Table of Contents
DECENTRALIZED AUTONOMOUS ORGANIZATION SPRINT
Comparison to a traditional organization
DAO
How It Works
Underlying Philosophy: Strange Loops
Constituent components do not communicate between levels through the actions taken.
Constituent components work together to communicate between levels when outputting a “meta” action.
Continuous motion can be maintained in a closed cycle.
Legally Recognized Organizations
Why don’t DAOs fit into Australia’s Legal Framework?
Closing the Gap Between DAO Compliance and Legal Recognition
Decentralized Autonomous Organization Sprint
Abstract
The following content is collected and presented during a Deeplink research sprint. It covers the basics of “What is DAO” to the present legal challenges of DAO.
Authors
Gavin Stein: Researcher/Editor
William Godfrey: Researcher
Jack Lodge: Researcher
Stephanie Shen: Researcher
Cameron Dimovski: Researcher
What is a DAO?
DAO stands for decentralized autonomous organization. A DAO is a type of decentralized organization which incentivizes people to engage in activities that they all agree on without there being any central point of authority that forces them to do so. It is collectively owned and managed by its members.
Why do we need them?
DAOs revolve around the concept of Trust. If you’re thinking about starting a group, it would require lots of funding, and you’ll also have to place a lot of trust in the people you’re going to work with. With a DAO, however, everything is transparent. It’s all open. It can be verified by anyone within your group, and this opens up worldwide opportunities for project collaboration.
Comparison to a Traditional Organization
Traditional
Traditional organizations have a hierarchical structure. Voting for implementation or change isn’t usually democratic: whilst voting can be offered, it’s mainly up to a key stakeholder or top board member to make decisions. Because of this, the system could be manipulated to serve the benefit of those people, not the whole community.
DAO
There’s full transparency — all activity within the organization is seen by all members. The same goes for voting on a change, everyone is required to participate. Also, because a DAO is decentralized, decisions are handled automatically, making the decision processes faster than in a traditional organization.
How It Works
DAOs are enforced through the use of smart contracts. They define the rules an organization must follow and have a hold over its treasury. These rules prevent users from doing what they’re not supposed to do and any changes to be made to that contract have to be done via voting.
No one can spend the organization’s assets without approval. Because of this, a DAO doesn’t require a central authority. Decisions are made collectively, and payments are issued automatically when a vote is passed.
Typical DAO
A DAO is run by some form of governance. Its role is to act as a fund that would help finance a blockchain network’s future with some business model. It allows people to collectively create and develop, with a DAO issuing its tokens when someone volunteers to participate. People can also make proposals and vote according to their token ownership, so whether or not they would like a proposal to be funded.
Most of these proposals include some kind of promise of what a revenue stream will look like, what benefits the DAO would receive, and how it would be distributed amongst all the users who have their token.
DAO vs Top Down
Underlying Philosophy
Complexity Through Emergence
Emergence: An etiological concept describing complex systems with properties that are not present in their constituent parts; such properties and behaviors are said to ‘emerge’ via the interaction of these parts.
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‘Greater than the sum of their parts.’
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Theory of governance emergence.
· Collectively constructed governance — rules and instruments.
· Defined and redefined intentions formed from the knowledge and experience of the system’s constituents, shaped by their interrelations.
Examples
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Human society
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Conway’s game of life
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Neurobiological processes
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Markets
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Ant colonies
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Individually, ants are not particularly intelligent, but when operating en masse, intelligence arises.
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Individual ants process partial information available to them to decide which role they should play in the larger colony in harvester ants: foraging, patrolling, nest maintenance, and midden work (construction). They must first decide what role to fill and whether or not to consider it an active or passive task. Local role selections of individual ants make up the coordinated behavior of the whole. These decisions are based solely on local, individual information — decentralized. There is no centralized governance controlling the whole.
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As with most systems, ant colonies follow the Pareto principle, the 80/20 rule. Approximately 80% (possibly closer to 60/40 for ants) of consequences result from 20% of causes — in other words, a minority of workers contribute to the vast majority of work.
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The incentive model for cooperation in ants is found in the codependence of individual ants, a lone ant has little chance of survival without its colony. Lacking individuality (self-awareness) or theory of mind (awareness of others), ants do not have complex incentive models. That is, hard-working ants are not rewarded, and laggards are not punished.
Relation to DAO
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Similarly to ants, decentralized human collaboration’s individuality and group identity are emergent processes entailing self-organization, communication, specialization, and labor coordination.
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The decentralization of tasks is pertinent to emergent properties.
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Particularly in knowledge-based industries such as science and technology, where innovation and production rely on the presence and exchange of information.
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Heterogeneity in knowledge-based agglomeration economies.
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Knowledge economy: an economic system in which goods and services are based principally on knowledge-intensive activities that contribute to a rapid pace of advancement in technical and scientific innovation as well as accelerated obsolescence. Knowledge spillover, Positive feedback loop — unintended benefits (knowledge externalities), and Boosts innovation via healthy internal competition and knowledge diversity.
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Essentially, emergent properties cultivated through diverse, decentralized collaboration enable a DAO to achieve innovation and complexity at a rate that may not be possible via centralized governance.
5. Differences between human and ant emergence, further relation to DAO.
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As humans generally have a strong sense of individuality, incentive rewards and penalties are prevalent across all of society, this can be seen quite tangibly in the space of DAOs through token rewards. Human survival in the developed world is no longer a matter of codependence (arguably it still is, but we have various support nets) as it is with ants, and thus more abstract reward and penalty structures are required.
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The way in which DAOs tend to differ from ant colonies is in the presence of information pertaining to the whole and the causality of its direction.
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While there is, by definition, a lack of centralized governance, the group’s intentionality is generally democratized rather than purely result entirely of disjointed local decision-making. Participants generally have access to a broader image of the project’s scope and direction.
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However, the specific tasks undertaken by participants are left to the discretion of those participants, much the same as an ant selecting its role.
Underlying Philosophy: Strange Loops
What do Decentralized Autonomous Organizations (DAO) and Mathematician Douglas Hofstader’s strange loops have in common that differ from banks and traditional organizations?
Systems created by human beings in the past do not always resemble their initial purpose in the future. And, this seems, if not downright correct, how society functions with the systems it creates as time progresses. However, this distinction is important to the discussion that will take place in this article, a discussion that began in 11th-century Europe, the center for trade [1]. Merchants would meet from all over the continent to trade goods, but with many different locations came the many different forms of currency, particularly in Pisa, Merchants were dealing with more than 7 different types of coins, exchanging money constantly. These exchanges took place outdoors, on benches otherwise known as “banco” in Italian, which spurred the origin of a well-known word today, bank. However, this doesn’t seem very similar to the banks we know today. From simple origins, ideas began to flourish, such as if a business could manage risk for merchants traveling, counterfeit money being exchanged, and providing loans. This sounds familiar, right? Not just yet, because the banks we know today are pivotal to the correct functioning of our economic system by taking our savings and capital, providing interest, and selling the funds at a higher interest rate [3]. We, of course, get out of the agreement a storage place, a safe place, a vault for storing our money, or do we?
The amount of money being kept in world banks is estimated to be about $5 Trillion [4], with some saying even tens of trillions or more depending on how you define it. Cryptocurrency is said to have roughly $1.5 Trillion, which seems peculiar considering its origins only 13 years ago and rapid adoption only in the 2017 “mooning” a couple of years back [5]. Why is this peculiar? Banks have a much longer and stronger track record than cryptocurrencies. They have been around for hundreds of years, while cryptocurrency has been around for tens of years. The growth comparison is unprecedented, and if it continues, there is a clear winner. Why are people so positive about cryptocurrency in comparison to banks?
Because banks have shown the power of greed, banks working within your network? Fine. If you want to send money outside the network, say overseas, there are high and prolonged fees, possible fraud, and other dangerous events. Identification of your address and social security number will be exposed, and what do banks do to mitigate this, nothing. They continue to use your money as if it’s their own [6]. The solution? Decentralized Autonomous Organizations (DAO).
To decentralize is defined in the Merriam-Webster dictionary as “the dispersion or distribution of functions and powers.” Autonomous is the right or power of self-government, carried out without outside control, capable of existing independently and responding, reacting, or developing independently of the whole [7]. The Bitcoin Network, developed by Satoshi Nakamoto, is the first decentralized protocol. There is no leading entity governing its actions, instead of distributed by autonomous stakeholders, aka nodes. A worldwide power outage could shut down the Bitcoin Network [8].
DAOs typically have five key differences from traditional organizations [9].
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Unlike the traditional hierarchical structure of an organization like Apple or Microsoft, a DAO operates flat and fully democratized.
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Changes can be demanded from a sole party in traditional organizations, or voting may be offered, while in DAOs, voting is required by members for changes to be implemented.
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If voting is accepted in 2, then an internal team tallies votes and is traditionally handled manually. Although when it comes to a DAO, voles are tallied and put into operation automatically without trusted intermediaries.
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Traditional organizations are prone to manipulation between human handling or centrally controlled automation. However, a DAO’s services are all handled in a decentralized manner.
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Lastly, the activities of the DAO are always transparent. Even marketing wallets, for example, could be tracked on Etherscan. While in traditional organizations, activity open to public scrutiny is typically limited, if not nonexistent.
Although there is a lot to unpack here, I’d like to suggest that to understand the underlying philosophy of a DAO, there is no better place to look than the philosophy of mind, mathematics, and computer science in Douglas Hofstadter’s work on strange loops. Douglas Hofstadter won the Pulitzer prize for a book titled Godel Escher and Bach [10], a book written about how the individual neurons in the brain unify to create a connected sense of some sort of coherent mind, with, of course, many pits stops through Bach’s symphonies, Escher’s artworks, and Godel’s theorems.
A strange loop is defined by Hofstader as the following — “an abstract loop in which, in the series of stages that constitute the cycling-around, there is a shift from one level of abstraction (or structure) to another… yet somehow the successive “upward” shifts turn out to give rise to a closed cycle. That is, despite one’s sense of departing ever further from one’s origin, one winds up, to one’s shock, exactly where one had started.” [11]
Let me catch you before you think — what could this possibly have to do with Decentralized Autonomous Organizations?
Many autonomous and decentralized nodes connect to form a trusted network. Smart contracts operating automatically without human intermediaries? Order still arises out of this disordered distributed network, just like a strange loop. DAO’s and strange loops can be thought to have three components in common.
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Constituent components do not communicate between levels in their action.
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Constituent components work together to communicate between levels when outputting a “meta” action.
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Continuous motion can be maintained in a closed cycle.
Constituent Components do not Communicate between Levels through the Actions Taken.
The neurons that then make up the brain and the nodes that make up a decentralized network function independently, autonomously, and anonymously to create their symbolic “meta” counterpart. Essentially, parts of the system never communicate beyond the level they reside in.
Look at the image below. What captures your attention? Angels or Devils or Both? [10]
Image credit to Pragathi at https://www.dejvid.net/blog/2018/6/19/on-the-case-of-eschers-angels-and-devils
The lithograph above is Angels and Devils by the brilliant Mauritius Cornelis Escher. The image immediately takes you on a journey, a focal point first may be the angels or the devils or both. Each angel and devil are uniforms in design and shape. They become enumerable in the center and quickly change to a seemingly countless, barely visible border skirting the lithograph. Each component is independent and autonomous in its action, its self-sufficiency is seemingly communicative to the artwork’s every point. A strange loop of independent particulars.
A decentralized node with self-enforcing code (smart contracts), each chain link is a seemingly self-sufficient bank. Autonomously, anonymously working and shaping its constituent part, bearing negligible or little heed to the function of a chain but completely content to play its part as a link. Seems similar right?
Constituent Components Work Together to Communicate between Levels when Outputting a “Meta” Action.
Although you may be concerned with something we have said prior, the first component claims constituent parts aren’t communicative to any network they’re within, while component two claims that constituent parts work together to communicate a “meta” action. Are we running into contradiction and paradox, or maybe self-recursive destruction of the order we are attempting to initiate? Fear not, because this is all intended for the nature of a strange loop is inherently paradoxical, at least at face value.
The gestalt image below is a Penrose triangle, something we know cannot exist, although why does the mind persist in the notion that it can?
The answer to the above question can shed some light on a DAO. The structure of a DAO relies on every part coinciding to create this notion we have been referring to as the “meta action” of all the parts. In the above triangle, we have vertices, angles, faces, edges, and lines — ok, no problems there! We have three rectangular prisms — still no problems! Problems arise when we take each part and link them together to create a concept our mind knows doesn’t exist but persists at least conceptually as true. Although not as spectacular of a fashion, DAOs build trust in a way like this Penrose Triangle. Each part together seems more centralized than decentralized when thought to not build trust or be as secure. By our current standards, an object that could not exist still arises.
Continuous Motion can be Maintained in a Closed Cycle.
Lastly, below can be seen a perpetual motion machine, albeit an idea from fairy tales, as quickly the amount of force used would diminish, leaving a still machine. However, the strange loop idea does not have to be practically usable in physics for us to glean an important concept. Continuous motion in DAOs and in strange loops is maintained without an open-ended system.
Image credit to Harp from Wikimedia Commons.
DAOs are locked within the smart contract code, and the consensus is established by nodes. A strange loop arises hierarchically, however, persists within a flat horizontal structure. Both systems can exchange hoards of data in various forms that can be self-verified without paying heed to other open-ended systems that could potentially manipulate the system while still allowing for the free-flowing of information.
Final thoughts
The similarities between DAOs and strange loops have been explained above, with constituent components in a system do not communicate explicitly beyond the level involved in the system, constituent components in a system do communicate implicitly beyond levels involved in the system, and finally, there is perpetual motion in a closed system. The opportunities for DAOs are endless and strange loops help to shed some light on the operations of decentralized autonomous organizations.
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https://blockchainhub.net/dao-decentralized-autonomous-organization/#:~:text=The Bitcoin Network can be, anybody is free to adopt.
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https://www.businessinsider.com/heres-how-much-money-there-is-in-the-world-2017-10?r=AU&IR=T
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https://www.conyers.com/publications/view/why-is-crypto-so-important-and-should-i-care/
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https://en.wikipedia.org/wiki/Gödel,_Escher,_Bach#:~:text=Gödel%2C Escher%2C Bach%3A an Eternal Golden Braid%2C also,1979 book by Douglas Hofstadter.&text=One point in the book, in a colony of ants.
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https://www.dejvid.net/blog/2018/6/19/on-the-case-of-eschers-angels-and-devils
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http://digitalphysics.ru/pdf/Kaminskii_A_V/I_Am_a_Strange_Loop--Douglas_Hofstadter.pdf
Governance and Tokenomics
Tokenomics
A combinatory field of behavioral science and economics involves supply and demand characteristics of a system and methodologies for cultivating desired behavior amongst participants. The first principles by which an economic system is sustained.
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Governance: The governance of such an economic system shall entail procedures for regulating the creation, distribution, and destruction of assets and managing behavior via incentive and penalty, often via the implementation of a token economy in which tokens are assets that consist of a function and can hold value. Tokens are generally distributed as reinforcement for desirable behavior and can be exchanged for other reinforcers.
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Tokenomics and governance in DAO.
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Governance and tokenomics are important factors when designing a DAO, as they are the systems by which the project will be sustained and seen to fruition.
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One must carefully consider the distribution of assets, taking into consideration tokenomics models regarding such things as the approach to inflation management, fairness of distribution, the frequency and reason for rewards, and the impact of penalty methods such as slashing on the asset.
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The functionality of rewards is another key aspect deserving of attention, should your incentives take the form of governance tokens, should those tokens hold value, possibly backing tokens with assets (stablecoins) or introducing dual-token models with each token having distinct functionality (value store, governance, staking, discount, etc).
Three important factors for governance models in DAO.
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Member participation — how can member participation be incentivized while considering member retention and gas fees?
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Avoiding centralization — how can the organization refrain from devolving into a traditional top-down model, this can be an issue as real companies are legally required to have a board.
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Governance tokens can be used for weighted voting, boards can whitelist and/or quality control proposals. Voting could be an action that warrants reward in itself.
3. Avoid stagnation in the event of low member participation — how to keep the project afloat when participation is scarce.
Advantages/Disadvantages
DAO has a few advantages and disadvantages. The first and most obvious advantage is that squabbles or power plays are not likely in DAO. In traditional corporations, it is common that powerful people don’t get along or their interests don’t meet. Then the company’s decisions are made based on the company’s benefits but on someone in charge’s benefit. But in DAO, the decision-making is according to the rules. An ideal DAO will have a set of prearranged rules. Once a standard set of rules are in place, most decisions can be automated. And everything happening in DAO is transparent and is recorded in the public ledger.
When the decision-making replies to the community instead of relying on one person, it could be a double-sided sword. With community-based decision-making, you take in more points of view and reflect on what people want. This could be a disadvantage when people are biased. It’s good to give everyone a choice to vote. But not all people are wise. People’s choices are largely affected by personal experience and exposure to other people’s views. For example, if a person keeps reading about the potential risks of vaccinations. Even if the risk is real, it has been exaggerated and will affect the decision of whether this person will get a vaccine.
Another perk of DAO in the special COVID situation in 2020 and 2021 is that contributors can be anywhere in the world. If everyone in DAO works remotely, they will not be affected by any COVID lockdown. All they need is a laptop and an internet connection. And working remotely could attract the best suitable contributors all around the globe.
Speaking of the disadvantages of DAO, as new terminology, it is facing certain instability issues at the moment. Many features and details in the operation of DAO have been experimented with and investigated at the moment. This indicates that this concept might not be mature enough for most companies to adapt.
As suggested by DAO’s name, it is decentralized. it is theoretically not bound to any state or government. For a DAO, this sounds very beneficial: All the complex laws and taxes companies must take care of are eliminated. But this sounds like a threat to governments and traditional companies. This implies that maybe soon, governments in the world will modify their laws to accommodate this situation. Once this happens, DAOs will face major changes. The risk of this happening is a source of instability. And more about legal restrictions will be covered later.
Even though human actions in management are minimized, the rules of DAO are still written by humans. The smart contract is still coded by humans. There will always be some human involvement to some extent. And humans are prone to make mistakes.
The last instability of DAO comes from the smart contract failure. I will talk about this one in a famous example of the DAO. This example will show how a small mistake can cause the whole situation to collapse. When this happens, a little rescue or legal barrier can help shareholders.
Case Study: The DAO
Now I will demonstrate the above pros and cons of DAO in the example of ‘The DAO.’ “The DAO” is the name of a particular DAO. It was launched in April 2016, with a 28-day funding window. After the funding stage, it has raised over $150m from more than 11,000 enthusiastic members. A smart contract with that much money is susceptible to attacks. And the attack did happen just a month after the funding. The hacker exploited a vulnerability in the DAO’s smart contracts. They managed to drain more than 3.6m ether into a “child DAO” with the same structure as The DAO. This consequently led to the price drop of ether from over $20 to under $13 because a significant amount of money was affected.
Reviewing this catastrophic event, the DAO has made some mistakes along the way. The first one is Smart Contract Vulnerability, where a recursive function is exploited by the hacker. The reason that much money is lost is that all the money is stored in the same address. Because the designers didn’t expect this much money, all the ether was in a single address. This is an example of human error. Because if the designers have a bit more vision, they might consider the precautions in advance. But that might be too much to ask since we are all humans, and mistakes are inevitable. This is also an example of how naive mistakes are bound to be made in the early stages of new technology.
After the attack, several people wanted to save the situation. They attempted to split The DAO to prevent more ether from being taken, but they couldn’t get the votes necessary in such a short time. This is where the “correct” decision is not recognized by the crowd. And this situation will often be seen in such a democratic organization.
Eventually, a majority of the investors who made up The DAO agreed to introduce what is called a “hard fork” to return the funds, where many users agreed to alter their copy of the blockchain to a new version where the “hack” had never happened, and the smart contract bug has been fixed. This has the effect of rewriting the rules the blockchain executes, which is supposed to be impossible. And there are people opposing this action.
One commenter on Reddit wrote.
“I made a bad contract in the first days ETH was online and lost 2K ETH with it, can I also get it back? Thanks!”
This person has a good point because when people make mistakes, they are supposed to face the consequences. Changing the rules for some people will compromise the integrity and security of blockchain. This further showed how this whole thing is a new concept, and many unpredictable things could happen.
Legal Status and Challenges
Under Australia’s legal system, corporations are legal persons. This means that corporations enjoy legal identity, limited liability and perpetual existence, and other tax and fundraising benefits. This enables many business ventures to exist at all. If the corporation’s liability extended to all of its members completely, it would make conducting business too risky or too expensive for the public.
Legally Recognized Organizations
Organizations recognized by the law can be grouped into five categories.
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Sole trader
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Not applicable to DAOs
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Partnership
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Max 20 partners, more for organizations such as doctors or accountants.
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Attribute liability jointly and severally, which would be impossible amongst the anonymous participants of a DAO.
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Not-for-profit Association
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Most DAOs are not entitled to be registered as a non-profit (AUSTRALIAN CHARITIES AND NOT-FOR-PROFITS COMMISSION ACT 2012 — SECT 25.5).
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Trading trust
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Possible if a company is a trustee (gives limited liability and perpetuity).
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Who are the beneficiaries? must be identifiable, and DAO participants are typically anonymous — can’t have trust for a purpose.
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Insanely complicated tax law and structure, which increases compliance costs.
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Company
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Registration is limited to proprietary and public companies that are limited by shares/guarantees.
The benefits that DAOs bring to many industries are inhibited by the rigid development of laws surrounding their identity and enforcement. These categories either implicitly exclude DAOs or would severely inhibit their activities.
Why don’t DAOs fit into Australia’s Legal Framework?
By their nature, DAOs are challenging the traditional systems to regulate and control typical corporations. Firstly, the issuance of tokens has been a hotly contested topic in the US with the Ripple/SEC case as it reflects a similar system to that of shares and other company securities. An ICO by a DAO could be inconsistent with the current Australian framework for issuing securities. Secondly, DAO governance does away with necessary corporate instruments such as a company constitution and shareholder agreement through smart contracts on blockchains. Finally, the fact that DAOs operate outside the scope of the Corporations Act and their lack of legal identity makes it impossible to regulate and protect people engaging with the organization from criminal conduct or system and market failures.
Because of these things, DAOs do not fit neatly into Australia’s regulatory framework and cannot enjoy the benefits of limited liability, and participants of a DAO could be liable beyond their participation. The official legal status of a DAO is uncertain as the issue has never gone before an Australian Court, but lawyers say that it is likely a partnership or unincorporated association. Each of these classifications has its problems.
Closing the Gap Between DAO Compliance and Legal Recognition
Moving forward, it is important to develop the law so that it doesn’t inhibit this technology. However, it is likely much too early to formally include DAOs in Australia’s regulatory framework until their nature and scope are fully defined.
One step to increase compliance of DAOs with the current regulatory framework is to develop smart governance contracts in parallel with governance provisions of corporate law, specifically part 2B.4 of the Corporations Act 2001.
Another step towards legal compatibility would be recognizing DAO tokens as financial products rather than securities.
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s 763A Corporations Act 2001 (Cth) defines a financial product as a facility through the acquisition of which a person makes a financial investment.
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Disclosure requirements are much less onerous and are governed by part 7.9 of the Corporations Act 2001 (Cth).
This significantly reduces compliance requirements associated with issuing a financial product compared to security and would benefit the DAO token’s uptake in the Australian market. However, this approach to the legal status of token issuance would largely be affected by the ongoing SEC/Ripple case outcome.
It is important to mention that legal development relating to DAOs can not be limited to Australia. Compliance frameworks must be implemented consistently around the world for them to succeed and not create regulatory arbitrage.
Another possible legal compliance approach is recognizing a DAO as a general partnership. This approach works better in the US. While Australia has limits on the size of organizations registered as partnerships, the US does not.
Recent Developments
Developments in this space have been accelerating recently, likely due to the Defi boom seen last year. Less than a month ago, Wyoming’s state senate passed a bill recognizing the legal status of DAOs. Interestingly, it provides two categories of DAOs, a member-managed DAO LLC and an algorithmically-managed DAO LLC. While it may be quite some time for DAOs to be formally recognized in Australian law, it is an important issue. In Australia, the Digital Law Association has proposed a new approach to corporate governance which involves replacing a board of directors with an internet community. Such changes might require DAOs to commit to transparency, a minimum registration standard, and smart contract auditing. These developments are important for the future of DAOs in Australia. Favorable policies and regulations will determine whether DAOs will be able to thrive or not and secure a future for Australia’s Defi space.