a16z: Why governance is important to build and run DAO

Note: The original author is Tarun Chitra, the following is the full text compilation.

With the huge growth of the DeFi and NFT communities, how to govern decentralized protocols becomes more important. One of the most immediate challenges facing these communities now and in the next few years is to figure out governance, that is, the behavior of managing collective decision-making in order to optimize funding and operations.

However, governance requires a lot of coordination costs, because network participants need to participate in the voting for each decision. In a new type of decentralized network, these coordination costs can be fundamentally reduced. In this type of network, smart contracts enable participants to govern in a cooperative manner.

These new networks are called DAOs (Decentralized Autonomous Organizations)-people come together with consistent incentives and common interests, there is no leader or single point of failure, and it is almost entirely run by code. Many new agreements are being established using this structure. So far, most activities have been based on open finance systems, but there are also more and more cultural networks buying and trading artworks and other collectibles. In many ways, DAO can be seen as a hybrid of investment banks, companies, and social clubs stitched together through cryptographic promises.

Despite being called a decentralized autonomous organization, DAOs are usually not completely autonomous–someone needs to establish a decision-making framework to ensure that the DAO is effectively governed and financially incentivize network participants to participate so that the DAO can grow.

So, what are the questions that greet the creators and participants of the DAO? What decisions need to be made? What kind of financial incentives can be used? Under what conditions should DAO be formed? What are the main governance tasks required today? And what tools can be used to help governance?

Before answering these questions, let’s ask another question-how did we get here? -And briefly discuss the development of DAO. This will allow us to see how the decentralized structure has formed and changed in the past half month, and will help explain why financial incentives are a key factor in the advent of the DAO governance era.

Early experiments paved the way for modern DAOs

The world first heard of these Internet-native organizations in 2016. The most famous early DAO is called “The DAO”. It is a collective investment tool designed to become a rationalist form of crowdfunding-a decentralized venture fund-and it demonstrated this for the first time. How a decentralized organization that runs through code manages itself. Participants provide ETH to The DAO and receive DAO tokens. These tokens represent the holder’s economic interests and voting rights in the DAO.

The goal of The DAO is to allow any participant-no matter how much they contribute to the vault-to be rewarded in the Ethereum ecosystem. However, a critical smart contract vulnerability caused the funds in The DAO contract to be evacuated by the attacker. Immediately afterwards, the word DAO became unpopular and led to the emergence of “DAO Winter”, which is precisely the bear market after 2017.

With the decline in expectations and the decline in attention, some important governance experiments in this period paved the way for the modern DAO. The first of these solves the security problem-if users are worried that their funds will disappear, no network will work, let alone development. First, Ethereum’s competitors, such as Tezos, have promised a more secure smart contract programming language, which will make it easy for developers to avoid DAO problems. On Ethereum, some experiments have appeared, such as Aragon, dxDAO, Kleros, and Moloch. The implementation of these DAOs has brought better programming standards and experiments with new token distribution mechanisms to this field.

With the reduction of security issues, the biggest problem faced by early DAOs is that they cannot find an incentive model to encourage people to participate in DAO affairs. Without the participation of voters with the expertise required to make informed decisions, the governance of the DAO will stagnate.

The rise of financial incentives

In recent years, the rise of DeFi has opened the door to more complex open financial systems and tools that do not rely on banks and other traditional systems. New DAOs are beginning to emerge and use financial incentives to encourage participation in these systems.

These incentives, and the way they establish each other, have become the key to DAO governance-without economic incentives, there is no reason for network members to invest their time, money, and energy into the network, to vote on proposals to improve the network, or at all Don’t care about their continued growth and success.

There are several types of incentives, and some key events in their formation process, to help builders understand how we got here, when we need DAO, how incentives are critical to governance, and effective governance DAO’s strategy.

Growth incentive

An important development is that in June 2020, the on-chain lending protocol Compound decentralized itself-its core developers handed over the operation and ownership of the network to the community. Unlike the previous DAO, Compound’s governance DAO allows community members to control the reserve assets of the agreement, and these assets are generated through borrower fees. These cash flows are the highest revenue generated by the (at the time) on-chain agreement.

Compound proposed a novel token distribution model aimed at stimulating capital growth within the agreement and providing users with better loan pricing. This model involves the continuous distribution of Compound’s native tokens (COMP) to users who provide liquidity to the agreement and obtain loans from the agreement. Subsequently, each user of Compound immediately became a stakeholder, and some of them also became active contributors and voters.

These financial incentives are essential to control key parameters such as margin requirements and interest rates. Compound’s distribution measures provide a glimpse into the dream of decentralization – the user of the protocol controls the protocol (and its cash flow). Since the Compound Agreement has billions of dollars in assets and liens to be governed, the basic setting of the new DAO has been determined, that is, participants have clear reasons to use their time, assets and votes to act in the best interests of the network, because the network Their growth and success can benefit them personally.

Income farming

The development of governance token distribution has created many design spaces for new models for protocol users, not just investors and development teams. The first is to create various incentive actions on the agreement-“income farming”. Income farming occurs when users receive rewards for performing loans, mortgages, or providing other forms of asset liquidity-the rewards appear in the form of tokens and represent part of the ownership of the agreement itself. Recipients can accumulate this ownership and expect the value of the agreement to rise, or they can sell it on the open market, compounding their actions and increasing revenue. Imagine if the major banks gave you a small share of stock every time you made a deposit-then you would be more willing to deposit because it would be good for you and the bank.

For example, users of Compound can achieve a kind of income by locking up their capital in the agreement (that is, using borrowing and lending as collateral to trade in the agreement) and earning priced DAO governance tokens. In this way, Compound can use COMP to incentivize growth and create a user base that motivates them to vote and contribute to the agreement, because the promise of revenue attracts more users.

As soon as developers realized that they could attract capital into the new DeFi primitives through income farming, there was a race throughout the summer of 2020 to develop the DeFi protocol through DAO governing the distribution of tokens. The growth catalyst this summer is the launch of DeFi yield aggregator Yearn Finance (YFI), which “fairly distributes” (all tokens are allocated to capital providers, not to developers), shifting the narrative from VC-funded projects to Community funded projects. As soon as YFI was launched and achieved rapid growth, many competitors also launched clones and counterfeit products, promising slight improvements, but more importantly, the launch of new DAO governance tokens.

YFI shows that only the promise of governance can lead to network adoption. The fair launch model, and its use of initial token distribution to lock in ideal future users, has become very common since then.

Retroactive airdrop

The new agreement builds on these models to further motivate users. A prominent example is airdrops, or the delivery of tokens to current or previous users to spread awareness, establish ownership, or retroactively reward early users. For example, the decentralized trading protocol Uniswap launched the UNI token and airdropped it retroactively to everyone who had used the Uniswap protocol. This airdrop caused some early users to earn UNI worth tens of millions of dollars.

More importantly, airdrops and token issuance proved to be an effective capital protection weapon and soon became a necessary condition for the new DeFi protocol that hopes to gain market share.

The increase in the issuance of tokens has also led to changes in governance power-early users did not know that their participation would give rise to governance rights, and they began to own important parts of the network, thus promoting greater decentralization.

Retrospective airdrops have become a tool to increase the issuance of tokens and the governance participation of active users.

Cultural DAO and Game Guild

The development of the financial incentive mechanism outlined above has contributed to the exponential growth of the DeFi protocol in the past year. However, other types of DAOs are also emerging, with different cultures, incentive models and governance structures. Recently, we have seen the rise of DAOs with a token distribution model (unlike DeFi DAOs) that are not tied to use or participation.

These are collector DAOs, made up of people who decide to buy artwork or other digital items collectively. One example is PleasrDAO, which was established after pplpleasr (ie Emily Yang) created a commemorative video for the launch of Uniswap V3 (I am a founding member of PleasrDAO). That video is regarded as an iconic art that captures the spirit of DeFi in 2020. At that time, the video was cast into NFT and auctioned and the proceeds were used for charity. And this auction and the collective spirit surrounding the art has triggered some long-term DeFi developers and entrepreneurs who want to create a DAO to buy art.

The advancement of PleasrDAO is a unique NFT fragmentation mechanism, which greatly increases the feasibility of collectively owning a piece of art. This vision portrays the DAO as an art museum, just like MoMA, although all works in the museum can be collectively owned by patrons.

Another culturally significant collector DAO, born in the fall of 2020, is FingerprintsDAO (I am a member of it). Unlike PleasrDAO, FingerprintsDAO focuses on building a collection of generative art and on-chain art. The uniqueness of NFT-based generative art is that it allows the artwork to change every time the ownership changes–for example, for an artwork like $HASH (proof of beauty), its underlying metadata is transferred every time the artwork is transferred. Time will change randomly as a function of the state of the blockchain. FingerprintsDAO collects such artworks and owns some of the largest collections of Autoglyphs, Bitchcoins and 0xDEAFBEEF.

FingerprintsDAO and PleasrDAO use their DAO governance tokens to manage their treasury, conduct asset sales (including fragmented income), and use them for asset planning. DAO token holders have the right to vote on these issues. In many cases, the results of these votes are directly executed on the chain using DeFi protocols, such as Fractional or Uniswap.

Since the distribution of collector DAO tokens is not tied to use or participation – and the financial incentives are not as consistent as the usual DeFi DAOs – this may lead the early DAO organizers to undertake increasing commitments to maintain the DAO’s Effective operation and complex dynamics among DAO members. This consistency challenge is unique to cultural DAOs, (and therefore) builders in this field should use different types of governance strategies to keep DAOs running effectively.

One method is for collectors DAO to hire full-time engineers and product managers, who directly use DAO governance tokens for incentives (while ensuring that this organizational structure maintains DAO’s decentralized governance and operation). By ensuring that those who work for the DAO can obtain an increasing share of the assets of the DAO, one can establish a stable balance between early token holders and those engaged in the day-to-day management of the DAO.

The last type of DAO has its own culture, incentive model, and governance structure, that is, a simplified version of the game guild—a game family in the form of DAO (basically a group of players that play games in a team). These decentralized guilds collectively own game items and/or collectibles, and share their use and profits when they are sold.

Unlike traditional player guilds, the game profit mechanism found in games such as ” Axie Infinity ” can encourage cooperation strategies and revenue sharing among participants. These mechanisms make them more like DeFi DAOs-participating in the network can be rewarded, and at the same time can promote the development prospects of the network-but at this point, the governance of the network has little to do with pure financial indicators, but with game performance and society The indicators are more related. These DAOs are worthy of attention, because as they develop, they may find new mechanisms to increase their decentralization in ways that other DAOs have not used.

When do you need DAO

The general growth of DAOs and the great success of some of the most innovative DAOs inevitably lead people to believe that the route of growth and strong network participation requires a DAO structure. At times of enthusiasm, market forces make it easy to think that every organization, community, or project needs a DAO, just like the crypto tokens we saw in the 2017 ICO boom.

But this is not necessarily true. DAO works best when the governance burden related to curation, security, and risk can be reduced faster than the coordination costs that naturally increase with each decision that requires members to participate in voting. This is why the protocol builder must evaluate the true goals of the organization when deciding whether to form a DAO.

The governance areas common to all DAOs are:

  • Collective asset ownership and management. The DAO’s vault and balance sheet should operate like a decentralized company, considering assets and liabilities, liquidity, income, and where to allocate financial resources.
  • Asset risk management. Volatility, prices and other market conditions require continuous monitoring.
  • Asset planning. From the collected artworks to the collateral for loans, all DAO assets benefit from the planned goals and processes.

People should form a DAO only if it is clear that all these governance areas are needed by the community.

It is worth noting that although DAO may focus on a subset of these activities, it does need to provide all three functions. For example, suppose a cultural DAO owns an asset, and it suddenly has the opportunity to obtain income or output from it. So even if the DAO completely ignored risk management (for example, only focused on asset curation), it would face this kind of challenge in such sales.

One of the most prominent examples of this kind of incident is the sale of $DOG tokens by PleasrDAO for $225 million, which represents part of the ownership in the original Dogecoin meme NFT. Prior to this, PleasrDAO only focused on asset planning, while ignoring the issue of risk management. The launch of tokens through Sushi’s Miso platform forced the group to learn different token distribution mechanisms and economics, especially since the fragmented NFT market structure is just getting started. The group must also establish a community development fund to ensure that community members have real ownership of the NFT.

The key lesson here is that DAOs need to add new collective skills and governance processes as their activities change, and successful DAOs will quickly recognize their shortcomings.

Three key governance areas

Growing DAOs may reach the point where their communities need governance structures for all three key requirements. Below, I share a more detailed breakdown of each field to help builders/protocol developers clearly determine where they need to focus if they want to build a successful DAO.

Collective asset management

All DAOs have some initial capital, held in the form of governance tokens held by the DAO smart contract and assets used to purchase governance tokens. For example, if a DAO minted 1,000 governance tokens at the beginning, and sold 500 of these tokens to the founding members at a price of 100 ETH, then the initial capital pool of this DAO would include 500 governance tokens and 100 ETH. However, as the DAO grows in terms of users or accumulated cash flow (such as Compound), it becomes important for the community to manage their capital, just like a company, because the best practices of corporate governance are well suited to the DAO, but at the same time increase The difficulty is the reduction of privacy.

Risk Management

Since the DAO’s balance sheet is usually composed of risky assets, it has become increasingly important to manage the currency risk of the DAO to ensure that future operations can be funded. Some DeFi and NFT DAOs have capital pools of hundreds of millions or billions of dollars in assets. These assets are intended to be used to fund development and audits, to provide insurance if the underlying agreement fails, and to spend on user growth and acquisitions. In order to achieve these goals, the DAO needs to manage the treasury to meet specific indicators or key performance indicators (KPIs), for example, “Can we survive a 95% drop in asset prices?” or “If we are holding If we get X% interest on the assets, can we still buy high-value NFTs?”

Here is a recent example to illustrate this in practice. Aave is a decentralized money market protocol. Last week, its network participants discovered potential loopholes in the use of xSushi as collateral in the protocol due to the mispricing of the oracle (used 130 million U.S. dollars in CREAM Finance) ). Gauntlet ran simulations to assess the threat and found that under current market conditions, potential attackers would not be able to successfully manipulate the currency. As an additional preventive measure, Gauntlet put forward a proposal in Aave governance to prohibit certain types of borrowing to mitigate risks, and the proposal was overwhelmingly approved by participants. (Aave’s DAO is a client of Gauntlet)

a16z: Why governance is important to build and run DAO

Here, we see three key governance dynamics at work-one is a financially consistent community that is sensitive to potential threats, one is a model to assess the true nature of the threat, and a governance process in place to make the necessary Change (preferred to safety).

Asset curation

The most natural place for asset curation is NFT collection of DAOs, such as PleasrDAO. These DAOs naturally act as art and cultural curators, and DAO governance tokens are used to vote to add or delete assets. However, DeFi DAO also often faces this problem. Although some mechanisms, such as Uniswap, allow unauthorized asset additions–anyone can create a trading pool with new assets–but other leveraged mechanisms cannot do this. In particular, lending protocols like Aave and Compound use governance to determine which assets can be added or deleted. This is because certain parameters must be selected for each asset, including margin requirements, interest rate curves, insurance costs-and these decisions are critical to the security of the agreement.

Let us provide a simple example to illustrate what might go wrong. Suppose we minted a new asset-TarunCoin-in which I am the owner of 100% of the TarunCoin supply. Now, suppose I create a loan pool that allows me to borrow at 100% of TarunCoin’s value. If I control the price of TarunCoin and USD (for example, through the Uniswap pool where I am the only liquidity provider), then I can make the market value of TarunCoin very high (for example, $100 million), and then use TarunCoin to borrow $100 million. However, when my loan inevitably defaulted, because TarunCoin had almost no liquidity, the lender who pooled the assets to lend me $100 million would bear the loss.

This example illustrates that asset quality–measured by the distribution of tokens, the ease of liquidity/price manipulation, and historical trading volume–is essential for the leveraged DeFi DAO. Since many such DAOs use their governance tokens as implicit or explicit insurance funds to repay lenders in the event of adverse events, for such DAOs, be careful about the assets they accept and how to choose these assets The parameters are critical. With the development of this field, insurance products are likely to help improve and reduce the amount of governance intervention required for asset planning in DeFi.

How to run DAO

A natural follow-up question is: “How can our community really accomplish these three tasks? Our community only cares about X.” As the DAO matures, a growing ecosystem of companies and agreements begins to emerge, aimed at Automatic analysis and monitoring as well as help to carefully select assets and parameters to reduce the burden on DAO members. And there are some strategies to reduce the complexity inside the DAO and allocate resources more efficiently. Here are some steps that DAO can take:

Use governance tools

First, the emergence of quantitative tools allows your community to visualize the risks in the DAO (and potentially related agreements) as a function of market conditions, and let DAO members understand the implications of voting to reduce collateral/margin requirements or increase interest rates, etc. what. This provides greater transparency to the level of risk held by the DAO treasury and allows the community to update the composition of the treasury to meet specific KPIs.

For example, the billions of dollars in assets held by the lending agreement Aave and Compound effectively served as insurance support for the underlying lending agreement. For example, if there is a large price disturbance that causes a large number of loan defaults and causes losses to the lenders in the agreement, these DAOs can use their funds to make up for the losses of the lenders (for example, see the Compound DAI liquidation event).

Adjusting the parameters in the agreement, such as collateral requirements, helps reduce the possibility that the DAO will have to use its funds for such support events. Below is an example of a real-time dashboard used to monitor different Aave market risks. (Disclosure: I am the founder and CEO of Gauntlet that provides these services). Tools used to quantify risk include simulation tools that combine algorithmic trading and tools used in artificial intelligence (such as AlphaGo).

a16z: Why governance is important to build and run DAO

a16z: Why governance is important to build and run DAO

The goal of such tools and services is to allow the community to expand to a larger and more diverse population. Due to the composability of smart contracts, agreements become more and more complex and intertwined, and governance becomes more and more difficult for each new member. This in turn makes it harder for new members to join the DAO and participate in a meaningful way.

By helping users simply explain the complex behaviors hidden in the DAO, visualization can help new members onboard. For example, tools can allow all members to understand what they are voting for, without the need to understand the complexity of the underlying technology. Then, each DAO tool or service can provide an explainable and easy-to-understand dashboard of DAO health from a technical, financial, and community perspective.

Within DeFi, the main issues that DAOs tend to deal with involve financial and technical risks, so their token holders use tools to assess these risks. They can also help proxy voters (for example, a voter who delegates voting rights to another voter) to evaluate how well their proxy is improving the performance of the protocol.

Divide the DAO into “subgroups”

Another potential strategy that can help expand the membership and scope of the DAO is to divide the DAO into subgroups, each of which operates independently and focuses on specific tasks (development, marketing, etc.). One of the first DAOs to successfully partition was Yearn Finance. Yearn’s rapid growth and continuous product evolution have led to the need to divide the team into multiple groups to independently handle tasks such as front-end user experience, core protocol development, and marketing. Early Yearn contributors tracheopteryx, zemm, and zakku created Coidinape, an Asana in the form of DAO, to help contributors coordinate. This product allows DAOs to manage tasks and wages across teams, time zones, and anonymous identities.

a16z: Why governance is important to build and run DAO

As for a more decentralized approach, people can use DAO smart contracts to clearly divide DAO into teams. People can do this by allowing certain subgroups (called sub-DAOs or pods) to call certain functions in the DAO’s smart contract. The Orca protocol has built tools around automating this process so that those without development experience can easily create pods. This protocol allows you to create authorization groups that can manage certain functions in DAO, and allow different subgroups of your community to independently operate these tasks.

a16z: Why governance is important to build and run DAO

Hire employees

A final note on DAO governance. Once the DAO has a large enough community and assets, it must hire people who can devote their energy full-time to maintenance, communication, and management tasks. However, DAO must be careful not to create any “active participants”, token holders may rely on these participants to promote the value of related tokens. Therefore, increasing service providers must consider the issue of decentralization.

DAOs who have failed to hire full-time developers, community managers, and other staff often find themselves at a crossroads when their assets are exhausted or when they need services. The once-hot DeFi protocol lost momentum as their DAO vaults were exhausted, and none of the DAO members believed that they had sufficient mechanisms to ensure continued operations (for example, through protocol improvements or asset reallocation).

Although PleasrDAO has a board of directors (much like the company’s board of directors) to help guide the long-term direction of the DAO, key contributors cannot ensure that the start-up, financing, and curatorial work performed by the DAO is flawless. In this regard, DAO can often learn from the best practices of formal organizations.

The coordinated effort to form an asset-owned decentralized Internet organization is sometimes regarded as the “Wild West” in uncharted territory. But many of the problems and solutions found in traditional systems-in which humans are also coordinating-can provide information and guidance to the DAO; they have undergone centuries of stress testing and can be adjusted for this new world. In many ways, learning from the past and the recent history of the DAO may help new builders find and adjust ideas for the future of online agencies.

Thanks

Thanks to John Morrow (Gauntlet), Nick Cannon (Gauntlet), Julia Rosenberg (Orca), John Sterlacci (Orca), Luiz Ramalho (FingerprintDAO), Jamis Johnson (PleasrDAO) and Robert Leshner (Compound) for their helpful feedback and comments.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/a16z-why-governance-is-important-to-build-and-run-dao/
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