Han
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Since the early days, going back to some of Vitalik’s and his crypto forebears’ conceptual posts on DAOs, the idea of a decentralized, automated organization has held wide appeal within the community.
In this post, we examine the key issues standing in the way of their wider adoption.
As originally conceived, a DAO was essentially “committed code” on a decentralized ledger, deployed in an unstoppable way, free of human interference.
In this narrow sense, there are arguably only a few DAOs around.
The original and perhaps purest DAO still is Bitcoin. Automated Market Maker smart contracts too fall within this narrow definition of a DAO, even though they are not typically pushed in an anonymous way (which may create some liability leakage into the real world, see below).
DAOs however risk becoming tainted when governance mechanisms are introduced. Few of these mechanisms work without human intervention, and even if voting is entirely onchain, there is still a risk of identifiable large token holders - typically the projects leads - being linkable to a DAOfied project and hence exposed to potential liabilities.
To understand the risks of using DAOs more broadly, take the risk inherent to any new venture and cube it.
Entrepreneurial risks are well-known and as such not unique to the crypto space: people risk, financial risk (running out of money), operational risks including possible fraud, etc.
The use of experimental technology squares this risk: Things can and have gone wrong, though in very few instances have we seen legal action from participants in e.g. following a DeFi exchange hack. The ethos and behavior of participants in the crypto community is very much one of self-reliance and in this respect it is debatable whether they would even seek the consumer protections regulators seem so concerned about.
Entrepreneurial risk multiplied by technology risk is then further compounded by regulatory risk from working in the crypto space, leading to risk cubed.
As is known, regulators are increasingly looking at taming the “Wild West” (according to Sec Chair Gensler) of crypto.
Some in the community welcome new regs, others don’t. Irrespective, increasing regulation is most certainly on its way and regulatory zeal is likely to grow as Crypto increasingly encroaches on traditional finance.
From where we stand at Otonomos, we see clients and the wider community deal with this prospect in three different ways.
Some teams we see are just cavalier about this. They do an internal risk calculation and look at a number of precedent enforcement cases, which resulted in a slap on the wrist plus only a couple of hundred thousand dollars in regulatory fines for the projects involved.
Typically, these projects were found in breach of regulations they may not even have been aware of, or were able to demonstrate their best intent to comply with regulations but failed to do so.
In this respect, a paper trail showing such best intent, including for instance an independent legal opinion in the case of a token sale and care in how such sale was conducted, may provide attenuating circumstances.
Undeniably, some teams also gauge the probability of enforcement action in the first place, on the basis that mathematically there's a lot of projects out there and very few enforcers, though such regulatory Russian roulette is probably not a commendable strategy!
If the proverbial sh*t does hit the van, a legal shield between their efforts and the leads as individuals will provide the best protection: Just wrap yourself in a limited liability skin to reduce the risk that you could be held unlimitedly liable, since the default analysis when people pool resources and labor is that they established an unlimited partnership.
Being held unlimitedly liable if something goes wrong may mean you’ll be hounded by bailiffs until the day you die, and your children until they day they die, etc. In the case of a criminal conviction, you’d be either jailed or become a fugitive of the law.
A separate corporate structure makes the company the culprit and creates distance between its actions and you as one of its agents.
A limited liability structure is not a perfectly impermeable legal shield: the law will pierce through it in the case of gross negligence or fraud. But it is the best solution the market has come up with and has been battle-tested for over three centuries now.
Still, some in the community look at incorporation suspect. They think it is a thing of the State.
In many ways they are right: The State has increasingly occupied the space of private entrepreneurship generally and in the case of entity formation, States have come to monopolize the chartering of companies in their territory, in the same way they monopolized the issuance of money.
Both company formation and money issuance used to be private. Now, limited liability is granted by statute and money can only be issued by Central Banks.
Limited liability in its origin is a pure contractual arrangement but has been put at the mercy of the State, who require companies to file with official company registries, access to which is controlled.
As a result, crypto ideologues who shy away from anything Government are therefore reticent to incorporate.
Beyond ideology, there’s a lot to be said for remaining unincorporated. You can’t be a bit pregnant: once you decide to have a legal nexus with the real world, tomes of regs and laws kicks in.
Practically, for small teams with limited resources, the cost of de-risking their setup can be significant. Many are loathe to deal with this less sexy part of building a venture.
It may be very enticing to extract yourself from all this, but is it feasible?
We believe that it is but that many teams lie to themselves about what it takes.
Let’s examine both this philosophical and practical argument closer below.
First, the goal of a DAO cannot - and in our opinion should not - be to reach some state of ”untouchability” and dodge all responsibility under the law.
No human endeavor can extract itself from the field of gravity provided by laws, whether such laws are natural or man-made: There is no escape velocity from rules of some sort that govern our behavior as economic participants.
What a DAO does achieve is to move - and to a large extent remove - the risk from the shoulders of the traditional bearers of risk in an analog setup (the founders or owners) to a much more dispersed set of actors in the digital space.
There is a strong case to be made that when open source code is pushed by an initial group of developers and further developed and used by a wider group of participants who are required to use a token to access a service and who receive the same token as reward for their participation, the arrow of risk if this code fails and somehow does damage should no longer point to the leads of such project.
This is not as a result of the leads wanting to become outlaws but rather because the risks have shifted as the project evolves: It is out of their hands and they no longer have control.
As a result, they can arguably be more relaxed about limited liability: the project could be a DAO whilst as individuals they could wrap themselves in limited liability.
This is in many ways what many of our clients do who set up development entities in real-world jurisdictions that receive grants from DAOs to cover their expenses and to reward them for their contribution to the project.
The question then remains if it is practically doable to keep the project itself as a DAO?
This question was at the centre of an online webinar I participated in on 1 September organized by our friends at Pillar titled: Why bother with DAOs?
Practically, to achieve a state of pure DAOfication, as Erik Voorhees of ShapeShift testified, you need to be prepared to shed any link with the real-world.
This means employees turn contractors and accept crypto for their efforts, all legal contracts are to be rescinded since there is no legal counterparty that can sign on behalf of the DAO, bank accounts (if ever you had any) in the name of your legal entity will be closed and the same for accounts with centralized exchanges. Office leases break and real-world expenses can only be reimbursed in crypto (and assumedly only after approval by an onchain vote amongst tokenholders). Basic stuff such as subscriptions to servers and software tools on which the DAO depends have to be paid by appointed agents who act on behalf of the DAO. Even email accounts become problematic.
Doable? Yes for certain use cases, such as e.g. Automated Market Maker smart contract and decentralized exchanges. However, for mere mortal entrepreneurs who deal with a myriad of operational issues, DAOs may still be a bridge too far, at least for now.
This will change, which is why we are hopeful for the future of DAOs and are actively working towards adding tools to OtoCo that will help users create and manage a DAO.
We see three critical components missing towards wider use of DAOs as an alternative to real-world chartered entities (in addition to the general UXUI adoption problem crypto still suffers from):
Entrepreneurial risks
In our knowledge, there is as of today no jurisprudence that has emerged from a blockchain-specific case in which the issue of liability and risk, and how this is different from a traditional organization, has been addressed. We look forward to the day these issues are examined in court.
Limited liability
It is difficult to imagine how DAOs over the short term could gain limited liability. Redemption will have to come from an acceptance that because DAOs state they have limited liability, they have limited liability, as with joint stock companies before the State monopolized their chartering (see above). We believe - or at least hope - that wider use of DAOs will eventually lead to this recognition of a DAO as an onchain limited liability entity.
Infrastructure
The infrastructure is still missing to operate DAOs (beyond rather narrow use cases) without contamination by the meatspace. There is still too much reliance on components from the traditional world, from email service to server space to fiat banking and card payments, to fully run a project as a DAO on blockchain. In this respect, we believe a lot of projects lie to themselves about the extent to which they actually operate as a DAO and have an active role as humans in their “DAO”: A smart contract written and maintained by a small group of developers who also own the majority of their project’s tokens, liberally DocuSign agreements on behalf of their DAO and use their debit card to pay for an AWS subscription is not even halfway towards a state of pure DAOfication.
For DAOs to become more practical beyond the current narrow use cases, we may need to wait until more players accept payment in crypto and more of the world’s plumbing runs on blockchain.
In addition, the position around a DAO’s liabilities will need to become clearer, preferably through legal precedent in court rather than blunt statute or overbearing regulations.
Most importantly, a DAO will need to gain recognition as a separate legal body without any explicit anchor in the real-world.
As a community, we can all accelerate such recognition by the sheer force of numbers, and tinker with the DAO until together we get it right.
