Part I of DAOs: New Horizons and Challenges in Depth
Talking about DAOs…
Incredibly the world’s first DAO — that is “The DAO” — has raised over $130MM in ether funding and is now basking in the glory of early success. Naturally the world is beginning to wake up and ask what exactly is a Decentralized Autonomous Organization, what opportunities do they introduce, what benefits they bring and what risks they might present. Some are also asking whether they also should be investing money into The DAO.
I have a particular perspective on these questions. I work in decentralization both as an entrepreneur and, in a not for profit role, as a theoretician researching protocols that can drive scalable decentralized networks. String (see http://string.technology) the for profit startup company I cofounded, is currently developing a number of “open chain” financial systems that will themselves manifest as DAOs on the Ethereum chain. At the time of writing, String is the first company with significant venture capital funding pursing a DAO-based business model: our aim is to launch completely open DAOs that will be fully owned and controlled by the community and profit simply by holding a share of their “voting tokens”.
What is a DAO?
Loosely speaking, a DAO is a software object constructed from smart contracts running on a “world computer” blockchain such as Ethereum that encapsulates business logic that performs an organization-like role. A DAO is “decentralized” because it runs on a blockchain, and “autonomous” because it can run in the cloud completely independently of any real world person, organization or, indeed, local regulatory jurisdiction. A particularly exciting feature of DAOs is that they can hold their own funds in the form of cryptocurrency and digital assets, which can be used for liquidity or paid to external contractors or investee entities. Of course, because they run on a world computer blockchain they are tamperproof and the only way to interact or update them is through the business logic they define.
DAOs may in principle implement any governance structure whatsoever, or even have none at all. Many though will choose to create their own voting tokens, which can be distributed through a crowd sale or some other means to enable “the crowd” to lend their wisdom and intelligence to decisions they make by voting on proposals. Often, if the DAO generates returns in some manner, it will distribute a pro rata share of the returns to voting token holders as remuneration for their voting services. But it is important to see that these are not in any way defining characteristics. A DAO can be created with or without voting tokens, and may or may not hold funds.
If this sounds nebulous, don’t doubt your understanding. DAOs will be used for many different purposes. As their numbers explode in the coming years, we will see a large number of variations — after all, any organization or business process design that can be crafted in software may be used. To make this a bit more concrete, here are three hypothetical DAOs that have distinct purposes.
- Venture Capital DAO
A decentralized investment fund is created (like “The DAO”). The fund is initially capitalized by investors buying voting tokens. Thereafter, they can vote on proposals to fund external ventures. If they do not like the direction of the DAO’s investments, they can split off to create a new DAO, carrying with them a pro rata share of funds remaining and a proportional stake in the old DAO that reflects their part of the funds it invested.
Without a controller, premises or hosting computers, this DAO exists as a extranational entity outside of regulated local financial jurisdictions - P2P Ride Sharing DAO
A decentralized ride sharing system is created that can compete with Uber. The business logic of the system is implemented on Ethereum and encapsulated by a DAO. When the DAO was brought into existence it had no funds, but then automatically sold voting tokens in a crowdsale and used the monies raised to fund additional R&D. Once the system was operational, some voting tokens were also dispensed as incentives to the first drivers providing rides, and token holders continuously vote on proposals to update and improve the business logic. Voting token holders receive a small share of the revenues generated by the provision of rides.
Whereas Uber takes a 28% cut of revenues, the DAO only takes 1%. - Identity Management DAO
Business logic is created that maintains a list of persons granted some authority in the real world who are identified by cryptographic public keys (public keys enable people to create cryptographic signatures that only they could have created). The list may be updated by a supermajority of list members, for example using multisig.
No investment funds or voting tokens are involved.
So why are DAOs better?
There are two answers to this question. The first is a technical one, and derives from the special properties that smart contracts and blockchains provide. The second is much more profound and not at widely understood — the big picture that is going to dramatically change the world.
So to cover off the semi-obvious first answer: the implementation of organizations and business processes using smart contracts promises to provide enormous efficiency gains. Andreessen Horowitz, the well known venture capitalist, likes to say that software is eating the world and DAOs take that idea to a whole new level. Moreover, they can allow people around the world to collaborate within organizational frameworks without the enormous bureaucracy that would otherwise be needed to create trust and ensure correct behavior. These things would not be possible using normal software and servers. Smart contracts running on blockchains change the game by providing for creation of systems that are tamperproof and transparent and guaranteed to run as expected and, because they are “autonomous”, exist independently of the support or wishes of any real host that would otherwise also have to be trusted (and might be regulated or taxed).
This simple extension of software already provides a enormously compelling reason for DAOs. But the bigger picture relates to globalization, and to outdated legacy bureaucratic and regulatory systems that are bursting at the seams.
Globalization and the challenges of regulation
In the past year my general work in decentralization has taken me all of the world, and this, together with my more specific focus on open chain finance, has highlighted three things:
- We need global rails
Our world is becoming increasingly globalized yet there remains no efficient way to create global businesses and systems. Part of the challenge is that each geographical area often has its own regulatory systems and bureaucracies that must be addressed. In some areas of business, conflicting approaches to regulation make it extremely difficult to create international enterprises without huge investment. - Regulatory and bureaucratic systems are often not fit for purpose
That is, oftentimes regulation and bureaucracies no longer serve the best interests of humanity despite the the beliefs and desires of those operating them. This is especially true where large amounts of money are at stake. They often create barriers for new entrants and perpetuate harmful monopolies that then extract rent from the world’s citizens with justifications including that they “protect jobs” and “deny access to terrorists”, which on closer analysis hardly ever bear scrutiny. - Intractable human factors make it impossible to meaningfully reform bureaucracies in a timely way
Powerful industries nurture extraordinary access to government and can exert enormous influence by lobbying and providing support to politicians (Goldman Sach’s payment of $225,000 to Hilary Clinton for a short speech, and the $21.6 million dollars she collected for making other speeches in just 3 years provides a glimpse into how relationships can be nurtured completely legally). In this system, regulators often draw their officers from the very industries they regulate perpetuating elitist self-serving systems. For these reasons, it is unrealistic for those wishing to introduce truly disruptive new systems to press for wholesale regulatory change — it would take more than a lifetime’s work to achieve. Where international systems are involved the situation is equally difficult because competing national and regional interests ensure changes can only be negotiated extremely slowly.
Those seeking evidence of how big business is leveraging regulation and bureaucracy need look no further than America where there has been a remorselessly growing concentration of profits in ever smaller numbers of giant firms, small company creation is at its lowest levels since the 1970s and entrepreneurs are being suffocated by red tape. A recent article in The Economist did a fantastic job of exploring the issue, starting with the sentence “AMERICA used to be the land of opportunity and optimism…”
- Article http://econ.st/1Ssad2X
- Profit concentration stats http://econ.st/1ooHT6O
How decentralization can provide a breakthrough
Imagine for a moment if systems and business logic could be created in the decentralized cloud in a manner that transcended regulation — and I ask you here to suspend disbelief for just a moment, and just imagine. Venture capitalists and entrepreneurs would rejoice. In the early 2000s cloud computing made it possible for small technology startups to introduce new systems such as social networks, chat applications and source code repositories and then simply scale out hosting operations as demand grew without massive prior investment in equipment. A decentralized cloud with the properties mentioned might provide a means for startups to unbundle heavily regulated monopolistic industries and drive real disruption. Moreover, such a platform would enable startups to scale out internationally far less expensively since the regulatory burden of entering new territories would be eased. In short: this would be the cloud on steroids.
How then might such magical properties exist in practice? To understand, we need to look more closely at what open decentralized networks such as Bitcoin and Ethereum really are. Both of these systems manifest as stateful protocols running autonomously between computers on the Internet without controlling computers or organizations. The protocols are “stateful” because by broadcasting protocol messages we change the response to future messages — for example, trivially when once someone broadcasts a transaction to spend a bitcoin a subsequent broadcast of the same transaction will have a different effect. In Ethereum, we can broadcast transactions to upload smart contracts, and then more transactions to interact with them. Although the functionality is more complex, the fundamental nature remains and when we upload and interact with smart contracts we are really just extending the underlying Ethereum protocol.
In this Satoshi gave us a critical advance: regardless of inclination, regulators and bureaucracies cannot regulate and control systems that run freely runs as stateful Internet protocols between computers. For this reason, although many governments, monopolies and bureaucracies around the world dislike Bitcoin, it remains in action. Since the protocol approach is generic it can be refined and extended.
Nonetheless, the experience of Bitcoin shows that decentralized currency alone is not enough. Regulators can of course turn their attentions to exchanges that govern people’s interactions with the system and moreover, and much more importantly, when startups try to build higher level financial systems on top of Bitcoin’s currency system they find themselves subject to regulations in the jurisdictions in which they operate greatly diminishing the advantages Bitcoin’s decentralization can bestow. The leap provided by Ethereum’s “world computer” approach is that now complete higher level systems can be implemented as protocols, which is a game changer.
To better understand why this is so, we will go back to our hypothetical decentralized P2P Ride Sharing DAO, and consider how the system might take on Uber…
How a Ride Sharing DAO could win
Let’s imagine that the central business logic our P2P Ride Sharing system, which we shall call D-uber, is encapsulated as a DAO written using smart contracts on Ethereum. The core DAO organization framework might go live before the system as a whole with a crowdsale of its voting tokens to raise funds from a worldwide community of tens of thousands of crypto investors for R&D then used to develop smartphone clients and technological paraphernalia and media for purposes such as marketing. Investors in voting tokens thereafter help the DAO make decisions by voting on proposals to update smart contracts that add features or address issues, pay external contractors or modify key operating parameters, and in return receive a share of revenues generated as remuneration for their services.
In the completed system, separate smartphone applications are provided for those offering rides and those seeking rides. In contrast to the Uber system, these do not talk to servers operated by some company, but interact peer to peer through smart contract logic provided by the DAO running on Ethereum. This provides a critical advantage since there is no central point of control, and those wishing to attack the system or extract rent must direct their attentions towards the multitudinous and difficult to identify end users.
Upon launch, the DAO examines proposals for the first territory where efforts should be made to find users. Eventually, a proposal to target a city called Gotham wins. Gotham is notable because the Uber’s high powered management team spent millions of dollars negotiating with local municipal authorities and unions to gain licensing — providing the basis for the extension of the taxi monopoly to include them. Next the DAO adopts a proposal to pay early adopter drivers voting tokens as rewards, and D-uber’s DAO evangelists start taking rides on Uber to spread the gospel.
Their message is simple. Uber has spent billions of dollars negotiating with regulators, bureaucracies, unions and other incumbent taxi defending monopolies worldwide to gain access to markets, and for this reason needs to consume an ever increasing slice of ride revenues to pay down its investments. In the San Francisco bay area for example, Uber takes 28% of ride revenues. The difficulty for drivers is that they must also pay for their own cars, fuel, insurance and other things, such that Uber’s slice reduces their net profits to almost zero. For this reason, during the 2016 Super Bowl in the area, Uber drivers planned a strike to make their anger felt in the most visible way they could. D-uber by contrast takes only 1% from ride revenues, which will be distributed among voting token holders as remuneration for voting services. Drivers immediately realize that the system can increase their net profit per ride by orders of magnitude.
Driven by a worldwide community of token holders in the D-uber DAO who have become its ardent evangelists, the system starts to gain a foothold, slowly at first and then more quickly, at which point Uber and the parties they negotiated with call foul. It is undeniably better for drivers to earn more money and for riders to get cheaper rides, so the “safety” of the system is attacked because the drivers aren’t licensed. While this has some effect, riders quickly realize that smart contracts based reviews of drivers (and the reverse) are far more reliable than those managed by large companies where bad reviews are deemed bad for business and often deleted after complaints. Upon seeing their growing success, soon the DAO is voting upon proposals to expand in other cities, other states and other countries, assisted by its enthusiastic token holders. The press begins to take notice, and controversy fuels growth. The genie is out of the bottle and the world moves to a P2P ride sharing model where there isn’t a rent seeking intermediary sitting between drivers and riders — the old taxi monopolies, their supporters, and Uber, have been disintermediated.
This hypothetical example illustrates how the removal of a regulable center can create breakthrough decentralized businesses that can take on monopolistic industries and succeed by avoiding and reducing costs. Furthermore, we can see how a DAO framework allows an autonomous software entity to make business decisions, make payments to arbitrary external entities (in this case, voting tokens are provided as incentives to new drivers), update and develop its software and business logic, and leverage a worldwide network of tens of thousands of voting token holders as evangelists.
Financial DAOs
The financial industry is one of the most heavily regulated and monopolistic industries in existence. Regulation does exist for good reason — history shows that wherever air is provided, financial scammers and bandits soon gather. Nonetheless, over time the financial regulatory system has become a Frankenstein’s monster and now maintains a status quo in which society is exploited by rent seeking monopolistic giants. For example, in Europe and the US the major banks can trace back their histories hundreds of years and yet, despite the banking business providing means to generate enormous profits, no significant startup ventures have managed to dent their hegemony. The apogee of the inherent problems came with the 2007–2008 financial crisis. Greedy banks securitized loans that should never have been made, leveraging their crony system to have them rated AAA by credit rating agencies and selling them to pension funds where they could be swapped for ordinary people’s retirement savings, among other misdeeds. The US Treasury estimated total losses to household wealth caused by the crisis at $19.2 trillion (see http://1.usa.gov/1TkOXww).
What then if open chain decentralized systems can provide alternative financial solutions, which depend more on cold hard smart contract logic than regulations to provide security while also providing more advanced services at lower cost? String spends its time examining exactly this type of system, and hopes to unbundle many financial functions using approaches that are somewhat analogous to the D-uber example given. We are not yet ready to announce what our first systems will be, so in the mean time let’s examine the extraordinary unfolding story of The DAO. It’s launch is an epoch defining moment in the history of the Internet — and I would argue economics and politics too — that both shines the light forward and draws attention to the kinds of challenges we still face.
