Imagine replacing your manager with a line of code. Who would benefit? You? Your company? No one? Now imagine replacing your manager, mission statement, and daily assignments with a public smart contract that is (nearly) immune to corruption. Enter the DAO: the most exciting idea to hit organizational theorists since Ronald Coase first proposed the economic theory of the firm. The industrial age was marked by the rise of huge intermediary powers — stock exchanges, central banks, commercial banks, brokers, courts, lawyers, escrow agents, etc. — that allowed global business transactions to occur by establishing trust among strangers. Lately, that world of centralized, cumbersome exchange systems has come into question on the blockchain, a technology where trust is already built into the public ledger. Many see DAOs — decentralized autonomous organizations — as the 21st century’s natural successor to the LLC. We’ve been wanting to talk about decentralized finance — perhaps the field most ripe for eye-popping yields — for some time now. But we quickly realized that talking about DeFi doesn’t really make sense until we’ve covered DAOs, the foundational template for any blockchain-based organization. So, what is a DAO and why should you care about them?
The First Dao
The first DAO — confusingly named “The DAO” — was an investor-directed venture capital fund that quickly morphed into a spectacular failure. It was started by a small group of Ethereum developers inspired by the ideas of 22-year-old Vitalik Buterin, co-founder of Ethereum and patron saint of decentralization. Buterin had long wondered if an investment fund could operate without management. Ethereum was designed to minimize the need for intermediaries by making trust native to the platform through smart contracts. In 2013, Buterin outlined his goals in the first Ethereum whitepaper: “What if, with the power of modern information technology, we can encode the mission statement into code; that is, create an inviolable contract that generates revenue, pays people to perform some function, and find hardware for itself to run on, all without any need for top-down human direction?” asked Buterin. In exchange for Ether (“ETH”), the currency of Ethereum, The DAO issued tokens to investors which provided each token holder with certain voting and ownership rights that were proportional to how much they invested. In less than four weeks, The DAO had attracted over 18,000 token holders and was valued at $150 million USD. The 28-day creation period marked the biggest crowdfunding venture in history (at time of), and The DAO investors held over 14% of all ETH in circulation. And then things fell apart. Since The DAO’s code was publicly displayed on the Ethereum blockchain, anyone could see it, including hackers. The DAO’s founders stated that its source code had been reviewed by “one of the world’s leading security audit companies” and “no stone was left unturned during those five whole days of security analysis.” In June 2016, an unknown attacker would beg to differ. The attacker noticed a vulnerability in the codebase and successfully drained a third of the DAO’s funds to a subsidiary account. “The attacker simply read the terms and conditions more closely than anyone else,” Emin Gun Sirer of Cornell University told The Economist.
Ultimately, the funds were recovered by forking the blockchain — essentially rewriting the code as if the attack had never happened — but not without great upheaval among the Ethereum community. Some cyber-libertarians believe the code never should have been altered, as this defeats the whole purpose of immutable contracts. Others claimed it wasn’t a crime at all since, technically, no rules were broken. But despite the heist, The DAO’s core objective — to demonstrate a wholly new method of capital formation and organization — remained sound. A disparate group of strangers was able to raise a huge sum of money without the use of any traditional intermediaries. What else could they do?
What’s So Special About DAOs?
Perhaps the most radical feature of DAOs is the idea that business models should be open, public, and replicable. Why reinvent the wheel when it’s already illuminated on the blockchain? Gone are the proprietary days of yesteryear, when secretive firms like Bridgewater and Oracle once guarded every business insight as if under a cloak-and-dagger operation. With a DAO, all of its business logic is written in the code. This hands your business plan to the general public on a silver platter: anyone can see, copy, and reverse engineer the same exact business model if they wanted to. Naturally, iteration of superior models is much faster. The wisdom of crowds, it turns out, can reduce dramatic amounts of cost, redundancy, and error. “This will be achieved,” writes Richard Gendal Brown, CTO of R3, an enterprise software company, “by applying the fundamental blockchain insight: ‘I know that what I see is what you see.’ This is key to help us move from a world of isolated, custom, inconsistent IT infrastructures in each firm, to one based on shared business logic, securely shared data, and common processes.” It’s not hard to see how this might also apply to our labyrinth of financial institutions — a system so bloated with intermediaries that a mere wire transfer of $5,000 can cost up to $125 to send and take many days to get through. DAOs bring to business what the open-source movement brought to code: an invitation to the broader public to participate in, improve upon, and take ownership over a joint community project that thrives off of bottom-up design rather than top-down control. Eric Raymond best described this revolution in his open-source classic, The Cathedral and the Bazaar. “I believed that the most important software needed to be built like cathedrals, carefully crafted by individual wizards or small bands of mages working in splendid isolation, with no beta to be released before its time,” writes Raymond. “Who would have thought … that a world-class operating system could coalesce as if by magic out of part-time hacking by several thousand developers scattered all over the planet, connected only by the tenuous strands of the Internet?”
Agnostic, User-Controlled Corporations
The Drawbacks of Democracy
Ironically, one of the key issues faced by subsequent DAOs is inefficiency. Most shareholders, it turns out, are apathetic towards the majority of issues and have no interest in voting on the minutiae of everyday operations. “Berkshire Hathaway would look a bit like the DAO if, instead of leaving things to Warren Buffett, all of its shareholders got to vote on every investment decision,” observed Matt Levine in the early days of The DAO. “When I put it like that you can probably see why this structure has not been super popular so far.” The community has responded with more efficient forms. Jack Du Rose, co-founder at Colony, a DAO whose mission is to provide groups of people with intuitive, voting-minimized DAO templates, was inspired to start Colony in response to the “original sin of DAOs,” i.e., democracy. “Most DAOs actually increase the coordination costs of the market mechanism by requiring everything to pass through this absurd voting process of token holders,” said Du Rose. “It really just slows everything down. It’s as though companies, rather than trying to behave as agile startups, are trying to behave as multinational corporations where shareholders have to vote upon every little thing.” Voting hiccups aside, other questions abound. As Matt Levine points out: “Like, how does the DAO do its tax returns?” And since these are leaderless, virtual organizations, who takes the fall when things go wrong? You can’t extradite a smart contract. Last week, Wyoming became the first state to recognize DAOs as LLCs, but most jurisdictions have yet to make up their minds. Ultimately, any first-generation iteration of a new technology is bound to be sloppy. Remember the first cell phones? Huge clunkers that seemed more like a brick than a calling device. DAOs are approaching their fifth year of existence: we may have to withhold judgment for another iteration or two until a clearer form takes shape.
About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at firstname.lastname@example.org.