The governance of DAOs

From corporations to decentralized organizations

In order to understand the functioning and organization of the DAO, assimilating it, in analytical perspective, to the broader phenomenon of organizations based on blockchain, it is necessary to preliminarily distinguish between external and internal governance profiles.

Internal governance. It concerns the decision-making processes of the organization's participants, which require rules of procedure, often contained in a so-called blockchain governance code.

External governance. In this sense a key legal issue concerns the ability of token holders to exercise their right of exit, either by selling their assets or by initiating a split (so-called fork). In particular, they can disinvest if they feel that the enterprise is not properly managed.

What immediately emerges, in this sense, is the attempt to assimilate decentralized organizations to corporations, at least to derive indications in terms of internal organization and governance.

On the one hand, the differences between the two organizational forms are indeed undeniable, especially on the structural level, given that corporations are based on Agency Theory, which well describes the existing relationship between the ownership of the enterprise (shareholders) and the control of it (managers), based on an eminently hierarchical structure.

On the other hand, however, the comparison between the two phenomena appears useful, among others, for three essential reasons:

1. both corporations and decentralized organizations face the challenge of coordinating and controlling the behavior of different actors: some with direct or indirect management functions (directors; core developers; miners), others spread horizontally, connected in collective structures (shareholders; token holders). And indeed, although the horizontal and democratic nature of blockchain-based organizations has been theorized, it has been noted in practice how the separation of ownership and control has in fact been maintained.
2. Both organizations (hierarchical or otherwise) face the same problems related to human decision-making processes, which suffer from the limitation of personal cognitive capabilities. The only possibility of overcoming the resulting difficulties lies, on the one hand, in the division of tasks and, on the other, in the enhancement of specific skills.
3. The tokens issued by blockchain-based organizations are not only a decentralized payment method, but also, and more importantly, a way to finance entrepreneurial projects, which would otherwise require the establishment of companies.

In conclusion, “many of the problems that corporate governance should solve reappear in cryptocurrencies and decentralized enforcement schemes. It is clear, however, that in adapting corporate governance concepts to cryptocurrencies, we must take into account not only the similarities but also the profound differences between these entities”.

DAO	COMPANY
Loose	Tight
Grassroots	Hierarchical
Transparent	Usually not transparent
Open	Invite-only
Fully global	Not always global

Table: A. Dhanani, B. J. Hausman (2022), p. 2.

The administration of a DAO

Managerial and organizational decisions, within the DAO, are made by the token holders, based on a bidirectional relationship between token and governance: on the one hand, the token is an instrument of governance, in that it confers property rights (right to profits) and administrative rights (right of proposal; right to vote); on the other hand, the rules of organization and power relations affect the value of the token itself.

Under the Wyoming regulatory framework (for further details see DAOs’ current forms of regulations: an overview), in particular, the administration of the DAO can be entrusted to the members ("member managed decentralized autonomous organization") or to a smart contract ("algorithmically managed decentralized autonomous organization"). The former constitutes the rule: it applies in the absence of an express statutory exception.

On-chain and off-chain governance.

Blockchain governance can take place in two ways.

Off-chain governance. Most private organizations are governed in this way. These structures actually appear decentralized, but it is always possible for participants to organize a mutiny. They, in fact, in case of disagreement with the governance protocol used, can initiate a hard fork, creating a parallel blockchain.

On-chain governance. Participants vote directly within a self-governing and democratic structure.

It should be pointed out that, even in this second model, not all decisions are made in a decentralized manner: while it is true that the activities conducted by organizations are carried out through a self-governance structure, it is also true that they remain influenced, inevitably, by the external market. In particular, here again an external crisis situation may result in the need to proceed with a hard fork, a decision that in effect assumes the connotations of a centralized decision.

The "one token-one vote" principle and its exceptions

The types of decisions that can be delegated to token holders, according to the provisions of the smart contract they subscribe for, vary depending on the goals of the DAO and the interests of its participants, who are also incorporated into the code. Typically, they are called upon to vote on any changes or implementations of the code, hiring of employees, business strategies, and new investments.

It is also pointed out that while in traditional enterprises decisions remain private, in DAOs these are transparent and public.

As a general rule, it is possible to identify the operation of the "one token-one vote" principle, whereby the weight of the vote depends on the amount of tokens owned.

At the same time, however, certain exceptions to this principle can be identified.

First, a distinction must be made between governance and non-governance tokens, as only the former attribute actual decision-making power regarding the development and the operations to be carried out on the blockchain (for further details: https://academy.binance.com/it/articles/what-are-governance-tokens#).

Moreover, not all governance tokens, in any case, necessarily grant voting power over every organizational and managerial decision-making aspect.

Again, note how some DAOs include a requirement that tokens be deposited in order to exercise voting rights.

Finally, it is possible to envisage that some tokens attribute, on the decision-making level, greater weight.

In fact, although, as seen, DAOs are based, as a fundamental premise, on the distribution of ownership and voting power in a democratic and thus egalitarian manner among participants, there are indeed different voting mechanisms.

The voting mechanisms

1. Reputational voting: those who have obtained a good reputation – a concept, however, extremely difficult to assess in the absence of predefined and agreed-upon indices – against their activity exercised in the DAO, obtain tokens attributed with greater weight in terms of voting.
2. Quadratic voting: one token assigns one vote, while two tokens assign four, so that a large number of tokens ends up granting disproportionate voting power. On the one hand, this incentivizes token purchase and involvement in management; on the other, it risks concentrating power in the hands of a few, betraying those democratic drives that characterize DAOs. Fort further details: https://www.bloomberg.com/news/articles/2019-05-01/a-new-way-of-voting-that-makes-zealotry-expensive#xj4y7vzkg
3. Conviction voting: the weight of the vote increases as the period for which the token remains in the ownership of the same entity becomes longer. This, on the one hand, incentivizes the stability of the organization's ownership structure while, on the other hand, discouraging turnover, an equally important element in the life of the entity.
4. Holographic consensus voting: this is a multi-stage voting process based on mechanisms for betting on proposals made and published by participants. For further details:https://medium.com/daostack/holographic-consensus-part-1-116a73ba1e1c; Y. Faquir-Rhazoui, J. Arroyo, S. Hassan, A Scalable Voting System: Validation of Holographic Consensus in DAOstack, 2021, p. 5557 ss., available at https://scholarspace.manoa.hawaii.edu/server/api/core/bitstreams/d0686298-aa64-4f41-aa7c-ff4b379d0c87/content
5. Liquid democracy: this is a mechanism based on a system of proxies to individuals elected by the participants themselves to represent them. Importantly, the proxy is always revocable. For further details: https://www.peaka.com/blog/web3-dao-voting-mechanisms/; https://blog.xdao.app/unleashing-the-power-of-dao-voting-a-deep-dive-into-dao-voting-mechanisms-and-systems-4d4ece7aed36

The proposing right

Tokens grant the right to promote and consult proposals on the DAO platform, regardless of the share held or, at the participants' discretion, only on the basis of qualified holdings.

Usually, governance proposals have a three-stage roadmap: a pre-proposal poll; a draft proposal and finally a governance proposal.

Some essential problematic issues

Token holders' direct management powers over the organization results in governance issues that are not immediately resolvable.

1. First, there is the risk that decisions made by the organization's participants are often inadequately informed, even in the face of the use of blockchain precisely for informational purposes.
2. Second, there is widespread concern toward phenomena of "voter apathy," such that there is a risk that the rights granted to token holders may be rendered ineffective.
3. Again, note how often token-holders operate under pseudonyms, implying that a single person could create multiple digital identities and vote with them. In this scenario, voting systems would, in all evidence, lose their democratic connotation, considering that a single participant could control the entire organization.
4. The decentralization and, to some extent, democratization of voting mechanisms then leads to the risks of inefficiency that typically result from any attempt to coordinate a plurality of interests and actors.
5. Democratic instances, moreover, find a decisive limitation in the costs of entry (so-called barrier costs) for those who wish to become part of the organization, particularly in terms of technological skills.
6. Finally, security risks cannot be ignored: any bugs and security breaches in the system in turn require a vote of the members to be resolved. The slowness of the process, however, well may lead to a worsening of the situation, even to the point of encouraging hacking attempts or fraud. Noted in this regard is the example of The Dao case.

According to some authors, the most drastic solution to the problems listed so far is, simply, to rely on the algorithm. «Such an option implies that token holders should fully trust the functioning of the underlying code. The only governance tool in their hand would be the choice to acquire – or not acquire – the related tokens. Needless to say, algorithmic DAOs build on the (bold) assumption that the underlying code is actually fit for purpose and capable of automatically drive the organization throughout its life».

The main advantages of DAOs' decision making

Once we have seen the main issues related to decentralized governance mechanisms, the following is a brief survey of the advantages highlighted by scholars.

1. Transactions that are concluded on the blockchain allow for the movement of assets very rapidly.
2. Decisions made by the members of the DAO are, as seen, public, which allows for greater verifiability of compliance with the regularity of decision-making processes: first and foremost, the attainment of quorums, where provided, constitutive and deliberative. The decision-making process is, therefore, as well as transparent, secure and autonomous (at least in theory), since, thanks to the rigidity and automatisms of the rules embedded in the smart contract, it guarantees a reduction in opportunistic behavior or, more trivially, errors.
3. Blockchain-based decision-making processes are faster as there is no need for prior email communication or proxy voting. In fact, decision-making processes in DAOs are usually continuous; there are no votes reserved for specific times of the year.
4. The DAO incorporates information and feedback from a wide range of stakeholders, in multiple different situations and circumstances, allowing for more prudent decisions with long-term positive effects. This, however, while taking into consideration that token hokders tend to have an interest in maximizing the value of their investment in the short term, rather than making decisions that guarantee gains in the long term but result in lowering the value of tokens, which circulate in the secondary market, in the short term.

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