The Internet as Coordination: A Primer for DAOs

Dao's have become ubiquitous! We explore their history, utility, and future ideas in this primer.

Hey! We’re SmallStep, and we’re trying to use first principles thinking and scientific expertise to explore and write about different ideas, build long term theses, and sometimes invest in cool public companies and startups.

We’ve had 40 folks join our small, but growing community since our last post, and we’d love to have you along for the ride too! Subscribe here

For more than a year now, DAOs have been all over the news, and have almost become ubiquitous across the various tribes and countries that exist in Web3. We’ve seen both reality bending initiatives and absurd scams form, and have participated in a few of them ourselves. But the nature of DAOs holds a lot of promise beyond some of the interesting applications seen in 2021, and we wanted to share an accessible primer for anybody to get an idea about DAOs and also see where some of the exciting work is.

DAOs had a Rocky Start

Distributed Autonomous Organizations first entered the public attention in 2016, when an organization called The DAO raised over $100 million US dollars via crowdfunding.  A DAO is a distributed, collaborative initiative that is collectively owned, operated and governed. The DAO was a radical new type of organization, one with a totally flat hierarchy and managed by smart contracts that could execute logic necessary to the operations of the structure. It was able to win over this much support because of its mission, the mission of being a hub to disburse funds to projects. Unlike a traditional investment system however, decisions on fund allocation would be performed by the stakeholders in the DAO instead of central directors.

Despite this promise, The DAO is most famous for its spectacular failure. In June of 2016, security vulnerabilities in the code of the smart contracts were exploited during an attack, causing ether equivalent to $50 million dollars to be siphoned off into an external account. This attack forced the creators of Ethereum to carefully consider what to do next, and after heated debate, they decided to produce a “hard fork” to preserve the value of the Ethereum token. To many, this was a brutal violation of one of the central principles of decentralized structures, to have a central authority artificially manipulate the value of a token.

Major forks in Ethereum blockchain over the years from Visual Capitalist.

Why are DAOs important?

Five years have passed since then, and though the lessons that the collapse of The DAO taught the decentralized finance (DeFi) world were bitter, the promise of the original mission of The DAO remains valid. Last year is often called The Year of the DAO because of how much these types of structures exploded in popularity and mainstream awareness. So because a DAO is essentially an internet community with a treasury and a governing smart contract, there are a plethora of missions DAOs have the potential to tackle. There are DAOs for grants, investing, creating protocols, collecting, media, social activities, services, etc. And anybody can join, provided you are willing to purchase a stake.

A Look at How DAOs Work

The core functions of a DAO are carried out by the smart contracts. All of the rules of the DAO and all of its administrative functions, such as voting, are performed by this contract. A smart contract is a contract written to the Ethereum blockchain which can perform some computational operations. Perhaps most importantly, these smart contracts, their code, and the records of the decisions made are all publicly available ensuring transparency and accountability. DAOs are made in the following order:

  1. Founding members write a smart contract that is public.
  2. This contract is written to the blockchain of interest, usually the Ethereum blockchain.
  3. Then the DAO is funded, usually by selling tokens for the blockchain coin like ETH. Those who purchase the tokens are given voting rights in exchange for their trust in the DAO.
  4. Once funding is complete, and tokens are distributed, the DAO goes live and cannot be modified except via token-holder consensus as described in the initial smart contract.

After the last step in this process, the DAO has the funding and the participant engagement to begin its core mission, whatever that may be. The reward structure is in place because cryptocurrencies with defined value, like Ethereum or Bitcoin, are now tied into the system. The tokens of the DAO then have real value associated with these coins.

A timeline of the creation process of a DAO

A Look into the Ubiquity of DAOs

How much value is currently in DAO tokens?

Currently the market capitalization, the amount of US dollars tied up in an asset, of DAO Tokens is around 23 billion dollars. We can view market capitalization as being a measure of the effect of DAOs on the market as a whole. The top 5 tokens have market caps in the billions, with Uniswap leading at around 8 billion and Aave, Maker, Curve DAO Token and Dash being around 1-2 billion each.

The most popular DAO is Uniswap, which is a protocol DAO focused on being a decentralized crypto exchange. It allows you to add a Factory contract for your token, which can then create new Exchange contracts that hold a pool of the token and a pool of ether for users to trade against. The factory contract will check if an exchange contract already exists which has a pool of a given token, and if not then it will create one. So anybody can add a token to Uniswap for trading.

Uniswap also differs from a centralized exchange, because it doesn’t need an order book to derive the price of an asset. On Coinbase Pro, the price is determined by an order book kept by Coinbase which records where the highest price of the buyer and the lowest price of the seller meet. This requires consensus between humans, and so it can’t be instant. Uniswap uses the aforementioned exchange contract to determine the price. You trade in your token to an exchange contract for ether. The remaining amount of ether compared to the remaining amount of the token will automatically determine the price.

Example of a simple market maker equation used in Uniswap. Taken from Ethhub.

Aave, Maker, Curve DAO Token and Dash are the next most valuable DAOs in terms of market capitalization. A brief look at what each of these DAOs are:

  • Aave: This DAO is a decentralized lending protocol that allows integrations with numerous other Decentralized Finance (DeFi) apps. But Aave became most famous for “flash loans” , a method by which one can get an instant loan with no collateral, provided they can repay it within one ethereum transaction. Flash loans are new, but are being used to avoid the volatility of cryptocurrencies by instantly swapping a crashing asset for a more stable one.
  • Maker: Maker is a DAO that created Dai, the most popular stablecoin. Stablecoins are tokens that are linked to an off-chain stable asset, like the US Dollar. Dai specifically is linked to the US Dollar and therefore serves as a base for loaning and other DeFi applications that need stability or collateral. MakerDAO was started in 2017, and is one of the oldest DAOs and DeFi projects out there.
  • Curve: Curve serves a similar function to Uniswap, it serves as a crypto exchange that utilizes market maker equations to avoid the need for order books. However, Curve marks itself as different by only allowing similar asset classes to be traded against each other. By doing this, Curve can offer the lowest fees and slippage, which means the difference between expected trading price and actual trading price.
  • Dash: The promise of Dash is simple. It’s a coin whose transactions can be verified in seconds, making it orders of magnitude faster than other less efficient coins. This speed does two things, it makes Dash behave more similarly to cash in face-to-face transactions, and it makes Dash much more scalable.

DAOs in the Zeitgeist

Although The DAO created waves in the crypto community several years ago, awareness of DAOs really entered the popular viewpoint in 2021. Several news articles, explainers, and other forms of output were coming from mainstream media in 2021, likely because DAOs were finally starting to directly interact with and compete with more conventional structures.

Notable purchases by DAOs seem to make headlines, which makes sense, as purchasing expensive things is typically flashy. But outside of the US, DAOs like MakerDAO are gaining popularity, as they can allow crypto-savvy people to invest their savings into stablecoins like Dai. This lets them dodge the volatility of their own country's currency, which is oftentimes not nearly as stable as the US Dollar.

Attempt to purchase the US Constitution creates headlines in the BBC.

Why is DAO Activism Important?

Although the most popular applications of DAOs are in DeFi, they can also be used to make an impact on the world in a similar way charities or foundations do. DAO activism is a new and exciting phenomenon in the world. The decentralized, transparent, and autonomous governance of funds ensures that, in principle, DAOs are less susceptible to corruption than charities or other groups.

DAOs ensure trust between strangers by way of their smart contracts. In the same way as previously described, these smart contracts that DAOs are based on are fully public and visible. The contracts also handle the allocation of funds automatically, according to the rules laid out by the founders and amended by the shareholders if need be.

In the case of a charity, typically a donation does not carry any voting power with it. A centralized institution which may or may not have transparent practices will use your donation for their mission. Because of this centralization and lack of transparency, charities notoriously run into corruption issues. Now there are metrics to determine whether a charity is worthy of donating to, such as rankings or watchlists. But even if you find a good charity to donate your money to, you typically do not have a say in how that charity is run.

DAOs are different, as their method of fundraising involves selling their tokens. By purchasing the token for a coin with external value, like Ethereum, you put that coin into the DAO treasury. What you gain in return is a token representing stake and voting power in that DAO. Based on the rules set by the founders, that voting power allows you to play a part in deciding on DAO decisions as well as amending the smart contract.

After the initial fundraising, once the DAO is live, tokens can be distributed for performing acts in line with the mission of the DAO. This means activist work can be directly rewarded with tokens in the DAO, and if it is a successful DAO, then these tokens will have significant exchangeable worth with fiat currency like the US Dollar.

Example of charity-based DAO structure taken from Big Green DAO Lite paper.

Other Interesting DAOs Worth Watching

So DAO activism is pretty different and important. Although there are an uncountable and growing number of DAOs in existence, we will do our best to shed light on some of the amazing work being done out there in mission based DAOs that are not DeFi related:

  1. Proof of Humanity DAO - This DAO creates a registry of known humans based on currently existing paperwork, and provides decentralized universal basic income. Very interesting, as putting verified identities on blockchain could prevent identity theft or fraud.
  2. Opolis - Provides regular payroll and employment benefits to freelance workers or gig workers. Interesting way to provide a compromise between the two worlds, the freedom and flexibility of independent work and the regularity/dependability as well as the benefits of corporate work.
  3. Lex DAO - A group of “legal engineers”, many of whom are attorneys, who seek to codify a large portion of legal services. I see this as a perfect application of crypto philosophy, as legal services are so complex and so labor intensive, riddled with massive delays. Codifying it, wrapping up a lot of it in instant smart contracts etc. would help modernize the legal system in the US. But a lot of this shakes down to how crypto regulation plays out over the next few years.
  4. Klima DAO - Klima DAO is an environmental activism effort. Its goal is to encourage emissions cuts by pushing up the price of carbon assets. It does this by buying up carbon credits and hoarding them, and the more of these it does the higher the price of carbon credits become. In theory, this lowers the amount of carbon emissions companies can legally emit, or at least makes it more pricey for them to do so.
  5. Diatom - This DAO aims to clean plastic out of the oceans. Each of its tokens is backed by 1 USD, which makes it a stable investment should any readers be interested. And it directly rewards plastic removal from the ocean with its token. The DAO also sells NFTs of whales which fund the creation of their token. Owners of these NFTs gain special discounted pricing of the token.

Closing Thoughts

In summary, DAOs have potential beyond DeFi applications. As organizations, they have the potential to disrupt the role charities and foundations have traditionally provided, without incurring the potential issues of centralization and lack of transparency that charities may have. 2021 saw an immense uptick in the market capitalization of DAOs, the sheer number of DAOs, and the larger world’s awareness of DAOs. After 5 years, the wounds left behind by the failure of The DAO have largely healed, and its promise has been realized. Not to say that security vulnerabilities don’t exist with DAOs that currently exist, they will always exist and we as a community should always be aware of that. But the promise of a vibrant world of decentralized organizations, united by a common cause and bound by automated governance that doesn’t decide to embezzle money is beginning to realize its form. We’ve listed some of the most interesting DAOs that we’ll be keeping our eye on, but if you’d like to find some of your own, feel free to check out DAO discovery tools like The DAO Jones Report!

Subscribe to SmallStep Capital 🚀

Don’t miss out on the latest issues. Sign up now to get access to the library of members-only issues.