On-chain DAO governance enables dynamic regulatory features that facilitate unprecedented decentralized regulatory solutions. Part of the Blockchain & Procedural Law seminars (Max Planck Institute Luxembourg for Procedural Law).
Corporations and other forms of business organizations can be supplemented with blockchain-based agency constructs. Blockchain-based decentralized autonomous organizations (“DAOs”) expand the definition of the firm. On-chain DAO governance enables dynamic regulatory features that facilitate unprecedented decentralized regulatory solutions.
Corporate governance is characterized by agency constructs. The agency relationship in modern finance and corporate governance is characterized by attempts to optimize incentives between principals and agents, control costs, minimize information asymmetries, control adverse selection and moral hazard, optimize risk preferences between principals and agents, and engage in monitoring. The Corporate form remains the most popular form of a governance mechanism, despite the unresolved substantive agency problems associated with the division of ownership (shareholders) and control (agent),1 and the incomplete and suboptimal rules that govern such conflicts.
Shareholder value maximization has emerged as the dominant corporate governance solution for the agency problems.2 To reduce the risk of managerial misbehavior and the associated agency problems,3 alignment of the interests of the stakeholders within those of the investor-shareholders has become the dominant implementation of the shareholder primacy doctrine.4 The doctrine suggests that by aligning the interests and incentives of the various actors with those of the investor-shareholders, all of the stakeholders in a firm and the public benefit.5 Following this logic, increasing shareholder control over other actors within the firm has become the primary goal of corporate governance rules.6 The correct corporate governance is seen as naturally resulting in shareholder value.7
The existing corporate governance attempts versus inevitable agency problems fall short of accomplishing the needed governance quality and stability. In an effort to curtail the inevitable instability that is a by-product of the pervasive agency problem in the corporate governance system,8 governments have responded to corporate governance scandals by adopting a number of regulatory changes. Such changes include substantively increased disclosure requirements.9 Shareholder activism reform by itself has been unable to sufficiently improve the corporate governance system.10 Upgrading the U.S. proxy system has been another government priority.11 Changes in executive compensation have been another approach to address the instability of the existing corporate governance system.12 Government-sponsored organizational experimentation that enables new business models and new organizational structures is desirable and valuable and may be one of the few ways to facilitate much-needed corporate governance reform.13
Despite decades of governance experiments and extensive rule revisions, the existing scope of agency problems suggest that the core underlying agency problems cannot fully be resolved within the existing theoretical and legal infrastructure.
Blockchain-based technology has begun to offer alternatives to the existing corporate governance solutions. Blockchain technology can facilitate the removal of agents as intermediaries in corporate governance through code, peer-to-peer connectivity, crowds, and collaboration. Blockchain-based guarantees embedded in blockchain code can help ensure that no participant in business transactions and agency relationships can circumvent the set of governance rules. Blockchain guarantees include contract execution between principal and agent only if and when all contract parameters were fulfilled by both parties and verified in a consensus algorithm. Hence, in the blockchain infrastructure, a lower level of oversight and monitoring of agents changes the cost structure of the principal-agent relationship.
Smart contracts enabled by blockchain technology allow for the comprehensive, near error-free, and zero transaction/agency cost coordination of agency relationships. Smart contracts and smart property are blockchain-enabled computer protocols that facilitate, verify, monitor, and enforce the negotiation and performance of a contract between principal and agent. Agency relationships in smart contracts run exactly as coded without any possibility of opportunistic behavior of the agent. All contractual terms are public and fully transparent. Accordingly, a company’s finances, for instance, are visible on the blockchain to anyone, not just to the company’s accounting department. Smart agency contracts run on a custom-built blockchain that enables principals and agents to store registries of debts or promises and create entire markets, among many other aspects that have not yet been considered.
Blockchain-based legal constructs, known as decentralized autonomous organizations (“DAOs”), have started to challenge the core belief that governance necessitates agency. The first DAO, launched in May 2016, in the founders’ attempt to set up a corporate-type organization without using a conventional corporate structure, had a governance structure that was entirely built on software, code, and smart contracts that ran on the public decentralized blockchain platform Ethereum.14 Because it was pure computer code, it had no physical address, no jurisdiction that could claim jurisdiction/control over it, and it was not an organization with a traditional corporate hierarchy. The DAO did not use a traditional corporate structure that necessitated formal authority and empowerment flowing top-down from investors/shareholders through a board of directors to management and eventually staff. Indeed, it had no directors, managers or employees. In essence, all of the core control mechanisms typically employed by principals in agency relationships were entirely removed in the DAO.
For purposes of this Article, the DAO is a group of anonymized individuals who decide to follow a certain protocol in decentralized computing systems. For instance, the Uber DAO can be seen as Uber the company with all its constituents but without the company, e.g., the entity, itself and its hierarchical governance structures. If Uber were a DAO, the Uber drivers as a group with their respective non-fungible token holdings would become Uber, e.g., a fully decentralized company without hierarchies. The control and power over the Uber DAO would be in the hands of the DAO Uber token holders. Yet, the staking mechanisms for non-fungible tokens in emerging DAO protocols make the voting structure different than any previous attempts at creating liquid democracies.
DAOs are by no means mainstream and are subject to a significant emerging development process. Because the blockchain industry is still in its infancy and core decentralized infrastructure elements will remain lacking for the foreseeable future, DAOs are less likely to disrupt existing corporate structures and the associated governance solutions in the foreseeable future. However, DAOs have the potential to create significant decentralized equivalents of corporate structures. Such development is contingent on workable governance solutions for DAOs. Without DAO governance, their evolution is even less certain. The blockchain industry has begun to recognize the need for DAO infrastructure and governance solutions. Yet, such governance solutions are still largely lacking, even in the developmental phases.
Blockchain-based corporate governance solutions in DAOs require evolutionary blockchain governance protocols. Existing blockchain governance still mainly consists of forking a given chain. Even attempts to create socially optimal chain forking rules cannot suffice. Blockchain-based coded guarantees will evolve and require protocol upgrades for that changing environment. Without evolutionary governance upgrades the cost reduction for the agency relationship cannot be maintained.
This paper begins with an introduction to the issue of DAO governance and evaluates the distinguishing features of DAOs as they pertain to other forms of business organization in Part II. Part III explains the governance shortcomings in DAOs which render existing DAOs less optimal as a support and innovation incubator for the evolution of decentralized commerce. Parts IV and V evaluate possible optimizations of DAO governance through decentralized reputation systems. The paper concludes with a short vision of what improved DAO governance enables for the future evolution of decentralized systems.
Blockchain-based corporate governance functions only to a limited extent in traditional corporate forms. While several US states, including Delaware, have started to evaluate the use of blockchain-based technology for their proxy systems and for the transfer of stock ownership, among other benefits, the traditional centralized forms of limited liability entities can only partially benefit from the decentralized governance offered by blockchain technology. Blockchain-based corporate governance offers dynamic regulatory features that are partially incompatible with the rule-based traditional legal environment with which traditional limited liability entities are required to comply.
Distinguishing Features of Decentralized Systems
Existing decentralized systems display several core commonalities that affect commerce and society. Decentralized systems do not have a central intelligence or leadership system based on traditional hierarchies. Instead, the intelligence is spread throughout the system. Information and knowledge naturally filter in at the edges of the system, closer to where the action is and where most real-time information is created. Decentralized systems can also very easily mutate and change because the information flow is optimized through dynamic feedback effects. As a result, such systems become more attack-resistant on multiple levels. In turn, the ability to mutate rapidly allows the decentralized systems to grow incredibly quickly.
DAOs can be more efficient than hierarchical organizations and their governance. In a hierarchical organization, power is organized in a hierarchical tree structure by necessity. Governance in a hierarchical organization follows the tree structure and supplements the power structure further with agency constructs. By contrast, in a DAO, ideally each member is given autonomous power. The power distribution in DAOs enables greater flexibility and enhanced options for efficiency using the decentralized power structure of interacting domains of expertise. DAOs can be more productive in comparison with hierarchical organizations because the information allocation and feedback effects allow them to distribute the optimal amount of power to the optimal talent at the optimal point in time. The successful implementation of such dynamic power organization requires a decentralized governance structure that motivates DAO token holders to collaborate productively, by fairly rewarding development and work and policing any diminishments.15
Original 2016 DAO
The original 2016 DAO had many original features that distinguished it from traditional forms of business organization. During the DAO crowdfunding campaign in May 2016, investors could become DAO constituents by purchasing DAO Tokens.16 The DAO raised more than $168 million from approximately 10,000 “investors” and was considered the largest crowdfunding campaign of its day. The original 2016 DAO was the founders’ attempt to set up a corporate-type organization without using a conventional corporate structure. The founders’ central idea was that the wisdom of the crowd would lead to smarter and more game-changing investment decisions.17 The original 2016 DAO had to operate as a kind of venture capital fund managed directly by the token holders.18 The DAO governance structure was built on software, code and smart contracts that ran on the public decentralized blockchain platform Ethereum.19 The original 2016 DAO did not have a physical address as it was merely computer code. And it was not an organization with a traditional hierarchy as we know it from traditional corporate structures, where authority and empowerment flow downwards from investors/shareholders through a board of directors to management and eventually staff.20 Indeed, it had no directors, managers or employees. Because a series of smart contracts granted original 2016 DAO token holders voting rights, the blockchain-based smart contracts imitated the role of articles of association or bylaws. Because the DAO code was open source, the token holders would not only vote on “investment proposals,” but also on any change made to the code.21 Accepted proposals would also be backed by software code, defining the relationship (in terms of rights, obligations and performance metrics) between the DAO and the funded proposals.
The hack of the original 2016 DAO called into question the evolution of DAOs as governance vehicles. Fundamental flaws in the original 2016 DAO code enabled hackers to transfer one third of the total funds to a subsidiary account that could not be controlled by either the hacker or the original 2016 DAO members and founders.22 The hack in combination with additional technological limitations terminated the original 2016 DAO initiative.
The Theory of the Firm Revisited
The various interpretations of the theory of the firm suggest that firms exist to reduce transaction costs and as a response to the high cost of using markets.23 Coase suggests the existence of the firm can be explained by the incentives to internalize transactions in order to free workers/collaborators from the need for external regulation.24 A well-defined task can easily be posted on the market, where a contractor is paid a fixed sum for doing it. The firm is needed when simple contracts of this kind will not suffice. Instead, an employee agrees to follow varied and changing instructions, up to agreed limits, for a fixed salary. Others define the existence of a firm as the added efficiency of a centralized production-monitoring agency.25
Inexpensive open-source smart contracts eliminate a major motivation for creating a firm under Ronald Coase’s transaction cost theory.26 Coase posits the existence of the firm derives from the incentive to internalize transactions in order to free workers/collaborators from the need for external regulation, such as costly contracts for minor engagements (e.g., coworkers sharing office supplies).27 Smart contracts enable trustworthy transactions of any size with minimal transaction costs and high levels of transaction security. Barzel’s motivation for the existence of a firm, the added efficiency of a centralized production-monitoring agency,28 is also largely irrelevant with efficient smart contracting, as the smart contract performs the production-monitoring function and largely removes agents.
DAOs challenge the various versions of the theory of the firm, stretch the definition of a firm, and have us question the need for firms. Existing experimentation with DAO designs already contradicts fundamental assumptions about firms, such as the hierarchical organizational structure, the separation of firm members from market members, the cultural or technical homogeneity of members, and many other natural definitions for a firm.
Decentralized transaction cost economics call into question the theory of the firm. If the high costs of using markets, that legitimize the existence of the firms, can be lowered ad infinitum, it becomes questionable what the role of the firm can be. Peer-to-peer transactions in DAOs, facilitated by trust through decentralized consensus protocols and other emerging decentralized technology, can significantly lower transaction costs. Monitoring costs and the cost of agent supervision are largely superfluous in effective DAO designs. Overall, emerging DAO designs can be expected to continue to remove transaction costs. DAOs’ evolving design renders them a more efficient business organization vehicle, especially in comparison with traditional firms.
Economy of scale advantages of centralized firms are challenged by the evolving efficient DAO designs. Decentralized organizations can be organized effectively to achieve greater economies of scale than traditional centralized firms. Existing designs only give an early glimpse of what may be accomplished by future generations of DAOs. Future DAO efficiency can be significantly increased through parameter manipulations to DAO protocol development, security, stability, recruitment and retention of members and outside business. With such parameter upgrades, DAOs enable an eternal, reviewable record of all members’ actions that can facilitate a decentralized organization and achieve greater efficiency than traditional firms.
Like any business organization governance design throughout history, the evolving governance design of DAOs is subject to significant shortcomings. DAOs lack the centralized authority used throughout history to organize society, guide individual and organizational behavior, and enforce rules agreed upon by constituents. From a centralized perspective, such lack of organizational authority results in suboptimal governance outcomes for DAOs. Yet, evolving DAO governance designs can offset lacking centralized organizational authority with more efficient decentralized organization.
DAOs require governance mechanisms when inevitable gaps arise in the incomplete smart contracts of the firm. Corporate law’s core role revolves around the supply of majoritarian default rules that fill the gaps of parties’ necessarily incomplete contracts.29 Corporate governance solutions in the existing legal infrastructure and emerging coded governance solutions have a core common denominator—they are both incomplete contracts. As such, neither can anticipate all problems and eventualities that may arise in the respective entities. Decentralized code-based systems are a nexus of necessarily incomplete smart contracts. Unlike existing corporate governance systems, however, the decentralized nexus of incomplete smart contracts does not have a supply of majoritarian default rules that could fill incomplete code-based smart contracts. The default rules provided by corporate law are largely incompatible because they are based on natural language, among other incompatibility factors. Accordingly, blockchain-based entities have a governance problem like all governance systems that are based on incomplete contracts.
Centralized Design Elements in the Original 2016 DAO
The voting design in the original 2016 DAO introduced points of centralization and corruption. The tokens of the original 2016 DAO gave token holders ownership rights, voting rights, and property rights.30 These features are comparable to stock in traditional corporations. Just as with the traditional voting stock of a corporation, the original 2016 DAO token allowed its holders to vote on DAO investment proposals. Token holders with more tokens held more voting power than token holders with fewer tokens. Voting proposals in the original 2016 DAO did not involve staking of any non-fungible tokens towards a vote outcome. Nor did those voting proposals have a randomization element. All voting in the original 2016 DAO revolved around centralized voting power. As such, its voting design introduced opportunities to corrupt the DAO and its governance structure.
The governance structure of the original 2016 DAO relied on centralized leadership in the form of “curators.”31 The 2016 original DAO did not have an autonomous decentralized validation pool for contractor proposals. The curators created and controlled the whitelist of those preselected contractors that were authorized to receive ether from the DAO. 32 Because the smart contract on its own could not distinguish real from fake proposals, the curators had approval power and vote prioritization power over contractor proposals before the proposals were put up for a DAO community vote. DAO token holders who had been selected as contractors through a DAO member vote needed the curators’ verification that a given smart contract submitted by the token holder matched the public smart contract on the Ethereum blockchain, and that the contractor’s identity matched.33 The curators, thus, were the core point of centralization in the original 2016 DAO design. Curators would have become the control bottleneck of the original 2016 DAO as they would have had control—not over the contractor selection itself, as the DAO had voted on this, but over the addition of project proposals via smart contracts to the Ethereum blockchain.34
The payment structure for smart contract work proposals in the original 2016 DAO introduced a point of centralization. Any token holder in the original 2016 DAO was eligible to submit a proposal via smart contract for a DAO vote to become a contractor for the token holder community. Yet, the requirement to pay an ether deposit that the token holder would forfeit if the proposal failed to achieve the quorum requirement introduced a point of attack and centralization. Fungible cryptocurrencies, such as ether, are by their very nature a corruptive element. Decision makers can be influenced by the power that derives from fungible currency. Power in turn can grow with the size of fungible cryptocurrency holdings. Decentralized decision-making necessitates non-fungible payouts metrics combined with an indirect fungible payout structure.
Similarly, the payment structure for curators and contractors of the original 2016 DAO created points of attack on the overall governance structure of the original 2016 DAO. Any projects that were approved by the original DAO token member community would have required the contractor or curator to complete the approved task in exchange for ether from the DAO. Direct payments to the curator or contractor in a fungible cryptocurrency create points of attack and corruption for the governance structure. If curators’ and contractors’ payment come from a fungible currency source without a direct or indirect penalty for underperformance, such as lower token scores, DAO contractors and workers may be corrupted by external sources. A non-fungible form of payment with a penalty for underperformance would make those corruptive elements less likely.
Lack of Proper Incentivization
Existing DAO governance design structures failed to take into account the historical precedents on governance. Humanity has been debating governance designs since the inception of human organization.35 Common core denominators of existing problems in governance design include the corruptive effects of existing governance designs with fungible assets as well as the identity of actors in governance designs. These factors contributed to the resulting inability to govern institutions effectively.
The lack of proper incentivization is a core common denominator for all existing blockchain governance structures and especially on-chain governance structures. The participants in any institution need to be incentivized to improve their own utility while at the same time benefiting the entirety of the institution for the long run. Without that duality of incentivization, rational and opportunistic internal and external constituents will attempt to game the governance design.
Historically, when fungible assets are used as the dominant incentive design in the governance of institutions with identifiable actors, rational and opportunistic internal constituents and external participants have attempted to corrupt the system. If the governance and incentive alignment design via fungible assets allows for the optimization of personal utility, people will continue to try to game the governance design to maximize their personal utility at the expense of the common good of the institution and its members.
Identity of actors in governance designs contributes to corruptive elements. Throughout history, governance designs were created by identifiable members of institutions for their fellow members. Regulators and regulatees are usually able to identify each other individually. In these identifiable circumstances for institutional governance design, people have long failed to organize effectively. Corruption is possible if actors can be identified. Every instantiation of institutional governance design involving identifiable humans was afflicted by corruption sooner or later.
Lack of Default Rules
Default rules provide flexibility and cheap legal solutions for businesses. U.S. corporate law provides relatively few mandatory rules.36 Rather, business association law provides default rules to fill gaps in contractual associations.37 Such default rules create a nexus of contracts that are available if and when needed. Contracting parties can tailor the default rules. Parties do not have to anticipate all eventualities that may arise in their relationship because the default rules provide a nexus of contractual provisions that are available if and when eventualities materialize. This creates legal certainty and the associated economic benefits.
Blockchain-based smart contracting calls into question the application of existing default rules. For business associations organized via smart contracts on the blockchain, aka DAOs, existing jurisdictional points of legal intervention are less clearly established. 38 Default rules afforded by the existing legal system are less likely to provide the established nexus of default contracts for blockchain-based transactions. However, the architects, designers, and coders of a given smart contract ecosystem can affirmatively opt into the existing legal order through code. If and how such opting-in would be legally enforceable in the existing legal order or otherwise is less clear. The existing legal infrastructure still relies heavily on natural language, which is antithetical to smart contracting.
The DAO created a type of business organization that exists separate and apart from the existing legal order. DAOs are able to create a decentralized nexus of smart contracts that exist on separate nodes around the world with very limited points of centralization. Well-designed DAOs are in the unique position to create very sophisticated, autonomously, and evolutionarily morphing rules.39 These DAO rules go beyond any sets of traditionally conceived business association default rules. Well-designed DAOs can create oracles that allow the blockchain to interact with unvalidated data sources.40 They can provide internal and external governance and interaction with other DAOs, external blockchains, and centralized entities. External governance includes the ability for other non-native DAOs in a given blockchain to opt into the rules and templates for rules provided by a given native DAO that established over time the then-optimal set of rules by way of precedent.41 Because of the decentralized, autonomous, and evolutionary nature of the emerging DAOs, entity organization cannot be traced to any particular individual. In other words, it is very difficult to imagine any particular individual actor that the existing law could single out for jurisdictional reach or liability.
Lacking On-Chain Voting Mechanism
Existing decentralized protocols lack an effective on-chain voting mechanism. A one-token-one-vote voting mechanism in existing decentralized protocols with on-chain governance resembles a plutocracy. Token holders in a given DAO with a significant share of the total supply of tokens have more power than the rest of the DAO members. This is a common phenomenon among decentralized protocols at the end of 2019. For instance, on and around September 12, 2017, 4.11% of the bitcoin addresses controlled 96.53% of the total bitcoin supply.42
Suboptimal voting outcomes associated with one-token-one-vote voting mechanisms in existing decentralized protocols can largely be traced back to the immaturity of the existing decentralized protocols. For instance, the low voter participation in existing decentralized protocols43 underscores the lacking incentive alignment of the respective DAO voters and users. Coin owners of a given network have vested interests in the existing pricing structure of their respective network. The users of that network, if different from the coin owners, typically would like the prices to depreciate.
Socially Optimal Forks
Forking requirements in existing decentralized systems are different from those of other corporate governance settings. Hard forks are unique in governance settings in the sense that only a subset of the population, here the blockchain community associated with a given chain, is subject to the protocol change. The typical mandatory corporate governance rule change affects the entire population either via acts of Congress in the U.S. or agency rule changes.
In the current blockchain governance environment, existing blockchains generally need to calibrate forks for protocol upgrades.44 Forks result in previously uniform nodes that, after the fork, run a different protocol with different data. A soft fork is a backward compatible protocol upgrade. The soft fork creates a new, more restrictive protocol rule, e.g. a block size limit of 1 MB is changed by the soft fork to 500 KB. Because it is more restrictive and not more expansive, it is backward compatible with the previous protocol rule. By contrast, the hard fork creates a more expansive ruleset and is therefore not backward compatible. For instance, an increase of the block size limit from 1MB per block to 2 MB per block would not be backward compatible because the previous protocol limited the block size to 1 MB. While sometimes forks are merely used to test a process or upgrade,45 forking is more often used to implement a fundamental protocol change, or to create new digital asset characteristics.
The necessity of chain forking for protocol upgrades in the existing blockchain infrastructure is associated with significant negative effects. The bifurcation of nodes can lead to significant problems, confusion, errors, economic loss, and bugs. For example, in the case of the bitcoin protocol, changes in defining protocol parameters such as the difficulty of the cryptographic puzzle, the block size, and limits to additional information that can be added, among other elements, can result in some blocks being accepted by the new protocol but rejected by older versions of the protocol. A result can be the loss of funds. It is theoretically possible that the two and subsequent chains could grow in parallel indefinitely. The economic loss associated with such parallel existence can be quite significant. The reemergence of the double spend problem can also result from a hard fork. Because wallets, merchants, and users running the previous code deem the new code invalid and thus cannot detect the spending on the new code, cryptocurrencies spent in a new block could be spent again on an old block.46
Contention is another unique risk of a hard fork that can result in social and political turmoil and the need for blockchain reorganization. If after a hard fork, the respective community cannot agree on which chain is the true chain, e.g. the chain that provides the most likely survivable protocol, it may result in two blockchains that compete in perpetuity. This was the case with the fork that created Bitcoin Cash.47 A viable solution is for one branch of a chain to be abandoned in favor of the other branch. However, that can result in some miners losing out because the transactions they may have mined would be re-allocated. It is difficult to switch all nodes to the newer version of the protocol at the same time because decentralized systems are typically too widely spread for cohesion.
The emergence of decentralized evolutionary protocol upgrades can help ensure that future DAOs will be less affected by the negative effects of forks. While the forking necessity in the current system requirements can be socially optimal,48 the long-term social and economic loss of a fork could be avoided if decentralized systems are one day be governed by autonomous evolutionary governance protocols.49
Innovation, the complexities of financial markets, and ever-changing circumstances of smart contracting require decentralized institutional arrangements and a rulemaking process that continuously adjusts to these challenges. The complexities of today’s increasingly decentralized society,50 its coded solutions to remedy the complexities, costs, etc., and markets benefit from dynamic coded institutional arrangements and processes for coded rulemaking.
The success of DAO governance designs is determined by several core factors. First and foremost, the level of decentralization in the DAO governance design is determinative for its future resilience and attack resistance. Incentive alignment of DAO constituents is a core function of successful decentralization and has a significant impact on the success of the governance design. Dynamic feedback effects in the DAO governance design also impact its ability to evolutionarily provide solutions as the circumstances of the DAO change. The structure and extent of on-chain DAO governance is also an important evolving design factor. Finally, decentralized autonomous and anonymous reputation verification systems offer much needed governance design input parameters that so far could not been provided otherwise.
Dynamic DAO Governance
Decentralized dynamic DAO governance can serve as regulatory supplements enabling rulemakers’ adaptation to regulatory contingencies if and when they arise. Decentralization exacerbates the existing inability of centralized rulemaking structures to address the shortcomings in the rulemaking process for stable and presumptively optimal rules. Feedback effects in DAOs provide relevant, timely, decentralized, and institution-specific information ex-ante. By increasing the availability of information ex-ante, dynamic regulatory tools help reduce unforeseen contingencies in the rulemaking process pertaining to innovation. Improved information for rulemaking also helps to maintain certainty in the rulemaking process.
DAO governance must be dynamic to avoid corruptive influences. Stable and presumptively optimal static constitutional rules for DAO governance typically enable gaming and arbitrage opportunities. In any open and democratic system, naturally opportunistic rational parties will attempt to circumvent and game the sets of applicable complex static rules to increase their share of power and profit within the system. To enable sufficient protection of DAO members while at the same time allowing for DAO enhancements, the static sets of rules of smart contracts in such a system will need to be rather complex. With static complex sets of DAO rules comes inevitable corruptive opportunistic gaming and arbitrage behavior. To avoid these negative effects of static complex DAO rules, effective DAO governance designs should be focused on dynamic elements. Dynamic elements here include DAO members’ ability to re-evaluate existing precedent in the system.
Unlike the existing corporate governance framework, the technological infrastructure underpinning DAOs enables autonomous and evolutionary incomplete smart contract upgrades. With dynamic DAO governance mechanisms, DAO token holders can vote for a change to any outdated or flawed code as the flaws materialize or in anticipation of future contingencies. In that sense, DAOs can generate majoritarian rules ex-post without the need for ex-ante majoritarian rules that function as default rules.51 Ex-post code-based majoritarian rules are superior to ex-ante majoritarian rules because they are based on more accurate real-time information from the edge and decentralized feedback effects. Ex-post code-based majoritarian rules are not subject to the same information asymmetries as stable and presumptively optimal ex-ante rules. As such, DAOs enable a code-based governance infrastructure that can create dynamic governance protocol upgrades in real-time through dynamic feedback loops.
Dynamic and evolutionary reputation-based DAO governance is possible via a decentralized on-chain precedent system.52 A decentralized on-chain precedent system enables feedback effects between DAO members, the public record of work/posts on the blockchain, and the public users. The decentralized precedent system makes the continuous upgrading of real-time data possible.53 As a post/template on the blockchain is increasingly referenced by the DAO members and other users, it increases in non-fungible reputation weight and associated fungible salaries. Conversely, if a post/template on the blockchain dissipates over time, a new post/template emerges naturally. If the new post/template is more often referenced by the DAO members and other users, it becomes over time the new prevailing precedent. The old precedent dissipates over time with non-use.54
Level of Decentralization
The level of decentralization may be a proxy for optimized DAO design parameters. The more decentralized a given DAO design, the more likely it is to affect its precedence and adoption. The level of decentralization and the associated attack resistance and incorruptibility of DAO governance designs are among the core factors that influence a DAO’s design adoption, its precedence, and longevity. However, not all future DAO designs will comply with the ideal typical DAO parameters. Ideal typical DAO design parameters will naturally filter out at the edges. In other words, because the optimal DAO design parameters change constantly, if and when formerly ideal typical designs fail, new and optimized designs will replace them.
The level of decentralization in DAO designs increases with the following instantiations in DAO governance: a) anonymity of DAO members, e.g. DAO members cannot be personally identified other than by their respective merit in the DAO structure;55 b) merit identifiers, e.g. DAO members’ merit, knowledge, and influence is measured through their respective DAO non-fungible token ownership;56 c) non-fungibility of tokens; e.g. merit of a DAO member is expressed by an non-fungible reputation token that cannot be bought or sold;57 d) full transparency, e.g. all DAO decisions are fully transparently accessible by the public and the DAO members themselves;58 e) indirect economic incentives, e.g. DAO members are paid with fungible tokens in proportion to their non-fungible tokens;59 f) decisions in the DAO are made with a voting design that revolves around staking of non-fungible tokens;60 and g) fungible salary tokens are designed as stable cryptocurrencies and maintain their value at around $1 US.61 Several other factors influence the level of decentralization of DAO designs that are beyond the scope of this Article.
Incentive alignment is at the core of centralized and decentralized governance designs. The failures of incentive alignment in centralized governance structures are well-documented.62 Unlike centralized governance incentive design, decentralized incentive alignment in the DAO can be organized in an incorruptible way with non-fungible digital assets. Because of the technological infrastructure of decentralized systems, it is possible for decentralized incentive design to create solutions that thus far do not exist in centralized governance structures. Collective action problems associated with lacking incentive alignment in existing agency-based governance designs can be overcome by efficiently designed DAO governance.
Optimized DAO governance design needs to incentivize DAO members with indirect economic gain. This is possible with a combination of token designs. In a bifurcated DAO design with two disparate types of tokens, DAO members would only indirectly gain economically if: 1. Non-fungible tokens give them voting rights in the DAO and are used as a merit score in the respective DAO, 2. Fungible tokens allow DAO members to earn a fungible salary tokens in proportion to their non-fungible tokens. DAO members would increase their non-fungible tokens by making valuable contributions to the DAO. They would get paid in fungible tokens in proportion to their respective non-fungible token score in a given DAO. The indirect economic effects remove corruptive elements and make the governance design more attack-resistant and stable in the long run.63
DAO governance designs enable a much more equal distribution of power. Language, religion, race, physical presence, group identifiers, culture, etc., influence centralized power distribution. Similarly, commonly used identifiers in centralized governance such as social media profiles and credit scores, among others, are essential for access to the central system and to resources. Such relatively superficial identifiers play less of a role in DAO voting designs. The more equal distribution of power in the DAO governance design allows the inclusion of constituents who otherwise have no agency in centralized systems.
On-Chain DAO Governance
Since its inception, the blockchain community has debated the preferable modus operandi for protocol changes.64 Most cryptocurrencies would not exist if Bitcoin and Ethereum had incentives for future protocol development and governance built into the core protocol.65 The community has considered different attempts and proposals for more fully democratized blockchain governance. Those proposals included Ethereum Improvement Proposals, 66 Bitcoin Improvement Proposals, 67 Ethereum General Assembly,68 mailing lists,69 and suggestion pages on GitHub trees.70
On-chain governance is a necessity for most public blockchains. Because all existing blockchains need to calibrate soft forks for protocol upgrades, most public blockchain communities that value decentralization have considered on-chain governance for their protocol.71 Certain protocols have expanded their on-chain governance considerations. These include, but are not limited to: Tendermint,72 PolkaDot,73 DAOstack, 74Tezos,75 Dash,76 Bitshares, Lisk, MemoryCoin, Aragon,77 Cardano,78 Maker,79 and NuShares.80
Arguments against on-chain governance are bountiful. Arguably, an off-chain governance system that finds an equilibrium between several competing factors could be a better alternative for protocol governance than an on-chain governance mechanism.81 In an off-chain governance model, miners provide checks and balances on power over protocol changes. On-chain governance arguably removes such checks and balances. An on-chain governance model also arguably would take away participation in governance from miners and subsequently users. Because on-chain governance enables automatic protocol upgrades and is not dependent on manual interference by miners, miners are no longer required to make a conscious choice to participate in their chosen chain.82
More mature emerging voting ecosystems enable on-chain protocol governance with an incentive design that more optimally balances risk and rewards of voting. Alternative voting methods include quadratic voting,83 futarchy,84 liquid democracy,85 and reputation-based voting as an instantiation of non-fungible voting.86 These voting alternatives can ameliorate the traditional voting power corruption of one-token-one-vote.
On-chain governance models can further be optimized with reputation-based staking as voting mechanisms.87 Reputation-based voting revolves around voting by way of staking a non-fungible asset, i.e. staking non-fungible reputation tokens in a given DAO, towards a certain outcome. The corruptive elements of fungible assets/tokens are removed because third parties are less likely able to take over a non-fungible asset, such as reputation, that is organically grown and maintained through actual expertise in a given DAO subject matter. Even if third parties are able to take over or purchase non-fungible reputation, they are less likely able to maintain the reputation score and the associated revenue stream of fungible assets over time.
Reputation can take on an unprecedented role in decentralized governance mechanisms. Reputation-based governance can optimize actors’ incentive design in the decentralized governance infrastructure. Reputation can generally be defined as a predictor for actors’ future behavior given the history of actors’ actions. It is central for proper incentivization in the existing centralized infrastructure for business and government. Because of the advances in emerging decentralized technology, reputation can take on an unprecedented role in future decentralized governance mechanisms.
Existing reputation-based metrics have been ineffective in centralized governance systems. Before the emergence of blockchain technology, reputation could not be stored autonomously, anonymously, and transparently. Accordingly, reputation was not a reliable predictor of actors’ future actions in centralized governance systems. Existing reputation governance designs, such as the web of trust88 and even more primitive designs such as simple reputation triangulation metrics,89 suffered from countless inadequacies, including Sybil attacks90 and tyranny of the majority.91 These shortcomings undermined the meaning and value of digital reputation in centralized Internet platform-based businesses. Worse, these past centralized attempts at reputation verification were unable to meet the demands of constantly changing protocol needs.92 They were based on stable and presumptively optimal rules which are vulnerable to gaming.
Reputation has two key advantages over existing decentralized one-token-one-vote voting mechanisms: 1) it is non-fungible, which avoids corruptive elements,93 and 2) it optimally aligns incentives for DAO members individually and at the same time for the totality of the DAO as an institution. 94 Because reputation is non-fungible and ideally anonymous, it is much harder for DAO members and external participants to try to game the system to improve their own utility exclusively while hurting the common good of the DAO.
Reputation as a valuation metric allows DAO members to improve their own utility while at the same time improving the whole institution over the long term. If reputation is used as a metric for indirect economic benefits, e.g. a salary in fungible tokens that is paid in proportion to the non-fungible reputation token score, DAO reputation token holders are incentivized to increase their own reputation/utility by engaging in valuable conduct for the DAO. The more the aggregated individual reputation of all DAO members increases, the more the overall institution’s value increases, and the more the institution creates value-enhancing outcomes for its members.
Reputation-staking as a basis for DAO governance improves incentive alignment, enabling the correlation between individual and institutional value enhancement. DAO members rationally stake their own reputation tokens based on the outcomes they believe will increase their overall reputation/utility. If they do not, they would irrationally surrender a future income stream in fungible tokens. Through reputation-staking, the DAO members are incentivized to provide long-term positive contributions because the DAO member reputation is transparent and reviewable by the DAO and the public in a slow and stable review process that reaches far into the future. Valuable individual behavior/work that leads to individualized reputation-staking and individual reputation enhancement also enhances the DAO as an institution because the individual and institutional value enhancements are correlated.95
Reputation-based DAO governance design changes the dynamic of a zero-sum game to a positive-sum game. Existing DAO governance designs were mostly zero-sum games. They used mostly fungible rewards and incentive designs where DAO members pursued as large of a portion of the rewards as possible for themselves. By contrast, the reputation-based DAO creates a positive-sum game because DAO members have incentives to create lasting non-fungible value for the institution by developing a long-term non-fungible record of productive cooperation that in effect improves the DAO. Moreover, individual DAO member reputation can change dynamically if DAO member actions depreciate in value. The DAO member reputation should be inflationary in the DAO design. As such, non-use, e.g. non-staking or non-voting, would lead to value depreciation, which incentivizes action and thus value enhancement.
Future optimized DAO designs may accomplish significant upgrades for DAO governance that can help reform traditional notions of corporate governance. The remarks below are based on ideal-typical DAO governance design parameters. Not all future DAO designs will follow these ideal-typical parameters.
DAO token holders are largely free from existing corporate hierarchies and their restricting effects. People who work for a DAO are subject to a different kind of agency relationship and not subject to a centralized supervisor or CEO who received legitimacy through centralized validation. Instead, DAO workers work in a dynamic set of working relationships that continuously and dynamically self-organize around projects and outcomes, not corporate hierarchies.
The intrinsic motivation of DAO members changes incentive structure and governance outcomes compared with traditional hierarchical organizations. Most hierarchical organizations rely predominantly on extrinsic incentive structures, through wages etc. By contrast, the core common denominator for all DAO token members is the unifying desire to optimize the DAO structure and the DAO reputation token value. If a member-identified optimization has the potential to make the DAO more meaningful, useful, or valuable to the token holder members, the DAO token holders will desire to perform such optimization tasks as it is in their very interest to do so to help increase the value of their DAO reputation tokens.
DAO governance designs emphasize token holders’ incentives to add value to the DAO community. That benefits all constituents. Because projects that cannot add value take away token holders’ time from more productive endeavors, token holders become focused on managing their time and efforts. Unlike in traditional hierarchical organizations where “face-time” and unproductive meetings are the norm, the self-governing DAO token optimizer avoids any such corporate hierarchy inefficiencies and frees herself from top-down inefficiencies and negative outcomes.96
The value-to-effort focus of work flows in the DAO structure has the potential to reform agency relationships in governance. The value-focused performance in the DAO structure helps optimize work flows and creates sustainable solutions for DAO token holders. The supervisor in the traditional hierarchical corporate structure can determine where, what, and when workers have to perform, which often results in support for suboptimal outcomes to please supervisors, among many other suboptimal outcomes. By contrast, in the decentralized environment of DAOs, influence and outcomes are not created by hierarchy but rather determined by the value of a token holder’s contributions to a project’s success. Moreover, if a token holder adds substantial value to the DAO, other DAO token holders will want to add their skills in the same context, which focuses the token holders’ efforts on the highest possible value proposition.
For the first time in history, blockchain technology gives actors and institutions an environment to collaborate on neutral territory. Every member’s contributions to an institution can be recorded in a fully transparent way. These unprecedented technological features enable corporations and other forms of business organizations to be supplemented with blockchain-based agency constructs. As such, DAOs expand the definition of the firm, have us question the need for firms, and call into question the various versions of the theory of the firm. DAOs have started to challenge the dominant governance structures facilitated by legacy agency constructs. Future ideal-typical DAO governance designs will be filtered out at the edges of the system and will be subject to ongoing dynamic iterative change and upgrading. The technological infrastructure for DAOs enables these emerging features.