholders can occur without involving third parties.
Benefits of DAO
A DAO smart contract is like a legal agreement that’s written in code by software developers. Smart contracts can also be shorter, smaller, and more quickly produced than standard legal contracts, DAO proponents say. Plus, by using cryptocurrency registered on the blockchain, it’s possible to raise money far more quickly than via fiat currency processed through traditional banks.
In theory, the decision-making power in a DAO is distributed to include all participants, and automated to minimize the need for day-to-day administration.
Decentralized, Automated And Transparent
The decentralized and transparent nature of DAO gives its members full ownership to maintain the protocol. Moreover, DAOs are automated — thanks to smart contracts — and decisions are executed automatically. Compared to traditional companies, DAOs eliminate all third-party transaction costs and the organization only “pays” for existing on the blockchain, thereby increasing their profit margins.
Community-Driven
Decision-making power in the organization is given to each token holder. This power is proportional to the tokens held by a member, but it doesn’t give them more rights or privileges. Token holders have the right to effect changes that further develop the protocol, which makes it a rewarding and truly democratized space.
Potential Investment Returns
Owning a governance token in a DAO is a bit like holding equity in an early stage start-up — if it becomes successful later on, that equity will be extremely valuable. The DAO members who are also token holders are rewarded with a fixed percentage of the transaction volumes on the exchange. This helps create a more stable token user base with a long-term investment mentality. All in all, this reward mechanism is what differentiates these tokens from those launched by other non-DAO projects.
Drawbacks of DAO
Despite the name, the DAOs that exist today aren’t totally decentralized or purely democratic. They still rely somewhat on the participants trusting the group of human beings who initially set up the DAO and its goals and general terms. That group of humans must also be trusted to decide on a governance model that fits. In some models, every participant that contributes crypto–no matter the amount–is issued a single token, signifying one vote to cast in future decisions of the DAO. But in some DAOs, it might be unfair if a participant who contributed a large amount of crypto was granted the same say in important matters as someone who contributed a small amount.
It’s still early days for DAOs. These organizations, and the technology that underpins them, are promising enough that they should be watched closely as they mature, refine themselves, and find new use cases.
On-chain vs off-chain governance
On-chain governance refers to the governance processes that happen directly on the platform based on the rules specified in the blockchain programming code. A typical example of a purely on-chain governance process is the formal voting on some issue using the governance token of the platform.
Off-chain governance involves all the governance-related processes, formal as well as, very often, informal, that happen outside of the platform. Examples of off-chain governance processes on public blockchains are discussions on social media, online forums, conferences, and other events.
On private blockchains, off-chain governance rules are usually described in the documents of the corporate entity or non-profit organization that controls the blockchain.
For instance, one of the best-known private blockchains, Hyperledger Fabric, has the so-called open governance model where the governance rules are specified by the Linux Foundation and do not depend on any on-chain transactional activity. However, businesses can create protocols and tokens on Hyperledger Fabric, and are free to specify protocol-specific on-chain governance rules.
Several projects have adopted an on-chain governance model.
Tezos On-Chain Governance
Tezos (XTZ) is one well-known example of a platform with purely on-chain governance. Launched in 2018, Tezos is a smart contract-oriented blockchain. Tezos uses a variation of the Proof of Stake (PoS) verification model called Liquid Proof of Stake (LPoS).
All the governance at Tezos must happen on-chain using the rules already coded into the platform. Holders of the XTZ tokens can delegate their block verification, or “baking” using the platform’s terminology, and governance rights to other nodes. There are about 500 of these baking nodes, called delegates, with the voting power.
The delegates propose a change to Tezos, and the voting process involves five stages in total. The proposed change must meet a rather stringent pass mark of 80% of the delegated voting power to be implemented.
EOS On-Chain Governance
A blockchain capable of conducting millions of transactions per second, EOS implements another variation of PoS, Distributed Proof of Stake (DPoS).
EOS token holders elect 21 block validators who get the right to validate all the network transactions. No off-chain mechanism for discussion of or voting on potential changes is specified by EOS.
On EOS, all the governance happens on the blockchain and any accepted change is automatically implemented, no further questions asked.
Many public blockchains, including Bitcoin (BTC) and Ethereum (ETH), have a largely off-chain governance model. For example, all the major changes proposed to Bitcoin are thoroughly discussed online by key stakeholders.
Bitcoin Governance
There is virtually no on-chain governance mechanism on Bitcoin. The platform does not have a governance token, and holding BTC coins, while giving you a say during the off-chain discussions, does not grant you any specific voting rights. Thus, all the discussion and voting happens off-chain.
On Bitcoin, your share of the mining power does not give you the equivalent share of the governance rights.
Ethereum Governance
Ethereum’s governance model is quite similar to Bitcoin’s. There is a core development team managed by, now canonized in the community, Vitalik Buterin, as well as researchers, advisers, miners, platform users, and token holders. All the proposed changes are actively discussed off-chain on discussion forums, boards, and Social Media.
Most notable governance protocols
There are proponents of both main governance models. Those in favor of the on-chain mode argue that on-chain governance is the purest form of maintaining community consensus from the technical point of view.
On-chain governance has the advantage of being completely transparent to all network participants. The rules are explicitly specified in the blockchain code and are completely free from subjective opinion or interpretation.
On-chain governance aficionados also point out that off-chain governance might give some external actors without a significant stake on the platform an undue influence on the network’s key developments.
Also, the pre-written and automated nature of on-chain governance helps avoid long and messy online deliberations, arguments, and rope pulling.
The critics of on-chain governance state that blindly subjecting a network to the “rule of the software” may result in usurpation of power on the platform by a small group of actors. Their view is that off-chain governance helps keep the blockchain free from such a rule-based takeover.
The off-chain camp also argues that on-chain governance on some PoS platforms, especially those with some form of delegated voting, creates a form of plutocracy, where large stakers “buy votes” from the smaller users and influence the platform using their deep pockets.
The DAO Hack
On the 17th of June 2016, a hacker found a loophole in the source code of DAO. Through this loophole, he was able to funnel 3.6 million Ethers from the smart contract in just one day. At that time, 3.6 million Ethers had a collective worth of 70 million dollars. Via the faulty source code, the hacker was able to send a big number of ETH and subsequently ‘ask’ the DAO smart contract to give it back. The hacker repeated this request and repeated this request and repeated this request, causing the blockchain to double-spent multiple times. This ‘recursive call’ vulnerability was never patched. Also, the smart contract was programmed in a way to first release the funds and update the token balance after. The hacker could repeat the process infinitely but stopped when he had collected 3.6 million dollars. This faulty source code was written by the DAO (not Ethereum themselves) and eventually became their downfall.
