DAOs, decisions and dangers

DAOs – Distributed (or Decentralised) Autonomous Organisations – feel like a great way of putting power back in the hands of a community. They are recognised as having huge potential for social impact – the World Economic Forum has described them as ‘nascent and aspirational’ – and there are huge sums of money held in DAO treasuries, estimated at $25 billion in 2023. But there are deep-rooted problems with DAOs. Here’s a sample of the challenges they face.

Smart contracts are not infallible

The first ever DAO managed to showcase this key risk before its untimely demise. Launched in 2016, The DAO was a shared investment community that was developed to distribute funds to worthy applicants and divide the returns between investors. It was remarkably popular – around 14% of all the Ethereum in circulation at the time was invested in the project. However, a critical flaw in the smart contract allowed a hacker to drain invested funds straight out of the treasury, and all the founders could do was watch. The impact on the Ethereum ecosystem was so great that a special smart contract was deployed to suck all the funds back from the thief and return them to the investors. This resulted in a hard fork between Ethereum and Ethereum Classic – you can see it at block 1,920,000, if you’re interested.

Lesson one: get those smart contracts checked, checked and checked again. You can’t change them once they’re running.

A camel is a horse designed by a committee

Communities are not very good at timely and objective decisions. There are plenty of limited companies who started out as co-operatives and soon realised that a decision-making structure that involves everyone can mean missed opportunities and conflicts of interest. There’s a reason why in public life we start with the Parish Council and work up to government, deferring to our representatives. When DAOs are drawing up their governance structure, making votes advisory rather than binding on the operation of the business, and creating a two-tier structure for decision making, could avoid a world of pain.

Because community decision making is so tricky, DAOs may also have a tendency to be a little more centralised that we might think. A recent report by Web3 company De.Fi highlights risks including hidden owners (in 6.8% of DAOs) and single wallet controls (in 38.2% of DAOs).

Lesson 2: It’s hard to balance operational effectiveness with community decision making and secure decentralisation.

With great power comes great responsibility

A formal corporate structure protects decision makers and shareholders and sets out clear roles, rights and consequences for actions. A DAO, whose membership may be scattered across multiple jurisdictions, does not have that formal guidance and getting the governance structure right can be a minefield. There’s a real danger that token holders who participate in decision making by voting could inadvertently form a partnership and become personally and legally responsible for the outcome of their vote. For the creators of the DAO, what happens if a coalition of malicious actors uses their voting power to change the direction of travel of the organisation?

The goal for every DAO should be creating a strong governance structure that meets all its operational needs and protects its creators and its members. This is a huge undertaking and is one of the reasons why DAOs are seen as a vehicle for the future, not something that has yet been proven at scale.

Lesson 3: Governance is not an afterthought. Assume the worst and plan accordingly.

DAOs are set to be a significant part of our future and are already underpinning DeFi operations and helping a growing number of social impact projects to crowdfund and distribute support and aid. But the challenges of effective decision making and the dangers of getting it wrong are very real. To scale DAO activity, we need to develop strong, effective and transparent governance structures, and ensure that anything automated is audited and watertight. If we get it right, the opportunities for society and the rewards we can reap will be immeasurable.

Pre-order “Getting Started with Cryptocurrency: An introduction to digital assets and blockchain” out on 17th April from BCS Publishing.

Image by Chang Zun Shi from Pixabay