University of Miami business technology professors researching the emerging digitalized, decentralized finance and governance system highlight its potential and the vulnerabilities that heralds the newest generation of the web.
Many experts in the information technology field suggest that we are amid a generational change, transitioning toward Web3—a new iteration of the web defined by permissionless, collective governance and decentralized finance that will allow people to be connected anytime and anywhere.
Robert Gregory, associate professor of business technology, and Ola Henfridsson, Schein Family Endowed Chair and also a professor of business technology at the University of Miami Patti and Allan Herbert Business School, together with other colleagues are investigating a foundational facet of this proposed new governance system: the decentralized autonomous organization, or DAO.
This human-machine system touts greater transparency and tamper-resistant transactions in the financial domain, yet no new technology emerges in flawless fashion and this decentralized financial system has proved particularly vulnerable to hackers, especially in its nascent stage. Chainalysis documented 125 crypto heists for 2022, with losses totaling more than $3 billion—a record year, according to Forbes magazine.
In their research project, "Skin in the Game," the business technology professors assess the potential and vulnerabilities of the DAO. Gregory answers a range of questions regarding this emerging governance paradigm.
What is a DAO and what are the critical factors of its operation?
A DAO is a type of organization that operates on a blockchain—a decentralized, distributed digital ledger that records transactions across a network of computers. The "end goal" of a DAO is to be fully decentralized and run autonomously without the need for human intervention or control. Its proponents suggest that DAOs provide a more open and democratic way for people to organize and collaborate.
Key to the DAO's operation are its governance mechanism, transparency and immutability, and the voluntary contributions of community members to facilitate coordination and execute tasks.
For governance, members participate in decision-making and allocate resources. Members accumulate tokens that represent voting power in the organization, and decisions are made via token-based voting.
Since all transactions are recorded on a public blockchain, anyone can view the organization's operations and transactions. This transparency serves to ensure that the organization operates fairly and that all members are held accountable for their actions.
Similar to open-source initiatives, DAOs encourage free thinking and individual initiative to make improvements to the organization and to sustain voluntary participation in an autonomous way.
What prompted the emergence of DAOs?
The emergence of DAOs is rooted in the larger movement toward decentralization in the technology space, the transition from Web2 (characterized by social media and participation on the web) to Web3, and the resistance against centralized platforms that act as data aggregators and control users.
Decentralization, where control is distributed across a network of individuals or nodes, offers several advantages—such as increased security, transparency, and trust, as well as the reduced need and costs of intermediaries, according to its advocates.
For what are DAOs best suitable?
The role that DAOs play in society is still evolving, but they have the potential to play a significant role in shaping the future of how organizations operate and how people collaborate and create positive change in the world.
DAOs can enable global collaboration and coordination, without being limited by geographic or political boundaries or the boundaries imposed by the design of centralized platforms that operate only in certain markets. For example, a DAO could be created to fund and manage a global public goods project, such as building a new open-source software platform or funding a renewable energy project.
By utilizing blockchain technology and smart contracts, DAOs can automate many of the functions that are traditionally performed by intermediaries, such as banks, governments, and nonprofits. This can lead to lower costs, increased efficiency, and greater transparency in many industries.
What are the incentives for a DAO to function effectively?
Incentives for a DAO to function effectively can be provided through a mechanism commonly referred to as "skin in the game." This means that participants in the DAO have a financial stake in the success of the organization, which incentivizes them to act in the best interests of the DAO.
In a typical DAO, for example MakerDAO, members may be required to hold a certain amount of cryptocurrency or other digital assets to participate in decision-making or to receive a portion of the rewards generated by the DAO's activities. By holding these assets, members have a direct financial interest in the success of the DAO, which incentivizes them to act in ways that benefit the organization as a whole.
Another key incentive for a DAO to function effectively is the potential for reputation and status. In a decentralized organization, members are often identified by their public addresses or usernames, which can be linked to their contributions and activities within the organization. This can create a sense of competition among members to be recognized for their contributions and to build a strong reputation within the community.
In what ways does a DAO prioritize security that protects against theft?
Blockchain technology, which is secured by cryptographic algorithms and smart contracts, helps to prevent fraudulent activity and ensure that all transactions are recorded on the blockchain. Multi-sig wallets, another safeguard, require multiple signatories to approve a transaction before it can be executed.
Code audits aim to identify potential security issues in the smart contracts or other technical aspects of the platform. DAOs also have emergency protocols—measures to freeze or shut down the DAO—in the event of a security breach or other critical issue.
Ultimately the mechanism of decentralized governance, where multiple members participate in the DAO decision-making and oversight process and are collectively motivated for its success, limits fraud and collusion among members.
What are the key findings of your research on DAOs?
We initially believed DAOs to be fully decentralized and autonomous, as the name would suggest. Our assumption was reinforced by presentations at Bitcoin/crypto conferences, Bitcoin meetups in Miami, and many other informal conversations we conducted with crypto enthusiasts.
However, empirical investigation revealed that DAOs are never fully decentralized. Instead, they strike a balance between centralized and fully decentralized or community-based governance, and the governance structure we observed in our research resembles more a polycentric structure.
This means that there are multiple autonomous decision-making units in a DAO that each accumulate and aggregate massive decision-making power and influence through token ownership. Furthermore, actors in a DAO are also investors and so can buy themselves significant voting power if they have the financial resources and means at their disposal.
As a result, we observed that "whales"—large token holders—heavily influence the direction, purpose, and operation of a DAO. Thus, the promise of DAOs to be a newly democratic and equitable form of organization is true only to an extent: The dynamics of investment and large-token holders wield massive influence on the democratic processes within a DAO.
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