Despite the current bear market and the collapse of FTX in November 2022, the number of Decentralised Autonomous Organisations (DAO) continues to grow. Their innovative characteristics, use cases and potential, especially in the financial sector, make them a phenomenon of growing economic and social importance (DAOs’ treasuries and value may increase up to $10 trillion in 10 years).
So, what exactly are DAOs?
There is not a single definition but some describe a DAO as a blockchain-based system that enables people to coordinate and govern themselves mediated by a set of self-executing rules deployed on a public blockchain, and whose governance is decentralized. A shorter definition is a virtual organisation built and run on code and blockchain technology, where the primary focus is not the technology itself but rather the organizational structure of different communities. The US Department of the Treasury also gives some additional details which provide more clarity on how DAOs function - decisions are made based on members’ votes and subsequently recorded in a programming code, known as a smart contract. The smart contract defines the rules of the organisation and holds the DAO’s “treasury” (the funds accumulated and pooled by the DAO to achieve its objectives) and can be changed only by the voting of these same members.
One of DAO's core ideas is to implement features that distribute ownership and voting power transparently and efficiently. This framework facilitates collaboration and community engagement among all members of a DAO that share common goals and ideals but is it good enough for the financial sector?
Use cases
- Protocol DAOs - these DAOs are used as an ownership and governance mechanism for lending platforms and yield optimisers. Examples of protocol DAOs are Uniswap representing the largest decentralised exchange on the Ethereum blockchain, Aave and Maker. Uniswap launched its token, UNI, in November 2018 and its holders vote or delegate votes that control the protocol’s direction, fees and treasury. Other examples are Aave and Maker whose members can decide on things like the addition of new assets, management of platform parameters, adjusting the interest rate or the stability fee.
- Investment DAOs – these are similar to traditional investment funds that operate with pooled capital. Rather than a single centralised party, investment DAO token holders can vote on the investment of the pool of funds (ex. MetaCartel Ventures).
- Grant DAOs are DAOs designed to fund and foster new ventures or projects, most often within the DeFi (decentralized Finance) space (ex. Gitcoin, Moloch).
- Collector DAOs – aimed at purchasing collectable items such as NFTs, real-life artwork and music (ex. PleasrDAO, Flamingo DAO.
- Social DAOs – probably the most popular example of this category is Bored Ape Yacht Club which skyrocketed the NFTs to the moon.
Apart from the conventional method where each token grants one voting right, there are some innovative approaches. For example, quadratic voting allocates disproportionate voting power based on the number of tokens held. In this system, one token equals one vote, but two tokens grant four votes, three tokens result in nine votes, and so on. While this method encourages token ownership and commitment, it carries the risk of concentrating voting power in the hands of a few major token holders. Another approach, known as holographic consensus, involves a multi-step voting process that includes boosting and betting on proposals. Within this framework, members can forecast the success or failure of proposals and use tokens to bet on their predictions. If the prediction is accurate, the predictor receives token rewards, but if not, they lose tokens.
From a financial perspective, the features of DAOs implement trustless payments, without the necessity of the participation of an intermediary, which makes them a perfect solution for payments and investments in the metaverse, for value creation in cyberspace, etc.
Future potential, benefits and drawbacks of DAOs
Some of the significant benefits of DAOs compared to traditional legal structures are lower or no barriers to entry, time and cost-efficient way of voting and decision-making, flexibility, and transparency since the smart contracts are being executed automatically when the preconditions are met and are publicly available. Disintermediation, theoretically reducing costs in the payment chain, and direct payment for any ideal or economic activity from the payer to the payee, are also regarded as important benefits. At the same time, many people who use DAOs are attracted to these due to the fact that these organisations can still operate outside the financial regulatory framework and supervision.
On the other hand, some drawbacks shall also be pointed out – rigidity of execution meaning that even the smallest changes shall be voted on by the community, no legal certainty or clarity regarding their status and future legal implementations as well as the lack of accountability.
Regulatory Challenges
A complex regulatory landscape surrounds the DAOs. Currently, the most common approach is to include this new type of organisation within existing laws and concepts. Malta has been a prominent player in Europe's efforts to regulate blockchain technology. The Maltese government introduced a comprehensive blockchain strategy which includes a legal framework to augment prior initiatives concerning virtual currencies, covering various aspects, including the certification of "technology arrangements". Although legal recognition of DAOs continues to be very limited worldwide, some US states (Vermont, Colorado, Wyoming and Tennessee) have also introduced laws specifically targeting them, as have the Cayman Islands, Switzerland and Singapore. However, on a global level, DAOs are still being researched in order to be properly implemented in the existing legal frameworks.
What is of significant importance for the EU is the adoption of MiCA. The establishment of regulatory frameworks may force DAOs to rethink their legal status, governance and operational models. For example, a DAO providing services within the remit of MiCA has to be authorised and take on legal personality if it intends to continue to provide crypto-asset services to European citizens. According to MiCA, crypto-asset services may be provided by undertakings that are not legal persons only if their legal status ensures a level of protection for third parties’ interests equivalent to that afforded by legal persons and they are subject to equivalent prudential supervision appropriate for their legal form. It is also important to note that the future of DAOs and their risk assessment will be subject to further evaluation on an EU level.
Another perspective concerning the development of the DAOs in the following years is provided by the Bank for International Settlements (BIS) through their “Principles for financial market infrastructures” (PFMIs). In July 2022, a joint report by the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions (CPMI/IOSCO) provided guidance on applying PFMIs to stablecoin arrangements (SAs) considered systemically important financial market infrastructures (FMIs). While systemically important DAOs are not yet in existence, the report is relevant because DAOs, like SAs, perform functions related to transferring crypto-assets, which are considered as such infrastructures. DAOs also present novel aspects, including the use of non-central bank or commercial bank settlement assets, interdependencies between multiple functions, high degrees of decentralization in operations and governance, and the integration of emerging technologies like distributed ledger technology (DLT). It is no surprise that the evolution of technology raises some concerns and makes the implementation of principles such as appropriate governance arrangements (Principle 2), and risk management needed. In this regard, a more comprehensive overview of strategies to mitigate these risks, including security audits, insurance mechanisms, and governance frameworks shall be discussed.
The Path Forward
DAOs present a unique opportunity for implementing the achievements of technology in the way traditional concepts such as corporate structure and financial services are perceived. However, in order to develop their full potential, the need for a balanced approach, advocating for innovation while maintaining regulatory safeguards shall become a priority for regulators and the financial industry.
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