How DAOs Can Change Corporate Governance?

As the blockchain develops, the range of attractive options for its application also expands. One of the concepts that has received support from the community in recent years is the DAO model.

In 2022, decentralized autonomous organizations became part of the agenda of the World Economic Forum in Davos. Brinley Lear, General Counsel of clubs (developing the Celo network), noted in a publication on the occasion of the meeting that these structures can change the corporate world for the better.

"Although DAO is not without problems, it has the potential to modernize the corporate governance style, which has not undergone significant changes for hundreds of years," he said.

I figured out the advantages and disadvantages of the distributed management model, and also found out whether DAO is an effective alternative to traditional companies.

Prerequisites for decentralization

People tend to create emergent structures that have properties not inherent in individual individuals. This process is part of evolution, and the tendency to scale these groups has only intensified with technological progress.

Such cooperation led, among other things, to the emergence of traditional corporations, the form of which has practically not changed since the beginning of the 17th century. They all also accept investor funds in exchange for commitments to maximize shareholder value.

There are two sides to this approach. On the one hand, business efficiency increases; on the other, companies are often willing to pay a high price for the sake of increasing profits, including causing damage to the environment and reducing the working conditions of employees.

Some participants in the traditional economy recognize the shortcomings of the capital-maximizing structure, as evidenced, for example, by the emergence of the B Corporations certificate system.

From a utilitarian point of view, the classical model is also not ideal. In the information age, it can no longer provide the necessary level of business coordination - the consequence of this is the growth of the gig economy sector and the outsourcing services market.

The trend also manifests itself in the development of the "orbital" cooperation model, when the line between internal and external members of organizations is blurred. Andreessen Horowitz partner Chris Dixon noted that as centralized structures grow, it becomes more difficult to coordinate incentives between participants in such systems.

According to Dixon, at the start, any centralized platforms do everything possible to attract users and third-party participants like developers, business representatives and media. They need to increase the value of services because they are highly susceptible to the network effect.

"As platforms move along the S-shaped adoption curve, their power over users and third parties is steadily increasing. When they reach its peak, relationships with network members turn into a zero-sum game. The easiest way to continue growing is to extract value from user data and compete with contractors for audience and profit," Dixon wrote.

The stability of the classical management model, which was effective in the industrial era, has been shaken in the age of information technology development. Therefore, some community members believe that DAO can offer an alternative way of cooperation.

Advantages of automation

In 2014, Ethereum founder Vitalik Buterin identified the key attributes of the DAO that distinguish them from other coordinated systems:

"Automation is in the center, people are on the periphery. [...] Another important characteristic is internal capital."

Any DAO is based on smart contracts, which are responsible for structure management, financial management and organization of work flows.

Algorithms allow you to reduce operating costs by automating routine processes such as payroll and accounting. They also simplify the interaction of DAO with all interested participants, both external and internal.

As part of an extensive blockchain ecosystem, decentralized organizations have the opportunity to take advantage of the interoperability of dapps and the modular structure of Web3.

Dapps are able to effectively integrate with each other, and their software components (tokens, transmitted messages, and so on) they can interact with each other. This "Lego" allows you to combine applications into larger structures with enhanced functionality.

The modular structure of Web3 is characterized by the relative independence of its primitives. This increases the stability of systems and makes it possible to update individual components without interfering with the work of others.

DAO Anatomy

Contrary to popular opinion, not all participants of the DAO are equal, because they have different influence depending on economic, reputational or other factors. Conditionally , they can be divided into several groups:

The core of a decentralized organization is formed by the "main participants". These are people who make a key contribution to the development of the project — de facto full-time employees. The interests of this group are directly related to the success and sustainability of the DAO, so their activities differ little from the classical model.

"Contractors" perform clearly defined work for a specified price for a limited time. These people are often experts from the fields of finance, law, development and design, who provide services to several DAO at once.

Sometimes such participants act collectively, uniting in service DAO like Vector DUO or LexDAO.

Although "contractors" and service DAOs are similar to traditional outsourcing companies, their activities differ for several reasons:

• since smart contracts automate most of the routine functions, the rest of the peripheral work is clearly defined and highly specialized;
• DAO benefits from delegating some responsibilities — this allows you to maintain decentralization and eliminate a complex hierarchy;
• DAO transparency reduces the cost of third-party coordination.

"Users" are the largest group of DAO members. Decentralized organizations reward individual contributions regardless of who they come from. This means that everyday actions that have value for the network turn into an opportunity to generate income.

The shell of the DAO is the "token holders". This group brings together participants from all of the above categories, as blockchain democratizes investment opportunities. Anyone with a cryptocurrency wallet and internet access can purchase or earn digital assets.

This architecture resembles the structure of classical corporations with an admixture of decentralization, but it is very conditional. Currently, there is a process of diversification of DAO and their structure may differ significantly from each other.

Meritocracy of ideas

Theoretically, DAO can become a tool through which coordinated groups will grow and develop, while remaining flexible enough to adapt to a changing environment.

However, the main advantage of this concept over classical hierarchies is the primacy of the meritocracy of ideas — a decision-making system in which the best proposals win.

https://www.ted.com/talks/ray_dalio_how_to_build_a_company_where_the_best_ideas_win

In most traditional companies, the proposals of ordinary employees do not reach top management due to the abundance of bureaucratic obstacles and a lot of middle managers. In view of this, top-down management prevails.

In DAO, the principle works, according to which decisions are made based on the opinion of the community. Proposals are processed inside concentric rings — from soft to hard consensus:

• soft is a kind of preference signal that comes from the most lively communication channels like Discord;
• hard — achieved by collectively approving a proposal through a voting mechanism (for example, the Snapshot platform).

DAO needs to maintain a balance between the two forms of consensus if they do not want to get bogged down in bureaucracy (only hard consensus) or turn any discussion into a messy discussion (only soft consensus).

For this system to function, organizations must implement appropriate management structures. A popular approach is the coin voting governance method, which allows any DAO participant to propose an idea and use their tokens to support it.

However, this tool has a number of serious drawbacks:

• vulnerability to direct or veiled attacks (for example, manipulation of the management economy);
• inequality of DAO members in the context of voting rights;
• imaginary decentralization of power;
• unfair distribution of incentives;
• conflicts of interest.

Some of them can be leveled by the vote delegation system, but it does not eliminate problems like attacks on governance and inequality of community members.

According to Buterin, there are several solutions and all of them are related to the restriction or rejection of monetary voting. For example, reputation indicators recorded in the blockchain can be used instead of tokens.

Not a single management

Technically, it is quite simple to launch DAO. It is necessary to draw up a manifesto, create communication channels, invite to the community, issue a management token, and also connect voting tools and registration of participants' contributions.

It is much more difficult to scale an organization. The growth and prosperity of the DAO largely depend on community involvement, so it is extremely important to maintain a fair incentive system.

Teams should keep in mind the slow decision—making speed in the DAO problem, which becomes more and more relevant as the structure scales. Centralized companies are much more mobile in this regard.

DAO allows more users to participate in management, for which they have to pay a price. Due to lack of competence, unwillingness to delve into complex technical issues and other factors, the community may spend more time discussing a new logo, rather than solving really important issues.

Another key aspect is security. Given the cumbersome technology stack required for an organization to work effectively, providing protection can become burdensome and expensive.

Dmitry Budorin, the founder of Hacken, a company specializing in smart contract security, told that the cost of checking the project's code base grows exponentially with its size. According to him, the initial cost depends on the specific company. In Hacken, the minimum price is $7000.

Budorin explained that the audit allows not only to check the developers, but also to achieve certain marketing goals.

"For the community, the presence of an audit is mandatory. Investors, launch sites, centralized exchanges require [inspections] by auditors, often specific," he added.

DAO's legal problems stand apart. The rights of classical companies are legally enshrined, but decentralized organizations in the vast majority of regions are deprived of such a privilege.

A number of questions remain open to them: how to participate in commercial agreements, hire service providers, resolve disputes, use the courts to protect their rights, divide assets and distribute responsibility among members.

Without official recognition, the DAO has no legal form. The community can authorize a specific person to enter into agreements on behalf of the organization. However, in a number of jurisdictions, an organization can be classified as a general partnership. The latter implies the personal responsibility of the participants.

Therefore, some DAOs create classic corporate structures. But this approach is not very effective — almost all the advantages of decentralization are leveled.

When are DAOs effective?

In general, for the successful development of DAO, it is necessary to engage in the same activities as classical companies. They must competently manage their assets, assess risks, conclude profitable cooperation, and so on.

At a certain stage, each of the aspects will require its own management structure. This, in turn, threatens decentralization, returning the organization to the traditional model.

This thesis is confirmed by the initiatives of some large DAOs like the organization behind the Yearn Finance protocol. In 2021, a proposal was submitted for discussion by the community of the latter, which involves delegating certain powers to small teams.

Decentralization is not a panacea for the corporate world. DAO is effective when the costs associated with its scaling can be reduced faster than the natural increase in the costs of coordinating participants. Therefore, it is extremely important that project teams clearly represent their real goals.

Applying DAO to Hedge Fund Management: The dHEDGE Experience.

Traditional hedge funds structures

According to the US Internal Revenue Service, most hedge funds in the US use one of the following organizational structures:

• single entity fund — consists of a management company and a fund. Investors invest their capital immediately in a single fund that invests these funds in assets;
• master feeder fund — this structure is used by hedge funds to combine taxable and non-taxable capital. It consists of an internal feeder fund and an offshore fund in a tax-free jurisdiction, which merge into a single offshore master fund, where all trading activities take place;
• parallel funds — the structure includes American and offshore funds that trade in parallel with each other. They have one investment manager, a single strategy, but maintain separate portfolios;
• A fund of funds is a fund that invests in other funds.

Unlike traditional management structures, hedge is a fully decentralized platform that brings together the best traders and investors around the world.

Thus, investors are given a choice from hundreds of investment pools on the platform, with different strategies that they can evaluate and make their own decision.

Therefore, the movement of funds between traders and investors is carried out directly, without intermediaries.

dHEDGE Structure

1. Core team. Develops and implements new technologies within the platform. Full access to the technical side of the project.
2. Councils. Selected by the decision of the team and the community, the consuls carry out public administration and contribute to the adoption of major decisions on the development of the project community.
3. vDHT holders. Participants of the management voting platform. It is they who make decisions about the introduction of new technologies, the burning of toxins and the direction of development of the platform.
4. Managers. Independent participants of the platform who manage their own funds. Managers can be any users of the platform.
5. Investors. Independent users who invest in manager pools while maintaining full control over their funds.
6. Advisors & Contributors. Community members who help spread information about the project, create new content and contribute to the active development of the community.

How are decisions made in dHEDGE?

First, the team or councils put forward a proposal (on the forum, or in the official discord channel). After that, the proposal is put to the vote, in a special section.

The announcement includes the time of the vote and, as a rule, a link to the topic where the proposal is described in detail.

After the announcement of the start of voting, vDHT holders can vote for one of the options for the development of the event (accept, reject). The strength of each participant's voice depends on the value of his vDHT.

Conclusions

DAO organizations are indeed a promising structure for many modern industries. Of course, there are areas where the TAO cannot be effectively applied (mainly state structures). However, many commercial and non-commercial projects should take into account the fact that today a DAO organization can work much more efficiently than a centralized version of its management.

Using the example of the decentralized asset management platform dHEDGE, we have seen that DAOs can function today. By the way, dHEDGE does not have offices over the world, all management and organization is carried out using Internet technologies.