One of the more interesting consequences of the Decentralized Finance (DeFi) boom is how it revived the five-year-old concept of DAO, or Decentralized Autonomous Organization. DAOs are a fairly broad umbrella term for any type of business organized primarily through blockchain smart contracts. Like all things in crypto, DAOs hold great promise, but their overrated image does not stand up to close scrutiny. Worse still, some DAOs are neither decentralized nor autonomous, and sometimes they are not even real organizations. But more than that, there are some instances where centralized organizations offer a genuinely better alternative.
Perhaps the most famous example of DAO is DAO. Despite its somewhat quirky name, DAO was meant to be a truly revolutionary concept: essentially a chain investment fund run by the Ethereum community aimed at growing the ecosystem.
The DAO was hacked in 2016 when it held 15% of the entire Ether supply. The extent of the damage was so extensive that it resulted in significant political mess and the hard fork that created Ethereum Classic. In short, the community (represented largely by the Ethereum Foundation) has offered to manually adjust the blockchain so that DAO money can be returned to the original holders. The highly controversial proposal fractured the community into maximalists and pragmatists “the code is the law”, the first migrating to Ethereum Classic, the original chain. The pragmatists who have maintained the Ethereum brand, of course, seem to have finally won.
With The DAO’s bitter disappointment, the entire idea temporarily fell off the radar of the crypto community (although there are plenty of true DAOs outside of Ethereum that don’t use that term). The pure ideals of DAO were eventually replicated by the more “centralized” phenomenon of ICOs, or initial coin offerings, which allowed startup founders to raise money for their business ideas from the community – usually , it was done on Ethereum. Nexo was one of hundreds of these projects.
Now DAOs are back in public attention, and its most ardent supporters will often say how they are the new paradigm of human organization and governance, or similar hyperbolic statements. Now, I hope we can all agree that doing the same things on a different platform is hardly a paradigm shift, so to confirm the hype we need to look at other potential forms of innovation brought by DAOs.
Decision making and politics
One way we might imagine DAOs to be an amazing innovation is if they would somehow get rid of politics. Imagine if every decision could be made objectively by an impartial algorithm that simply takes some data and enters a clear answer. No emotions, no prejudices, just an algorithm that instantly makes a decision without the endless debates and attempts to persuade each other.
Unfortunately, this utopia comes up against a fundamental fact of life, namely that there are often no definite answers to a particular question. Imagine a computer trying to solve a real-life cart problem: a pandemic virus approaching your country. Let’s say, for simplicity, that there are only two choices: do nothing, or lock up the population. In the first, thousands of people will die, while the second will cause immense economic damage.
The problem isn’t even so much that the two are tough choices. The computer could come up with a monetary cost for everything, including the loss of life, and just pick the smallest number. The real problem is that the computer may not have all the data it needs to make an informed decision. In this situation, virtually nothing is known about the virus: how many lives are saved (or indirectly lost) by the lockdown, how many lives are lost by doing nothing, and what the ultimate consequences of the two decisions might be.
Uncertainty is the reason why politics must exist when making decisions. This is usually very ugly, as most of our problems cannot be objectively solved. As long as this remains the case, the DAOs themselves will always be political. And this poses a serious problem for cryptocurrency startups, the most prevalent category of organizations where DAOs are used today.
Why you can’t always afford to be political
There are tons of decisions to be made when building a business and a product. Answer questions such as “What design do we use?” Or “Is this feature worth the extra cost?” And “What price do we charge?” Is a big part of a CEO’s or product manager’s day. Very few of these decisions can be made with absolutely certain input data.
As a general rule, in the design of business products, the more people involved in the decision-making, the more time it will take. A corollary is that, most of the time, a collective decision will be worse than that of a single qualified person. There is a reason the term “design by committee” is derogatory.
Decisions made by a large group often turn out to be worse simply because of the disparity of opinions and necessities. This political process often involves making important compromises to please everyone, but unfortunately compromising in one direction is all too often wrong. In a business context, this often leads to losing to a more decisive competitor.
For this reason, start-ups are almost always dictatorships. There should be at most one decision maker, because the stakes are so high that a delay or a slight misstep can be the difference between success and failure. Then, over time, successful startups tend to become more “decentralized” and run by committees.
Of course, I don’t intend to argue for a one-party regime in general, and the flip side of relying on one decision-maker is that he just might not be. not qualified to make appeals in every situation that arises, hence a committee is actually a balancing force in earnest. But there are contexts where one approach works better than another, and DeFi and crypto are even closer to the “single decision maker” stage.
Leaders always emerge
Any DeFi DAOs that started forming last year would apparently refute my argument that early startups have to be dictatorships to be successful. Except, if you look closely, these are actually embodiments of what I meant.
Under Kumbaya’s chants of decentralization, the vast majority of protocols are led by a well-defined and powerful team of “main contributors” who are usually not elected. Sometimes this is quite obvious, for example when an existing team makes their project a DAO – while retaining all development control and “graciously” bringing irrelevant questions to debate. Some native DAO projects, for example Yearn and Sushi, are also open enough to avoid too much politics in general protocol development.
Perhaps the best example of truly decentralized and automated DeFi DAO is Compound, although its model is certainly closer to an oligarchy than to democracy. Compound has a veritable class of “protocol politicians” who regularly submit governance proposals, designed to be the only way to upgrade the protocol. It should be noted that the Compound Protocol has only undergone a few valuable changes since the release of COMP, as the governance proposals are mostly about adding new tokens or other minor elements.
Ultimately, having central depositories is inevitable when flexibility is key. Examples like the Ethereum DAO hack response, or Yearn’s governance structure, show that even the most decentralized protocols rely on effective “community will custodians”. Unfortunately, this exposes DAOs to the dilemma of “Quis custodiet ipsos custodes”, or how to ensure that those in power do not abuse the control inherent in their position. Time and time again, we see that subversion of the custody of power (e.g. control of the electoral process) is the most effective way to subvert power itself.
The arguments for honest centralization
While decentralization of power is a complex question, I don’t think just putting everything on a blockchain is the answer.
The problem of the equitable custody of power is too difficult a problem to solve without fallible human intervention. While smart contracts certainly won’t create a perfect automated decision maker, perhaps they could save us in the future and create a system in which custodians cannot reverse the established process. Either way, that’s not the case today – most DAOs use Snapshot, a centralized platform where users vote by signing in with their wallet keys. This is a good way to do Sybil-resistant polls, but there is no way to force the team or multi-signature holders to execute the governance proposals.
In addition, centralization has one obvious advantage: accountability. For example, if users lose funds, companies like mine would be legally required to return them to those customers by whatever means necessary.
Compare that to incidents like MakerDAO’s Black Thursday, where customers lost millions in unfair liquidations because someone was able to bid close to 0 DAI for every ETH. Call it what you want: faulty gatekeeper software, inefficient gatekeeper community, lack of cash, unforeseen gas charges… The ultimate problem was poor protocol design, and therefore Maker’s fault. However, the community hid behind the veneer of decentralization to completely refuse compensation.
Many arguments have been put forward to justify the refusal. One was that the protocol was unlicensed and anyone could use it, which sort of meant that Maker wasn’t responsible if something went wrong (many physical products are unlicensed as well, but their manufacturers are always responsible in case of failure). Another argument is that this was a market failure meaning users wouldn’t have gotten as much as they thought they would anyway (but why did they get zero, then?). Finally, some members of the community felt that it was the Maker Foundation that should pay, while the Foundation did not think so.
As the community discussed the finer points of philosophy about whether users ‘deserved’ to be compensated, few cared what message this sent to current and future users, and how it would affect confidence in crypto and DeFi. The liquidation ecosystem was then dramatically improved, which was a silent admission that Black Thursday liquidations were indeed not appropriate behavior. The aftermath of this accident was a clear example of a decentralized political process falling into selfishness and prejudice.
If we want crypto to achieve serious mainstream adoption, taking responsibility for mistakes is absolutely crucial to building trust. For now, only centralized finance (CeFi) guarantees this level of responsibility.