[Disclaimer: I do not own any cryptocurrencies nor have I participated in any DAO crowdfunding.]

This post will look at the difference between a decentralized autonomous organization (DAO) and a project called The DAO.

Brief explanation

The wikipedia entry on DAOs is not very helpful.  However, Chapters 2 through 5 may be of some use (although it is dated information).

In terms of the uber hyped blockchain world, at its most basic kernel, a DAO is a bit of code — sometimes called a “smart contract” (a wretched name) — that enables a multitude of parties including other DAOs to send cryptographically verifiable instructions (such as a digitally signed vote) in order to execute the terms and conditions of the cloud-based code in a manner that is difficult to censor.

One way to think of a simple DAO: it is an automated escrow agent that lives on a decentralized cloud where it can only distribute funds (e.g., issue a dividend, disperse payroll) upon on receiving or even not receiving a digital signal that a task has been completed or is incomplete.

For instance, let us assume that a small non-profit aid organization whose staff primarily work in economically and politically unstable regions with strict capital controls, set up a DAO — an escrow agent — on a decentralized cloud to distribute payroll each month.

This cloud-based escrow agent was coded such that it would only distribute the funds once a threshold of digital signatures had signed an on-chain contract — not just by staff members — but also from independent on-the-ground individuals who observed that the staff members were indeed doing their job.  Some might call these independent observers as oracles, but that is a topic for a different post.1

Once enough signatures had been used to sign an on-chain contract, the escrow agent would automatically release the funds to the appropriate individuals (or rather, to a public address that an individual controls via private key).  The terms in which the agent operated could also be amended with a predetermined number of votes, just like corporate board’s and shareholder’s vote to change charters and contracts today.

The purported utility that decentralization brings to this situation is that it makes censoring transactions by third parties more difficult than if the funds flowed through a centralized rail.  There are trade-offs to these logistics but that is beyond the scope of this post.

The reason the DAO acronym includes the “organization” part is that the end-goal by its promoters is for it to provide services beyond these simple escrow characteristics such as handling most if not all administrative tasks such as hiring and firing.

Watch out Zenefits, the cryptocurrency world is going to eat your lunch!  Oh wait.

A short history

It is really easy to get caught up in the euphoria of a shiny new toy.  And the original goal of a DAO sounds like something out of science fiction —  but these undertones probably do it a disservice.

Prior to 2014 there had been several small discussions around the topic of autonomous “agents” as it related to Bitcoin.

For instance, in August 2013, Mike Hearn gave a presentation at Turing Festival (see above), describing what was effectively a series of decentralized agents that operated logistical companies such as an autonomous car service.

Several months later, Vitalik Buterin published the Ethereum white paper which dove into the details of how to build a network — in this case a public blockchain — which natively supported code that could perform complex on-chain tasks: or what he dubbed as a decentralized autonomous organization.

Timing

The impetus and timing for this post is based on an ongoing crowdsale / crowdfunding activity for the confusingly named “The DAO” that has drawn a lot of media attention.

Over the past year, a group of developers, some of whom are affiliated with the Ethereum Foundation and others affiliated with a company called Slock.it have created what is marketed as the first living and breathing DAO on the Ethereum network.

The organizers kicked off a month long token sale and at the time of this writing just over 10 million ether (the native currency of the Ethereum blockchain) — or approximately 13% of all mined ether — has been sent to The DAO.  This is roughly equivalent to over $100 million based on the current market price of ether (ETH).

In return for sending ether to The DAO, users receive an asset called a DAO Token which can be used in the future to vote on projects that The DAO wants to fund.2 It is a process that Swarm failed at doing.

An investment fund or a Kickstarter project?

I would argue that, while from a technical standpoint it is possible to successfully set up a DAO in the manner that The DAO team did, that there really isn’t much utility to do so in an environment in which censorship or the theft of funds by third parties will probably not occur.

That is to say, just as I have argued before that permissioned-on-permissionless is a shortsighted idea, The DAO as it is currently set up, is probably a solution to a problem that no one really has.3

Or in short, if you “invested” in The DAO crowdsale thinking you’re going to make money back from the projects via dividends, you might be better off investing in Disney dollars.

Why?

Putting aside securities regulations and regulators such as the SEC for a moment, most of the crowdsale “investors” probably don’t realize that:

1. crowdfunding in general has a checkered track record of return-on-investment4
2. crowdfunding in the cryptocurrency world almost always relies on the future appreciation of token prices in order to break-even and not through the actual creation of new features or tools (e.g., see Mastercoin/Omni which effectively flopped)
   
3. that the funds, when dispersed to Slock.it and other “products,” could take years, if ever to return a dividend

Why would this pool of capital provide any better expected return-on-investment than others?

Or as Nick Zeeb explained to me:

My sense about The DAO is that it’s a fascinating experiment that I do not want to be part of. I also do not think that a committee of over 1,000 strangers will make wise investment decisions. Most good investment decisions are taken by courageous individuals in my opinion. Anything that can get past a big committee will probably not be the next Google. Imagine this pitch: “Hi I’m Larry and this is Sergey and we want to build the world’s 35th search engine.”

While it probably wasn’t the 35th search engine, tor those unfamiliar with the history of Google, Larry Page and Sergey Brin are the co-founders who created a search engine in what was then though a very crowded market.

So why the excitement?

I think part of it is quite simply: if you own a bunch of ether, there really isn’t much you can do with it right now.  This is a problem that plagues the entire cryptocurrency ecosystem.

Despite all the back-patting at conferences, the market is already filled with lots of different tokens. There is a glut of tokens which do not currently provide many useful things that you couldn’t already do with existing cash systems.5

Part of it also is that most probably think they will some become rich quick through dividends, but that probably won’t happen anytime soon, if at all.

With The DAO, only the development teams of projects that are voted and approved by The DAO (e.g., the thousands of users with DAO Tokens), will see any short term gains through a steady paycheck.  And it is only after they build, ship and sell a product that the original investors may begin seeing some kind of return.

Or in other words: over the past several weeks, the pooling of capital has taken place for The DAO.  In the future there will be various votes as to where that capital goes.  Shortly thereafter, some capital is deployed and later KPI’s will be assessed in order to determine whether or not funding should continue.  All the while some type of profit is sought and dividend returned.

Why, I asked another friend, would this pool of capital offer any better risk adjusted return-on-investment than other asset classes?

In his view:

The return might be high but so is the risk. Always adjust for risk. I think The DAO is better compared to a distributed venture capital firm. Whether that’s better or worse I don’t know — I mean you have the crowd deciding on investments. Or more realistically: nerds who know how to obtain ether (ETH) get to decide on investments.

Does that make them better VCs? Probably not. However, The DAO can decide to hire people with actual credentials to manage and select the investments, admitting its own weakness which would then turn into a strength. I think this can go either way but given the regulator is not prepared for any of this it will probably not work out in the short term.

Does the ‘design-by-giant-nerd-committee’ process work?

Over the past year we have already seen the thousands, probably tens-of-thousands of man-hours dropped into the gravity well that is known as the “block size debate.”  In which hundreds of passionate developers have seemingly argued non-stop on Slack, Twitter, reddit, IRC, conferences and so forth without really coming to an amicable decision any one group really likes.

So if block size-design-by-committee hasn’t worked out terribly well, will the thousands of investors in The DAO take to social media to influence and lobby one another in the future?  And if so, how productive is that versus alternative investment vehicles?

Redistributing the monetary base

Assuming Ethereum has an economy (which it probably doesn’t by most conventional measures), will The DAO create a deflationary effect on the Ethereum economy?

For instance, at its current rate, The DAO could absorb about 20% of the ether (ETH) monetary base.

Does that mean it permanently removes some of the monetary base?  Probably not.

For example, we know that there will be some disbursements to projects such as Slock.it, so there will be some liquidity from this on-chain entity.  And that future DAOs will spend their ether on expenses and development like a normal organization.

But we also know that there is a disconnect between what The DAO is, an investment fund, with what many people see it as: a large vault filled with gold laying in Challenger Deep that will somehow appreciate in value and they will be able to somehow extract that value.

Sure, we will all be able to observe that the funds exist at the bottom of the trench, but someone somewhere has to actually create value with the DAO Tokens and/or ether.

For the same reason that most incubators, accelerators and VC funds fail, that entrepreneur-reliant math doesn’t change for The DAO.  Not only does The DAO need to have a large volume of deal flow, but The DAO needs to attract legitimate projects that — as my friend point out above — have a better risk adjusted return-on-investment than other asset classes.

Will the return-on-investment of the DAO as an asset class be positive in the “early days”?  What happens when the operators and recipients of DAO funds eventually confront the problem of securities regulation?

So far, most of the proposals that appear to be geared up for funding are reminiscent to hype cycles we have all seen over the past couple of years.

Let’s build a product…

• 2014: But with Bitcoin
• 2015: But with Blockchain
• 2016: But with DAO

Maybe the funds will not all be vaporized, but if a non-trivial amount of ETH ends up being held in this DAO or others, it could be the case that with sluggish deal flow, a large portion of the funds could remain inert.  And since this ether would not touching any financial flows; it would be equivalent to storing a large fraction of M0 in your basement safe, siloed off from liquid capital markets.

Ten observations

1. Since the crowdsale / crowdfund began on April 30, the market price of ETH has increased ~30%; is that a coincidence or is there new demand being generated due to The DAO crowdsale?
2. A small bug has been discovered in terms of the ETH to DAO Token conversion time table
3. The DAO surpassed the Ethereum Foundation to become the largest single holder of ether (note: the linked article is already outdated)
4. In terms of concentration of wealth: according to Etherscan, the top 50 DAO Token holders collectively “own” 38.49% of The DAO
5. The top 500 DAO Token holders collectively “own” 71.39% of The DAO
6. As of this writing there are over 15,000 entities (not necessarily individuals) that “own” some amount of a DAO Token
7. Why is “own” in quotation marks? Because it is still unclear if controlling access to these private keys is the same thing as owning them.  See also: Watermarked Tokens as well as The Law of Bitcoin
8. Gatecoin, which facilitated the crowdsale of both The DAO and DigixDAO was recently hacked and an estimated $2 million in bitcoins and ether were stolen
9. Yesterday Gavin Wood, a co-founder of Ethereum, announced that he is stepping down as a “curator” for The DAO.  Curators, according to him, are effectively just individuals who identify whether someone is who they say they are — and have no other duties, responsibilities or authority.
10. Three days ago, the Slock.it dev team — some of whom also worked on creating The DAO — did a live Q/A session that was videotaped and attempted to answer some difficult questions, like how many DAO Tokens they individually own.

Conclusion

About 17 months ago I put together a list of token crowdsales.  It would be interesting to revisit these at some point later this year to see what the return has been for those holders and how many failed.

For instance, there hasn’t really been any qualitative analysis of crowdsales or ICOs in beyond looking at price appreciation.6 What other utility was ultimately created with the issuance of say, factoids (Factom tokens) or REP (Augur tokens)?

Similarly, no one has really probed Bitcoin mining (and all POW mining) through the lens of a crowdsale on network security. Is every 10 minutes an ICO? After all, the scratch-off contest ties up capital seeking rents on seigniorage and in the long run, assuming a competitive market, that seigniorage is bid away to what Robert Sams has pointed out to where the marginal cost equals the marginal value of a token. So you end up with this relatively large capital base — divorced from the real world — that actually doesn’t produce goods or services beyond the need to be circularly protected via capital-intensive infrastructure.

Other questions to explore in the future include:

• what are the benefits, if any, of using a centralized autonomous organization (CAO) versus decentralized autonomous organization (DAO) for regulated institutions?
• how can a party or parties sue a decentralized autonomous organization? 7
• what are the legal implications of conducting a 51% attack on a network with legally recognized DAOs residing on a public blockchain?8
• will the continued concentration of ether and/or DAO Tokens create a 51% voting problem identified in the “Curator” section?

Still don’t fully understand what The DAO is?  Earlier this week CoinDesk published a pretty good overview of it.

[Special thanks to Raffael Danielli, Robert Sams and Nick Zeeb for their thoughts]

Endnotes

1. Note: for the purposes of The DAO, “curators” are effectively identity oracles. [↩]
2. It appears that currently, once a quorum is achieved, a relatively small proportion of token holders can vote “yes” to a proposal to trigger a large payout. [↩]
3. The current line-up of goods and services are not based around solving for problems in which censorship is a threat, such as those facing an aid worker in a politically unstable region. [↩]
4. That is not to say that they all fail. In fact according to one statistic from Kickstarter, there was a 9% failure rate on its platform. Thus, it depends on the platform and what the reward is. [↩]
5. CoinGecko is tracking several hundred tokens. [↩]
6. ICO stands for “initial coin offering” — it is slight twist to the term IPO as it relates to securities. [↩]
7. An added wrinkle to identifying liable parties is: what happens when systems like Zcash launch? [↩]
8. This presupposes that a DAO will gain legal recognition and/or a public blockchain gains legal standing as an actual legal record. [↩]