The Ethos of DAO Governance

Traditional organizations like corporations and governments have for years adopted a ‘top-down’ management structure where a group of individuals can make decisions on behalf of a community of subjects (shareholders, customers, etc), who bear the risks of consequences of the decision. Such arrangements give rise to a social dilemma where the individuals in power are motivated to act in self-interest at the cost of their subjects.

The traditional organizational structure contradicts Defi’s two foundational qualities- trustlessness and decentralization. Therefore, Defi demands such governance that is self-enforcing and transparent, one that can be implemented by code, and decisions are made by the subjects themselves, whose self-interests align with the interests of the organization itself.

DAO Governance

What is it?

A decentralized autonomous organization (DAO) is a trustless system of governance that is typically adopted by Defi projects in Web3. The rules set by a DAO are immutable and open source, they are enforced by smart contracts on the blockchain. DAOs aim to achieve equitable governance, where each subject is offered a say in the trustless decision-making in proportion to their vested interest in the Defi project, which is typically measured by the ownership of a DAO governance token.

Here are some typical features of DAO governance –

• Trustless — A DAO’s governance is designed such that its every member’s honest conduct towards the development of the DAO is in their best self-interest as well. This creates an ideal democratized environment that eliminates the need to trust any member.
• Tokenized — The voting rights of a DAO are typically tokenized using blockchain-based assets.
• Autonomous — Smart contracts reside in specialized accounts on the blockchain with no owner. DAOs, therefore, achieve autonomy by encoding their governance into smart contracts.
• Open source — Every DAO activity, including governance proposals is executed on-chain and accessible to not just DAO members, but anyone. Therefore DAO governance is trustless and verifiable.

How does it work?

There are DAOs for every niche in Web3, spanning lending protocols, smart contract blockchains to NFT and Metaverse projects. The diverse use cases of DAOs lead to many models, but they can broadly be generalized into the following stages –

1. Development

A core team of developers designs the underlying project behind the DAO. This may be a DEX, lending protocol, NFT project, a cross-chain protocol, or anything on the blockchain. Then, the foundational rules like governance, incentive schemes, and tokenization of the DAO are programmed with smart contracts.

2. Funding

DAOs pool funding to commence operations through public and private sales of DAO governance tokens. Any interested individual can become a part of the DAO governance by purchasing these tokens. While some governance tokens are directly available for purchase, some DAOs may even require members to lock certain tokens in smart contracts for a fixed time to protect against dilution of the governance.

The pooled funds from token sales form the DAO treasury. The treasury is used to pay for further development of the DAO protocol, fund promotional campaigns, and bounty programs, or act as a security against potential malfunctions and attacks.

3. Launch

Once the smart contracts are deployed and the DAO treasury is set up, the DAO is ready to commence operations. From this stage onwards, every decision will be made through governance votes, the stakeholders are incentivized to work towards the development of the DAO network.

Every DAO activity like governance votes, protocol adjustments, bug fixes, and bounty programs happens on-chain, which can be tracked by anyone, including outsiders, who are not members of the DAO.

Why do Defi Projects opt for DAO Governance?

An evident trend with Defi projects is that many that were initialized with privatized governance modules soon adopt DAO Governance. Here are some reasons why –

DAO governance as a strategy to raise funds

Defi projects typically raise funds for the development of the project through token sales, where they create a project token (like UNI, AAVE, SUSHI) that represents a portion of voting power after the launch of the project. Therefore, token sales are an effective crowdfunding strategy.

DAOs build a worldwide network of contributors

The Defi landscape is incredibly fierce, where hackers are quick to exploit potential loopholes or bugs in the smart contract code of the DAO. In a race toward publishing attack resilient Dapps, a small group of developers often fall short against hackers that are spread worldwide.

By adopting DAO governance for an open-source Defi project, developers worldwide are welcomed to develop the Dapp and offer improvement proposals to make it bug-free and attack resilient in exchange for rewards and incentives. This facilitates faster upgrades and makes the Dapp phenomenally more secure than privatized models.

DAOs incentivize holding project tokens

DAOs often incentivize the holding of their governance tokens by offering derivatives that lock governance tokens in interest-bearing time-locked smart contracts. This helps limit the liquid supply of the governance tokens, helping the price drive forward.

Notable successful DAO initiatives

Here are some projects that successfully adopted thriving DAO communities –

Uniswap

With the launch of its governance token, UNI, Uniswap formally became a DAO in September 2020. The team minted 1 billion UNI tokens, which were distributed among community members, core team members, employees, and investors.

Maker DAO

Maker DAO was one of the first projects to adopt on-chain governance. Maker launched its DAO by minting 1 million units of its governance token, MKR. MakerDAO adopts a hybrid of on-chain and off-chain voting systems for its governance proposals.

CurveDAO

Curve is one of the largest DEXs in Defi and is the hub for stablecoin liquidity. Curve launched in January 2020 and became a DAO with the launch of the CRV token in August 2020. In CurveDAO, governance voting privileges are acquired by locking CRV tokens into a time-locked smart contract to obtain vote escrowed CRV (veCRV) tokens that compound with time as well. This model helps to concentrate the voting power with community members with a truly vested interest in the success of the protocol.

MultiDAO

Multichain launched the MultiDAO in Q1 of 2022. Like Curve, Multichain adopts a vote escrowed governance voting module that requires members to lock MULTI tokens to obtain veMULTI NFTs. Each veMULTI NFT represents a vote in the governance proposals. It also accrues a portion of proceeds from the fees collected from cross-chain transactions.

Adopting on-chain governance through DAOs is a formidable challenge where several things could go wrong. For instance, any loopholes in the smart contract logic or code could be exploited to drain a DAO’s treasury, or, a third party could take over the DAO by taking control over the majority of DAO tokens and exploit their position for personal benefit, or, an incompetent community could potentially approve proposals that could lead to the downfall of the DAO, or a severe bear market could collapse public interest and effectively kill the DAO.

Unfortunately, some failed DAO initiatives have faced similar challenges and have bitten the dust. It is crucial to learn from failures to understand what works in the industry and what doesn’t, so let’s look at some notable failed DAO initiatives –

Notable failed DAO initiatives

Genesis DAO

A few members of the Ethereum community together incepted the Genesis DAO for the Ethereum ecosystem in May 2016, it was one of the first major DAO initiatives of the time. The Genesis DAO treasury at a point was worth almost $250 million (when ETH was around $20).

Genesis DAO was built to crowdfund projects for the Ethereum ecosystem. Anyone could pitch their project ideas and receive funding from the DAO treasury if the project gathered enough votes, the voting was facilitated with DAO tokens.

In June 2017, a hacker manages to exploit a loophole in the DAO code which allowed him to drain the DAO treasury (about $70 million). The loophole was not a flaw in the Ethereum code, but a flaw in the DAO smart contract on top of Ethereum. Following the hack, Ethereum was hard forked to a state before the attack, which left the Ethereum community divided on the morality of the decision. Genesis DAO later faced headwinds from the SEC, which deemed the DAO tokens as securities, SEC thus claimed that the Genesis DAO violated federal securities laws, which led to the ultimate downfall of the initiative.

Constitution DAO

The constitution DAO is arguably one of the most interesting DAO experiments that illustrate the power of on-chain crowdfunding. It was initiated by a handful of crypto enthusiasts in November ’21 to raise funds to buy the first printed version of the US constitution, auctioned by Sotheby’s. The community managed to pool over $45 million.

The DAO ultimately failed to acquire the document due to Sotheby’s hidden expense of a 13.9% auction fee, and confusion over the storage of the document. It is believed that the DAO closed fundraising too early, and fell short of funds at the last moment. Furthermore, while the DAO promised to refund the funds back to contributors upon such a failure, they were not clear about contributors having to pay the gas fees for the refund. Ultimately, the DAO presented a choice for the members, they could either pay for gas and receive their funds back, or stay and earn the “We The People” governance token in return, which would be utilized for another such venture, which has not yet been made clear.

Closing thoughts

DAO governance is one of the most interesting applications of Defi, and one that resonates with its core qualities of trustlessness and decentralization completely. We believe that DAOs are the ideal governance module for any blockchain-based project, but the road to developing an attack-resilient DAO that stands firm in extreme market conditions is phenomenally challenging. we believe that a healthy DAO is one with a competent core team and a community that is adequately decentralized and is genuinely interested in making the project successful.