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Why Decentralized Autonomous Organizations (DAOs) Are Essential to DeFi

DAOs (Decentralized Autonomous Organizations) are becoming the primary DeFi governance mediums in crypto and conservatively oversee more than $480 million.
by James Beck, Mattison AsherFebruary 3, 2021
Q4 2020 DEFI REPORT blog  2

This is part of a series of articles from ConsenSys Codefi’s Q4 2020 Ethereum DeFi Report. Download the full report to learn more about token standards for assets and payments, NFT marketplaces, social and community tokens, flash loans, wrapped Bitcoin and Filecoin, lending projects and more.

Now that we have discussed some of the core innovations of DeFi applications, you might be asking yourself: Who is deciding the future of these applications? Almost all of the major DeFi applications, from Uniswap to Aave to MakerDAO, are now governed by DAOs, which stands for Decentralized Autonomous Organization. 

DAOs are governing bodies that oversee the allocation of resources tied to the projects they are associated with and are also tasked with ensuring the long term success of the project they support. This task is no small feat either, as DAOs conservatively oversee more than $480 million

Total DAO assets under management. Source: DeepDAO

Decentralized Autonomous Organizations inscribe as many rights and responsibilities that a corporation or nonprofit typically manages to self-executing smart contracts. Members of DAOs use tokens to vote on the rules of a larger decentralized protocol or system. While the most famous “DAO” was subjected to a major hack in 2016 just when Ethereum was beginning to take off (chronicled in Matt Leising’s new book, Out of the Ether), the concept of DAOs has still holds a powerful appeal to projects that want to extend governance decisions to the community of it’s token holders. MakerDAO is one such example, where holders of the MKR governance token vote on changes to the DAI stablecoin protocol. 

Thus far, most DAOs operate under the following framework. Anyone who holds a certain amount of tokens can suggest changes to the underlying protocol. These proposals can be technical in nature, such as Compound’s Proposal #31, which sought to adjust the reserve factors for various Compound markets, or more ideological, such as Dharma’s Uniswap Proposal #2 for the Uniswap DAO, which called on Uniswap to reward their users with UNI since they were left out of the initial token distribution.

After a suggestion has been successfully proposed, the community of governance token holders for the respective project must vote on if they are “for” or “against” the proposal. Different DAOs have different quorum requirements in order for a proposal to pass, but as long as that quorum is met, usually majority rules. Each DAO has some core differences just like each democracy around the world varies in how they execute democratic principles. There are distinct levels of checks and balances within the different DAOs.

Because the composition of smart contracts to create DAOs are open source, it’s becoming easier to use existing DAO structures, such as Aragon, MolochDAO, or DXdao to manage projects. Aragon is the most popular DAO framework, used by BarnBridge, PieDAO, and Aavegotchi, among others. DAOstack (or dxDAO), developed by Gnosis, manages Omen.eth (a prediction market platform), Swapr.eth (an automated market maker), Mesa.eth (a decentralized exchange), and Rails.eth (a micropayments system). In total, DXdao manages $30.9 million among 448 members. 

Top DAOs by assets under management. Source: DeepDAO

While many of the DAOs described above are experimenting with novel governance structures, some DAOs have opted to replicate more traditional governance models. For example, The LAO (a limited liability autonomous organization) is an investment DAO that closely resembles a venture capital firm. You must be an accredited investor in order to join this DAO, and once accepted, members discuss various projects to allocate The LAO’s funds towards. When a project is seriously being considered, members of The LAO then vote on if the project should receive funding from the group.  

Are DAOs Decentralized?

Of course, we are still very early in the DAO experimentation stage and have seen some DAOs run into some issues. For example, the Yearn “DAO” recently passed a YIP-57 titled “Funding Yearn’s Future.” This vote will lead to the printing of more YFI in order to incentivize future development from community contributors.

The problem? In September of 2020, the YFI governance token holders voted to burn the mint key, meaning that there was already a vote to get rid of the ability to print more YFI. The Core Development team of Yearn decided not to abide by the initial vote but are executing the vote to print more YFI.

The exact powers of the Core Development team of Yearn have not been outlined, nor has the role YFI governance token holders play in the governance process. This lack of structure has yielded confusion within the YFI community and has led to some questioning the decentralization of Yearn’s “DAO.”

Regardless, DAOs will continue to be a growing force in DeFi and beyond. We are in the early phases of experimentation for what these new governance structures will look like and how they will operate.