• Raveen Kuhadas

Exploring Crypto - Introduction to DAOs

This is the second article (first article here) in a series exploring crypto leading up to a profile on Minke, a decentralised finance (defi) wallet built on the Polygon network. Minke’s mission is to democratise decentralised finance.


Decentralised Autonomous Organisations (DAOs) use crypto tokens' transparency and incentive design to distribute decision-making away from centralised management teams. Successful DAOs require an aligned community of stakeholders to grow and benefit from network effects.


DAOs are becoming the primary defi governance structure and is used by AAVE, a lending and savings platform that Minke integrates with. This article will briefly explore what DAOs are, their defensibility and their risks.


Subsequent articles will explore a brief overview of AAVE and the next step of my crypto journey, where I sign up for a wallet. Note that Minke’s public beta has just been released!

 


What is a Decentralised Autonomous Organisation (DAO)?


The previous article discussed how blockchain technology

  • decentralises trust away from powerful central authorities with a combination of transparency and incentives

  • could be seen as a computing paradigm with the various solutions building on top of one another in layers.


DAOs are a form of smart contract. The blockchain-based smart contract in a DAO enables stakeholders to cooperate around a common goal without having to know or trust each other.


In a traditional company, a governance mechanism (e.g. shareholder voting) selects a management team that makes operational decisions and drives the business. Decision making is therefore centralised and there are costs and risks to ensuring these managers act in the best interests of the shareholder owners of the company.


In a DAO, this management layer is replaced by governance processes (e.g. member voting, review committees, etc.), allowing the organisation to make decisions. These processes are coded into blockchain-based decentralised smart contracts.


How are DAOs Organised?


Like many systems in crypto, aligning a group of people around the organisation's goals is done with a combination of transparency and incentives. This incentive structure is called ‘tokenomics’.


Tokenomics refers to the economics of holding the crypto project’s tokens. The attractiveness of a project’s token is governed by several factors such as demand and supply, ROI/yield and game theory/incentives. Read more here.


DAO tokens act as an incentive structure to align the interests of the token holder to that of the DAO.


There are many types of DAOs. Most of them require:


  • A community of people to do work such as product development, risk analysis, token mining etc. These people need to be compensated.

  • A treasury which essentially represents the capital in the DAO that is used to pay expenses, act as capital reserves etc.


A typical DAO structure would look as follows:



Typical DAO structure



The 6 broad parties above are described as follows:


Smart Contract:

Dictates the actions of the DAO, such as decentralised finance (defi) DAOs like AAVE. It acts as a platform connecting the demand and supply sides.


Demand Side:

An example would be borrowers in AAVE.


Supply Side:

An example could be lenders in AAVE.


Treasury:

DAOs often have a treasury of funds or capital to pay expenses, act as capital reserves, manage token supply etc. The treasury may hold a combination of governance tokens, major Layer 1 cryptocurrencies, stable coins (e.g.pegged to the US Dollar) etc.


Service Providers:

The group of contractors, developers, miners and others who provide the operational expertise needed to run the DAO. The DAO Treasury compensates them for their service.


Governance Tokens:

Examples include the AAVE and MKR tokens for AAVE and Maker DAO, respectively. These token holders influence and vote on the DAO’s key decisions, such as setting fees levels and how funds in the treasury should be spent.


Token holders get rewarded from a portion of the earnings/fees charged by the DAO. Therefore, the rewards (earnings and token value) increase as the platform grows.


In many ways, governance token holders represent the equity holders in the DAO. However, token holders have the added benefit of influencing key decisions through transparent voting processes and forums.


This builds trust and a sense of community.


DAO Defensibility


The smart contract coding behind most DAOs is open sourced. This significantly reduces any competitive advantage from software code or features as anyone can copy and paste the code to start a competing DAO. Unlike companies like Coca-Cola, whose original recipe can be kept secret.


As such, the community that forms around the DAO is key to its defensibility. This community is built by maintaining a healthy balance between all stakeholders in the DAO as described below:


  • Governance token holders will have the value of their tokens increase with the growth in the use of the DAO’s services. This incentivises designing a great customer experience and setting reasonable fees.

  • Qualified service providers are attracted to work on the DAO due to the attractive rewards/compensation that the governance token holders have approved.

  • Users (demand and supply side) are more likely to transact on the DAO due to the great user experience and reasonable fees.


A common DAO feature encouraging community engagement is the distribution of the governance tokens amongst the various stakeholders. For example, Index Coop DAO distributes 70% of its governance tokens to the community and only 30% to the founders.


This means it is the community rather than a relatively concentrated founding team that drives the decisions and direction of the DAO.


A healthy community will build the scale needed by the DAO to create network effects and defensibility.


For example, while defi lending and borrowing platform AAVE’s smart contract functionality can be easily copied, its collateral and liquidity are hard to replicate. I.e. More borrowers result in more collateral which attracts more lenders (better risk management), which increases liquidity (lower interest rates) therefore attracting more borrowers etc.




Smart Contract and Regulatory Risks


DAOs are a relatively new concept and therefore have several risks, including risks associated with their smart contracts and regulatory uncertainty.


Smart Contract Risk:

DAOs are based on smart contracts whose code is open sourced. While this transparency can be desirable, it does leave the code open to hackers.


The first DAO was created in 2016 and was known as the Genesis DAO. It was designed to act as a decentralised venture capital firm and raised $150m from investors.


However, the DAO was hacked due to a loophole in the smart contract’s coding. This led to the DAO’s failure though the $70m stolen was eventually recovered.


DAO users and investors therefore need to be confident that there are no loopholes or bugs in the code that hackers can exploit.



Regulation:

There is a lack of clear regulation given the infancy of DAOs. For example, DAOs are not recognised as a legal entity in many areas. This means that DAOs are not companies and members do not enjoy the limited liability protection given to company shareholders, i.e. members’ personal assets could be at risk.


Countries like Australia are taking steps to introduce regulation such as consumer protections and limited liability status. More on this here.


Next Steps


This is the second article leading up to a profile on Minke.


DAOs are becoming the primary defi governance structure and is used by AAVE, a lending and savings platform that Minke integrates with.


Subsequent articles will include a brief overview of the platform AAVE and the next step of my crypto journey of signing up for a wallet. Note that Minke’s public beta has just been released!.







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