Analysis of The Reasons for The Inefficiency of DAOs and Factors to Be Considered

5 min readAug 29, 2022

Treat DAO rationally and avoid falling into the efficiency traps and loopholes of DAO.

DAO Inefficiency Background

The DAO furthers its business goals by incentivizing user participation, and at the same time it enables individuals to work together, minimize trust, and remain resistant to censorship and coercion.

To facilitate this, DAOs require different layers of complex smart contracts, organizational structures and governance. As such, DAOs are often exposed to many vulnerabilities and inefficiencies. Kelsie Nabben describes many of these DAO vulnerabilities in her article “DAO Vulnerabilities” — — a multi-scale DAO ecosystem mapping tool for computer-aided governance.

The answer to the decentralized decision making and how it is made can be found some negative consequences. For example, many DAOs currently feature a form of multi-vote voting. Majority rules lead voters to compromise on the lowest common denominator, which in turn may produce suboptimal outcomes.

The structure of the organization can also affect the decision-making process. For example, the“flat”nature of MakerDAO and lack of hierarchy may cause it to lack of a common goal or purpose. However, simply imposing hierarchies will not necessarily remedy. There are subtle interactions between many different factors. Diverse views on this topic can be seen in MakerDAOs’ recent“First Principles of Crypto Governance”forum post.

To better understand the inefficiency of DAOs, let’s take a look at the limitations behind:

01 Path dependencies

Many DAOs are subject to forking or replication phenomena. Instead of creating or iterating specific designs to suit their unique needs, they fork/duplicate structures and processes. This is not only in governance, but also in tokenomics design and any other area. The common denominator of the current DAO tokens seems to be the intent to increase the value of the DAO tokens. For this reason, the performance of any DAO is evaluated through value optimization, not government procedures and other areas.

The prioritization of value can disrupt the efforts of token holders and contractors, and their work toward a common goal (provided one has already been established). This disruption is caused by the constant need for value extraction due to short-termism.

02 Regulatory Issues

Regulatory uncertainty creates another major limitation. Following the interaction with the SEC and “The DAO” in 2017, the SEC issued a statement saying that federal security laws apply to those who issue and sell securities in the United States, regardless of the issuing entity and regardless of the form of value used in the transaction to buy or sell, regardless of how is the distribution. Currently, the SEC is trying to apply the Howey test to the emerging digital economy.

The Howey test determines whether an instrument qualifies as an “investment contract” under the Securities Act — — “A contract, transaction, or plan in which a person invests her/his money in a common enterprise and are led to expect profits solely from the efforts of the promoters or third parties.”

Another issue for regulators is that of jurisdiction. Depending on the applicable jurisdiction, if the DAO is malformed with no formal off-chain legal entity, DAO participants may be held legally responsible for the DAO.

Notably, no U.S. regulations authorize the creation of a legally distinct entity in the form of a DAO. By interacting with smart contracts, DAO members combine their efforts and resources to pursue a certain goal, which satisfies the legal definition of partnership. Therefore, DAO participants may be liable for all debts, obligations and other liabilities of the partnership.

We have seen groups create a foundation that operates a limited liability company. This LLC will then be the only party responsible for the debt, obligation or other such liability. We can see it working as a “responsibility shield”. Additionally, legal anchors are always considered and used as lawyers may analyze systems and apply jurisdictional principles. Including “The DAO” registered as SARL in Switzerland, or Tokemak’s foundation registered in the Cayman Islands.

03 Design of Incentive Mechanism

Human participation itself or through any efficient machine derivatives requires incentives to overcome opportunistic attempts by internal and external members to game the governance system. These rewards must sufficiently incentivize participants to increase their utility while being beneficial to the long-term health and success of the DAO.

When fungible assets are utilized and distributed as the primary form of incentive design in DAO governance, internal and external actors, rational or otherwise, tend to harm the DAO by attempting to corrupt and profit from their own goals or apply.

Many of these factors of corruption can be reduced through the use of third parties, unforgeable tokens, merit recognizers, proofs of character, etc.

Conclusion

Decentralized applications rely on dynamic governance and are governed by the same fundamental principles as any organization. Best practices, standards, and framework compatibility are all to be established. The above should be considered along with seven key fundamental principles when it comes to DAO inefficiencies.

Suffrage — The right to vote is the right to participate. Those who are entitled to vote can participate in the decision-making process. It can be divided into active suffrage and passive suffrage, the former is the right to vote, and the latter is the right to participate in elections and be elected representatives.

Pareto efficiency — Alignment of intent between policymakers and community members is not just a matter of suffrage and accountability. Pareto efficiency refers to a situation where no individual or preference criterion can be made better without making at least one individual or preference criterion worse.

Confidentiality — When considering confidentiality, it is best to first distinguish between confidentiality and anonymity. True confidentiality can be difficult to achieve on a decentralized project or protocol, and even more so on a blockchain.

Verifiability — Verifiability is an essential part of any governance system, ensuring legitimacy.

It can be divided into:

Personal Verifiability — Voters can audit their own voting data to ensure it is correctly created, stored and counted.

Universal Verifiability — Everyone can audit recorded votes and verify that they were extrapolated by qualified voters, created, stored and counted correctly.

Responsibility — One is used to imply that certain actors have the right to hold other actors to a set of standards and values, and to judge whether they have fulfilled their responsibilities, and impose sanctions if those responsibilities are not fulfilled.

Sustainability — Sustainability differs from accountability in that it rewards development and engagement without regard to outcomes. The incentives set to meet the two factors of sustainability can be thought of as the cost of participation, which leads to more contributions, advice, and voter participation.

Effectiveness — To be effective, a blockchain or protocol must be able to adapt to urgent issues through a decision-making process, allowing termination within a reasonable time frame based on the urgency of the transaction at hand. Quick decisions are highly desirable.

Please don’t hesitate to support the content to encourage us to keep doing better. And you are also welcome to interact with us — —

through DappOnline Official Twitter https://twitter.com/DappOnline

See you next time!

Writer: Ouija

Translator&Editor: Florence Ho

(The above information is not intended as investment advice, this article only represents personal opinion)

DappOnline

The world’s leading blockchain ecosystem

Official website https://dapponline.io

Official account DappOnline

Weibo http://weibo.com/dapponline

Twitter https://twitter.com/DappOnline