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DAOs and How They Work

By Matthew Zeitlin · October 13, 2021 · 4 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

DAOs and How They Work

One of the strongest trends in technology has long been decentralization — from the creation of the internet connecting academics across the world, to the world wide web providing a platform for strangers to connect with one another. The advent of cryptocurrency has spurred another round of decentralization, the decentralized autonomous organization, or DAO.

What Is a DAO?

Decentralized autonomous organizations (DOAs) are innovative and potentially promising models for bringing blockchain technology to new areas of organization, beyond issuing and transferring value across the blockchain (aka currency). For example, DAOs could be used to develop blockchain in insurance or blockchain in real estate.

The goal of DAOs is to remove expensive and time-consuming processes and democratize how organizations are conceived and run, by doing everything in code. DAO stands for:

•   Decentralized: This means no one person or group is in charge of the organization by virtue of a title. Instead, decisions are made by the members of an organization by virtue of how big a stake they have in it.

•   Autonomous: The DAO is run entirely according to its smart contracts and the decisions of its members.

•   Organization: DAOs can still act as a single entity, producing things and acting on behalf of all its members.

While DAO typically refers to projects using Ethereum (aka Ethereum DAOs), some scholars have suggested that Bitcoin itself is a DAO.

It’s important when discussing Ethereum DAOs or DAOs in general not to get them confused with “The DAO,” a group that raised money to invest in cryptocurrency projects. The organization was hacked and more than $50 million of about $160 million worth of Ethereum raised was stolen.

How Do DAOs Work?

While there have been procedures for more open and democratic organizations for as long as people have been gathering to make decisions, DAOs are an innovation that specifically hinges on blockchain technology.

DAOs are typically built on top of the Ethereum blockchain, which supports the second-most popular and valuable cryptocurrency in the world and is designed specifically to support “smart contracts” or agreements that execute automatically and don’t require third parties to enforce.

Imagine a traditional organization as a bundle of contracts and agreements between the members: an employment agreement specifies what an employee is supposed to do in exchange for pay, contracts with suppliers, loan terms with banks, and so on. These contracts all need to be specified on paper and their execution can be up to third parties and legal systems to oversee. For the DAOs, these are problems to be solved with code.

How Are DAOs Funded?

Typically DAO contracts are also set up for the sale of a token, as a way of raising money for the DAO and for establishing who gets to be involved in the decision-making. Token holders vote based on a process specified and executed in the smart contracts themselves. The idea is that token holders will want to maximize the value of their tokens, thus ensuring the DAO does not work to the advantage of any one employee or group, but instead to the token holders as a whole.

DAOs: Pros and Cons

Pros

Cons

Change always happens by vote Can be hard to turn around in a crisis
Transparency through open-source Organizational discretion is difficult
Smart contracts avoid after-the-fact tinkering with agreements If contracts and code are poorly written, can be hard to change without consensus
Organizational roles specified in code Makes taking on responsibilities beyond what’s specified in code difficult
Decentralization means everyone in the organization is responsible for the organization’s decisions Lack of accountability for any one individual, like a central leader or chief executive
Open source means more eyes on critical functions and the best ideas rise to the top Legal ambiguity could make decision-making difficult or force DAOs to engage in more centralized, traditional behavior
Everyone involved in decision-making has a stake Token-based decision-making can make consideration of other stakeholders’ interests more difficult

Examples of DAOs

There are a variety of DAOs in operation right now. These are some of the well known ones.

MakerDAO

MakerDAO is one of the most prominent uses of the DAO structure and one of the most popular DeFi (or decentralized finance) projects that could serve as an example of how to use blockchain in the finance industry. MakerDAO produces a token, known as Dai, that has a steady $1 U.S. value and is used for financial products like loans. There’s also the MKR token, which is for governance of the overall project. This means that holders of MKR can “vote on changes to the protocol, like the addition of new collateral assets and protocol updates.”

Recommended: What is DeFi? Guide to Decentralized Finance

Augur

Augur is an Ethereum-based prediction market, meaning it allows people to place bets on events in the future. The platform is a bundle of smart contracts and OracleDAO was created to assist with its development.

Uniswap

Uniswap is a decentralized cryptocurrency exchange specifically for “ERC-20” tokens with a governance token called UNI. ERC-20 is a standard on the Ethereum blockchain that is used for applications and services built on top of Ethereum. In the ongoing dispute between centralized vs decentralized exchanges, Uniswap is decidedly on the side of the latter.

How to Invest in a DAO

Investing in a DAO isn’t that different from buying any other form of cryptocurrency. Here are the simple steps to do it.

1.    Have a wallet. A crypto wallet is a software program or hardware and software system that allows an investor to safely and effectively store and trade cryptocurrencies including tokens issued by DAOs.

2.    Do your research. There are new crypto projects starting every day. It’s important to have a detailed understanding of what the developers of the one you’re interested in are attempting to do, and that you are well aware of whatever rights you gain by investing in a DAO and purchasing a governance token.

3.    Find an exchange. Some exchanges host tokens, including MKR, which can be bought and sold using their tools. Uniswap, for example, hosts token exchange.

4.    Be an active participant. Study how governance works in the DAO you’ve invested in and be a conscientious and energetic participant.

The Takeaway

DAO stands for decentralized autonomous organization. In such organizations, there is no one person or small group of executives making decisions — instead, anyone holding tokens issued by that DAO has a say in policy and other organizational matters.

For investors ready to jump into the crypto world, or those looking to expand their crypto holdings, SoFi Invest® offers cryptocurrency trading in dozens of crypto like Bitcoin, Litecoin, Cardano, Dogecoin, Solana, Enjin Coin, and Ethereum, whose blockchain is the basis of smart contracts and DAOs.

Find out how to get started with SoFi Invest.

Photo credit: iStock/Pekic


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