HashKey Cui Chen: Discussing the governance goals, methods, and potential issues of DAO

This article is sourced from ChainNews, authored by Cui Chen, who works at HashKey Capital Research.

The concept of distributed autonomy predates blockchain technology by far, as evidenced in nature, with ants, which have a history of millions of years, passing down knowledge in this manner. Ant colonies have no central leadership; each worker ant makes decisions through information exchange with one another, completing tasks such as foraging and relocating. In this model, the group can continue to operate without the presence of a manager. Unlike the popular top-down management approach, distributed autonomy allows all members to participate in project governance and take responsibility. After the birth of blockchain, distributed autonomy rapidly developed in practice, stemming from the ability of smart contracts to publicly and uniformly execute governance rules on the blockchain, as well as the creation of a trustless environment and appropriate economic incentives within blockchain networks. The DAO (Decentralized Autonomous Organization) model seems to outperform the current mainstream top-down governance model led by organizations, but not all DAOs can successfully steer the organization onto the right track and fully engage participants. This article will discuss the goals, governance methods, and existing issues of DAOs.

Meaning and Goals of DAO

The concept of DAO (Decentralized Autonomous Organization) originated from the distributed autonomous corporation (DAC), whose goal is to disrupt traditional corporate structures, allowing businesses to operate transparently and flatly. DAOs encompass more than just corporations; any decentralized form of autonomous organization can be classified as a DAO. Decentralization is achieved through the equal relationships among organizational members and the absence of trust, believing that other members will not make decisions that harm the system. Autonomy requires rules to constrain behavior, and members must reach a consensus on the content of these rules and adhere strictly to them. Achieving these conditions to realize DAO functionality is inseparable from blockchain technology.

First, smart contracts ensure that the rules within a DAO are transparently public to everyone, immutable, and can only be executed according to pre-designed rules. Second, blockchain is a permissionless public network where anyone can freely join and exit, and participants hold equal status within the network. Finally, tokens issued on the blockchain can employ economic means to ensure that participants do not act maliciously within the system in pursuit of maximizing their own interests. Overall, DAOs use tokens to align individual interests with the overall interests of the project, with all rules operating within smart contracts to ensure transparency and decentralized execution.

Before the emergence of DAOs, the idea of distributed autonomy had already been circulating, initially manifested in nature. For example, ant colonies operate without a commanding leader, but each ant communicates information to ensure the continuous evolution of the entire colony. The goal of a DAO is similar, maintaining the operation and evolution of the organization through community self-governance. The advantages of DAOs are evident: members can increase their activity in the project by participating in governance, and everyone can fairly enjoy the benefits brought by the project. More importantly, it avoids issues that may arise from centralized management, such as the unexpected departure of decision-makers and bureaucratic tendencies. This organizational form has also attracted the attention of regulators. On July 1, 2021, the state of Wyoming in the United States officially enacted the DAO Act, which subsequently recognized the legal status of DAOs in the state. The DAO Act treats DAOs as a type of limited liability company, requiring compliance with the Wyoming Limited Liability Company Act. In DAO governance, it is necessary to clarify the relationships among members and their rights and responsibilities, the implementation of DAO activities, and the procedures for amending smart contracts. The DAO Act allows for the coexistence of algorithmic governance and human governance, categorizing smart contracts as organizational documents. Among organizational documents, including bylaws and operating agreements, smart contracts hold the highest priority.

From the above description, it can be seen that a DAO cannot exist as an independent project but rather serves as a decision-making center within a complete project. Decisions are made through decentralized member autonomy, and smart contracts are essential to facilitate this governance process. The concept of DAO has been proposed for several years, but how to maximize the role of DAOs within projects is still an ongoing exploration.

Governance Methods of DAO

Advantages of DAO in Governance

As mentioned earlier, the realization of DAOs is related to underlying blockchain technology, and blockchain projects also rely on the participation of DAOs. In pursuit of decentralization, blockchain projects, including on-chain applications and public chain protocols, have allowed DAOs to serve as decision-making centers. DAO governance employs a form of universal voting, which is more decentralized and aligns more closely with the goals of decentralized protocols. By using DAO governance, founding teams can exit after achieving their established goals, allowing the project to self-improve.

When governance occurs within a DAO, participants must align with the common goals of the project; otherwise, it is challenging to reach consensus on governance opinions. This requires binding individual interests to the overall interests of the project. Taking the collateral lending project MakerDAO as an example, users borrow the stablecoin DAI by over-collateralizing with Ethereum. If the collateralization rate behind DAI is insufficient, the system will liquidate the collateral assets, and the governors need to decide on parameters such as the collateralization rate and stability fee. The MKR token is used for governance and paying stability fees within MakerDAO. When users repay their debts, the MKR used to pay the stability fee interest will be burned, directly linking the network's value to the price of MKR. Therefore, as the number of users in the network increases, the price of MKR will also rise, and those holding MKR to participate in governance will make cautious decisions even without central leadership.

Members of DAO Governance

DAOs should be governance organizations with full participation. For proposals put forward, a universal referendum format is used for voting. The voting tokens are counted by quantity, and this simple and direct governance method has been adopted by many decentralized projects. For example, in Dfinity's neuron governance, anyone can create a neuron to directly participate in governance voting.

Another common type of governance participant is a committee or organization, elected by individuals to govern on their behalf. In the early stages of a project, committees are often used to guide the formation of correct long-term goals and frameworks, granting them significant power. For instance, in Polkadot, proposals put forward by the governance committee are more likely to pass under the rules. EOS has consistently adopted a delegated governance model, where users vote for nodes, which then manage tokens for voting. If users disagree with the actions of a node, they can revoke their vote.

Governance content not only involves deciding on changes to project parameters and long-term goals but also encompasses a significant portion of technical upgrades. However, most ordinary users do not understand the technical or other specialized knowledge involved and cannot learn it in a short time. To improve governance efficiency, specific matters are assigned to specific individuals, leading DAOs to develop different structures.

yearn.finance is a yield aggregation platform where autonomous communities are quite active in DeFi projects. The holders of the YFI token decide everything about the platform, and during its development, the DAO of yearn.finance evolved into version 2.0. The governance system is organized into different parts to exercise specific powers, referred to as the Multi-DAO format. The specific structure is shown in the diagram below, with governance participants consisting of YFI holders, yTeams, and Multisig.

Figure 1: Multi-DAO Governance Framework of yearn.finance

YFI holders delegate power to different management teams, which have the authority to approve yTeams and change Multisig members. Key issues such as minting and burning YFI, and applying treasury funds, are also decided by YFI holders. yTeams are divided into several parts, such as yBrain for strategy management, yPeople for team management, and yBudget for budget formulation. Multisig is responsible for executing on-chain, and they also have the right to veto decisions, although this is generally not utilized. Distributing decision-making within yearn.finance among different teams can avoid the need for everyone to make decisions, reducing the complexity of decision-making within the DAO. Additionally, within the yearn.finance DAO, users can choose to delegate their voting rights to others, following the voting results of others.

Methods of DAO Governance

According to the definition of DAO, rules are written into smart contracts, and DAO governance should be entirely conducted on-chain. However, the voting process requires multiple discussions, especially in cases involving parameter changes, and both deploying smart contracts and voting incur costs. Therefore, the current common approach is a combination of on-chain and off-chain methods for DAO governance. Before initiating on-chain voting, public opinion discussions need to be conducted in off-chain forums, and based on the results of these discussions, on-chain voting can be initiated. Below is an example illustrating the governance method of DAO in MakerDAO.

In MakerDAO, DAO governance is divided into off-chain and on-chain components. Off-chain discussions are conducted through forums, generally preceding on-chain governance, used for discussing and evaluating community issues. If there is a need to gauge community opinions or reach a consensus on certain matters, a public opinion poll can be initiated in the forum. If these issues receive majority support in the forum, on-chain voting can proceed, and the results of the voting will be recorded. There are two types of on-chain voting: governance polls and execution votes. Proposals in governance polls are primarily used to gauge the intentions of MKR holders regarding certain decisions, while the content of execution votes mainly pertains to changing the current state of the protocol, with the latter being more execution-oriented and important. Anyone can initiate on-chain voting, but there is no convenient UI entry related to it; users must interact directly with the smart contract, raising the threshold for initiating on-chain proposals.

Different types of voting methods and statistical rules also vary. Off-chain voting is conducted on an account basis, using a one-account-one-vote counting method, while on-chain voting is recorded in smart contracts and counted in MKR. In the MakerDAO forum, the reputation system of user accounts indirectly influences voting. Each account in the forum has corresponding badge labels and levels, assessed based on factors such as active days, number of likes received, and number of reports. Users of different levels have different management permissions in the forum, such as administrators and active participants, which is very similar to the operation mode of internet forums. Since on-chain voting is discussed through the forum, off-chain account identities also affect the results of on-chain voting; for example, higher-level users supporting a certain viewpoint in the forum will attract more attention. The MakerDAO Foundation holds a significant amount of MKR but does not participate in governance voting.

Other DAOs that use a combination of on-chain and off-chain governance methods are similar to MakerDAO, where proposals must be discussed in forums or other social media before the final on-chain vote. For example, proposals that pass on-chain voting in yearn.finance must meet two conditions: first, the discussion in the off-chain forum must last for more than three days and receive over 25% support in the forum poll; second, the on-chain vote must have more than half of the votes in favor for five consecutive days. Community proposals in Polkadot also need to rank first in off-chain community voting before they can go on to on-chain voting.

Content and Engagement in DAO Governance

In theory, all matters within a project should be decided and managed through the DAO. Different parts of the DAO governance method are responsible for different content. The three types of voting content in MakerDAO are shown in the table below, and they are in a progressive relationship.

Table 1: Classification and Content of Voting

The governance content in other decentralized applications is also related to the type of application. In yearn.finance, decision-making content includes adding liquidity pool tokens, adjusting YFI distribution parameters, and adding airdrops. Governance content for public chain protocols includes technical upgrades to the network and modifications to public chain parameters, such as adding governance participants and changing token distribution rules. The combination of on-chain and off-chain governance methods allows for off-chain statistics of community opinions and on-chain initiation of binding votes.

Throughout the development history of MakerDAO, it has faced several significant challenges, such as large drops in collateral triggering massive liquidations and insolvency, as well as deviations in the price of DAI from its benchmark value. These issues have been adjusted through the MakerDAO governance system, with the circulation of DAI continuously increasing and maintaining a long-term value near 1 dollar, proving that this governance method is viable. As a stablecoin issuance platform for collateral lending, maintaining the price stability of DAI and expanding its usage is the ultimate governance goal, which is related to the value of MKR. Participants in governance will not make decisions that harm the system for economic reasons, as they hold MKR.

The voting engagement of different projects varies, which may be related to governance content and the distribution of tokens. The YFI token of yearn.finance is distributed through liquidity mining, adopting a Fair Launch token distribution method, with no central institution or team involved in the early stages, leading to stronger management awareness among token holders and resulting in active governance. Moreover, as a yield aggregation platform, each decision made by users directly affects their potential earnings, providing immediate positive feedback for governance. In contrast, governance engagement on public chains tends to be lower. This is due to most people being unaware of the technical upgrade content, lacking interest in voting, and the results of participation having little impact on income. Additionally, token locking increases the opportunity cost for voters, which also affects voting engagement.

Issues and Improvements in DAO Governance

Based on past performances of DAOs, five issues currently arise in governance through DAOs.

Correctness of DAO Governance

Whether collective decision-making is superior to centralized decision-making, or whether DAO governance can lead projects in the right direction, is a challenging question to assess. Decentralized governance can harness collective wisdom, but centralized leadership may have clearer task allocations. Different projects at different stages of development may require different paths. For example, Synthetix encountered issues with DAO governance, where the founder, who had originally stepped back from decision-making, had to return to continue leading. Synthetix founder Kain delegated decision-making authority to the Sparta Committee (composed of 8 members for deciding protocol parameters and mechanisms) without holding a position in the committee. However, after the transfer of power without a core leader, many new problems arose, and no one was responsible outside of DAO management, affecting Synthetix's development. To resolve this issue, core participants generally need to remain in the DAO to guide decision-making after stepping back or expand the governance scale.

Free-Rider Problem in Governance

In actual governance, only a small portion of people participate in voting, yet everyone can enjoy the benefits brought by governance, which is the free-rider problem within the DAO system. Moreover, those participating in governance may face constraints and losses due to locked tokens. The free-rider problem is a social psychological issue without a solution. Encouraging governance behavior through rewards for participants, such as issuing token rewards for those who lock tokens to vote, can be a potential approach.

Degree of Decentralization in Governance

The goal of DAO governance is to achieve maximum decentralization, transferring management authority to all participants. However, in DAO governance, it is impossible to adopt a completely on-chain approach; proposal content will inevitably be discussed in forums or social media. Former leaders or community KOLs will inevitably influence community votes, and their proposals will receive more attention and support, affecting the degree of decentralization within the community.

The rules of on-chain governance are written into smart contracts, but they cannot prevent off-chain influences. Especially in cases of low voter turnout, voting results can easily be swayed by off-chain centers. These centers often consist of those holding the most tokens; if a project is influenced by centralization, they will be the most affected. Mutual checks among multiple centers can also limit centralization trends.

Security of DAO

Since on-chain governance requires smart contracts, the security of smart contracts affects the DAO. If a smart contract has vulnerabilities, it can impact the use of the DAO and even cause significant losses. The DAO was the first DAO application platform on Ethereum, serving as a fundraising platform. Users deposited Ether into a smart contract in exchange for DAO tokens, and the Ether raised was used to fund other projects in need of financing. The holders of DAO tokens decided on the allocation of investments and received returns on those investments. However, the DAO project was hacked before its launch, with 3.6 million Ether stolen through vulnerabilities in the smart contract. As a result, the DAO suffered reputational damage and was unable to conduct normal governance.

Regulatory Risks of DAO

As mentioned earlier, DAO governance involves issuing tokens and using tokens for voting, with the price of tokens related to the system's value, binding economic interests to avoid malicious actions by governors. However, the token issuance process may trigger regulatory issues. The U.S. Securities and Exchange Commission released an investigation report on the DAO incident in July 2017, stating that DAO tokens fall under the definition of securities in securities law. If the issuance of tokens does not obtain an exemption for issuing securities and is deemed to have securities attributes by regulators, it could deal a significant blow to the entire project.

Reflections and Conclusions

The ideal scenario for DAO governance is that projects can operate completely independently without centralized leadership. Currently, widely applied scenarios for DAOs include governance of decentralized applications and public chains, where users make decisions through voting with their tokens. The results of these decisions impact the overall value of the project, which is also the value of the tokens, economically incentivizing users to make decisions that do not harm the system. Some projects increase the token locking period in governance to enhance voting weight, ensuring that DAO voters are always aligned with the long-term interests of the system.

Generally, DAO governance is divided into two methods: voting by all members and delegated proxy voting. These proxies are elected through voting, and users can change their votes at any time. If multiple committees are established within the DAO, they will also form checks and balances among themselves. DAO governance typically combines on-chain and off-chain methods, allowing proposals to be thoroughly discussed off-chain, and public opinion polls can be initiated off-chain to gauge user intentions before initiating on-chain voting. In some projects, on-chain proposals also have strict limits on the approval rates of public opinion polls; for example, only public opinion polls that exceed a certain approval rate can initiate on-chain voting. Generally, once on-chain voting passes, contracts are automatically updated, reflecting the advantages of DAOs. If the content approved by public chain voting requires manual updates, in cases where both supporting sides are evenly matched, forks may occur.

Several issues exist within DAO organizations, such as decision failures, free-riding, centralization influence, regulatory, and security issues. Except for the last security issue, which requires professionals to strengthen code audits, the others can be improved by expanding the voting scale. Increasing the number of governance participants can enhance the system's fault tolerance, and expanding the scale of decentralization can also reduce the likelihood of tokens being classified as securities.

In addition to functioning within blockchain applications, DAOs can also be applied in more scenarios. The design of DAOs needs to meet several conditions:

1. The interests of governors align with the long-term interests of the project;
2. Users participating in governance are sufficiently decentralized;
3. All members have final decision-making authority, even in the presence of governance committees;
4. There is a unified consensus among all regarding governance rules.