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The Inefficiency Trap of DAOs

#9 Governance Series

The popularity of DAOs has grown enormously over the recent years. However, all that glitters is not gold. There are inefficiencies of DAOs and vulnerabilities that are frequently overlooked and unmentioned. Let’s explore.

DAOs are types of decentralized organizations which incentivize users to engage in activities in order to further their business objectives; they enable individuals to work together while minimizing trust and maintaining censorship and coercion resistance.

To facilitate this, DAOs require varying layers of complex smart contracts, organizational structure and governance. Due to these requirements, a DAO is exposed to many vulnerabilities and inefficiencies. Many such DAO vulnerabilities have been mapped out by Kelsie Nabben in her article “DAO vulnerabilities: A multi-scale DAO ecosystem mapping tool towards computer-aided governance”.

There are consequences of decentralized decision-making and how it is conducted. For example, at present many DAOs feature a form of plurality voting. This leads to situations where majority rule leads voters to compromise the lowest common denominator, which in turn may create suboptimal outcomes. Although efficient, it lacks the depth of consensus-type models or hybrid decision-making processes.

The structure of an organization affects this decision-making process; for example the “flat” nature of MakerDAO and its lack of hierarchy may contribute to its encumbrance, along with its lack of a shared goal or objective. However, simply implementing a hierarchy will not necessarily remedy this; there is a nuanced interplay between many and varied factors. Diverse views on this topic can be seen in MakerDAOs recent “governance from first principles” forum post.

Governance from first principles
Governance from first principles

To better understand DAO inefficiencies let’s explore their limitations. We can summarize these limitations into three.

Path Reliance

Many DAOs suffer from a forking or copying phenomenon; they fork/copy structures and processes rather than creating or iterating specific designs to suit their own unique needs. This may come in the form of not only governance but also tokenomic design and any number of other areas. The common denominator for DAO tokens currently seems to be the intent to increase DAO token value. For this reason the performance of any given DAO is evaluated through value optimization and not on governmental processes and other areas.

The prioritization of value can disrupt the efforts of token holders and contractors and their work towards a common goal (providing one has been established). This disruption is caused by the constant need for value extraction as a result of short-termism.

Regulatory Concern

Another major limitation has been created by regulatory uncertainty. Following “The DAO”s interaction with the SEC in 2017, the SEC released a statement that federal security laws apply to those who offer and sell securities in the US, regardless of the issuing entity, regardless of the form of value used in the transaction of purchase or sale, and regardless of their method of distribution. Currently the SEC is attempting to apply the Howey test to the emerging digital economy.

The Howey test
The Howey test

The Howey test determines whether an instrument qualifies as an “investment contract” for the purposes of the Securities Act: “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

Another regulator problem is jurisdictional. Depending on the applicable jurisdiction, a DAO participant could be held legally liable for the DAO, if the DAO is malformed and does not have an official legal entity off-chain.

It is important to note that no US statute authorizes the creation of a legally distinct entity in the form of a DAO. By interacting with a smart contract, DAO members combine their efforts and resources in the pursuit of a certain goal; this satisfies the legal definition of a partnership. As such, DAO participants may potentially be held liable for all debts, obligations and other liabilities of the partnership.

We have seen a number of groups create a foundation which operates an LLC. This LLC will then be the only party liable for debts, obligations, or other such liabilities. We may observe it serving as a “liability shield”. Furthermore, there has been consideration and use of legal anchors because of how lawyers may analyze systems and apply jurisdictional principles. Examples could include “The DAO” registering as a SARL in Switzerland or Tokemak’s foundation registering in the Cayman Islands.

Incentive Designs

Human engagement on its own or via any effective machine derivative requires incentives in order to overcome opportunistic attempts of internal and external constituents gaming the governance system. These rewards must adequately incentivize participants to improve their utility, while concurrently being of benefit to the DAO in relation to its long-term health and success.

When fungible assets are utilized and distributed as the dominant form of incentive design in DAO governance, the actors, rational or otherwise, both internal and external will, on trend, attempt to corrupt and profit towards their own aims, to the detriment of the DAO or application.

Many of these corruptive elements may be reduced through the use of third parties, non-fungible tokens, merit identifiers, proof of personage, etc.

Closing Thoughts

Decentralized applications depend on dynamic governance and are subject to the same fundamental principles that any organization is. Best practices, standards and framework compatibility have yet to be established. When regarding DAO inefficiency, the above should be considered along seven key fundamentals:

  • Suffrage is the right to participate. Those granted suffrage may take part in decision making procedures. It may be divided into active suffrage, the right to vote, and passive suffrage, the right to stand and become an elected representative

  • Pareto efficiency. Alignment of the intentions between decision-makers and community-members is not just a question of suffrage and accountability. Pareto efficiency refers to a situation where no individual or preference criterion can be made better off without making at least one individual or preference worse off

  • Confidentiality. When considering confidentiality it is best to first make the distinction between secrecy and pseudonymity. It may be true that true secrecy is difficult to accomplish on a decentralized project or protocol, and more so on a blockchain

  • Verifiability is a crucial component of any governance system, it ensures the legitimacy.

It can be divided into:

  • Individual verifiability — the voter may audit their own voting data to ensure it has been correctly created, stored and tallied

  • Universal verifiability — everyone can audit the votes recorded and verify that they were imputed by eligible voters, properly created, stored and tallied

  • Accountability. A term used to imply that some actors have a right to hold other actors to a set of standards and values, to judge whether they have fulfilled their responsibilities, and impose sanctions if those responsibilities have not been met

  • Sustainability differs from accountability in that it rewards development and participation without regard to outcome. The incentives put in place to satisfy the two factors of sustainability can be considered the cost of engagement which leads to more contributions, proposals and voter participation

  • Liveness. To be able to satisfy liveness a blockchain or protocol must be able to adapt to urgent issues through a decision-making process that allows for termination within a reasonable timeframe, according to the urgency of the matter in hand. Expedient decision-making is highly desirable

At StableLab, we recognize the complexity and interplay of the above-mentioned limitations, the key fundamentals and the domains they must satisfy. By providing impartial, professional and tailored support, we help to optimize any given DAO or project by reducing these inefficiencies and vulnerabilities.

Get in touch,
  • If you would like to support us in our governance efforts,

  • If you and your team need guidance on governance related matters, or

  • If you are a founder who is building something interesting in web3


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