Building and Running a DAO: Why Does Governance Matter?

As the size of the DeFi and NFT communities has grown tremendously, how decentralized protocols are governed becomes even more important. One of the most pressing challenges facing these communities now and in the years to come is addressing governance —that is, managing collective decision-making to optimize funding and operations.

However, governance requires significant coordination costs , as network participants need to be involved in voting on every decision. These coordination costs can be drastically reduced by a new type of decentralized network, the DAO  (Decentralized Autonomous Organization) . In a DAO, smart contracts enable participants to govern in a cooperative manner .

In this new network of DAOs, people come together with a common motivation and common interests, there is no single leader or single point of failure, and it is run almost entirely by code . Many new decentralized protocols are being built using this structure, and to date, many DAOs have been active in open finance-based systems, but are also increasingly buying and trading NFT artwork and other collections in a cultural network of products. In many ways, DAOs can be seen as a combination of investment banks, corporations, and social clubs , bringing these roles together through cryptographic promises.

Despite being referred to as “Decentralized Autonomous Organizations”, DAOs are often not fully autonomous – someone needs to create a decision-making framework to ensure that the DAO is governed in an efficient manner and that network participants are economically incentivized to participate so that the DAO can grow and develop.

DAOs creators and participants have many questions: what decisions need to be made? What financial incentives are available? Under what conditions should DAOs be formed? What are the main governance tasks currently required? What tools can be used to help governance?

Before we answer these questions, let’s ask another question – how did we get here? – and briefly discuss the development of DAOs. This will give us an understanding of how decentralized structures have formed and changed over the past five years, helping to explain why economic incentives are a key factor in the coming era of governance of DAOs.

Early experiments paving the way for modern DAOs

In 2016, the world’s first such Internet-native organization appeared. The most famous early DAO was called ” The DAO “, a collective investment vehicle designed to be a rationalistic form of crowdfunding, a decentralized venture fund , and was shown for the first time How a decentralized organization running through code can govern itself. Participants contribute ETH to the DAO and receive DAO tokens, which represent the holder’s economic interest and voting rights in The DAO .

The DAO’s dream is to allow any participant—whether their coffers to the treasury are large or small—to earn substantial  (Editor’s Note: Anyone can advertise them to The DAO community ideas and projects, and potentially receive investment funds from The DAO, and anyone who holds the DAO token can vote on the investment plan. If the project is profitable, the DAO token holder is rewarded) . Of courseHowever, a critical smart contract vulnerability led to the withdrawal of funds in The DAO contract by attackers, which in turn caused the term DAO to fall out of favor, triggering the so-called ” DAO Winter ” that coincided with the post-2017 bear market.

Despite diminished expectations and attention, this period saw many important experiments in governance that paved the way for modern DAOs. Security concerns are addressed first , as no DAO network can function properly, let alone grow, if users fear their funds will disappear. First, ethereum competitors such as Tezos promise more secure smart contract programming languages, making it easier for developers to avoid The DAO’s problems. At the same time, many experiments have appeared on Ethereum, such as Aragon, dxDAO, Kleros and Moloch. These DAO implementations bring better programming standards and new token distribution mechanisms to the field .

As security concerns diminished, the biggest common problem with early DAOs was that they were unable to find an incentive model that would encourage a high level of voter participation in DAO affairs . Without the participation of voters with the expertise needed to make informed decisions, DAO governance will stagnate.

The rise of economic incentives

The rise of DeFi  (decentralized finance)  in recent years has  opened the door to more complex open financial systems and tools that do not rely on banks and other traditional systems. With the rise of DeFi, new  DeFi DAOs  have begun to emerge that use economic incentives to encourage participation in these systems.

These incentives, and the way they are built on top of each other, have become key to DAO governance. Without economic incentives, there is no reason for network members to invest their time, money, and energy into these networks, vote on governance proposals to improve these networks, or care whether these networks continue to grow and succeed.

Below are several types of incentives and some key events in their formation to help readers understand how we got here, when DAOs are needed, how critical incentives are to governance, and how effective they are Strategies for Governing DAOs.

1) Growth Incentives

An important development in June 2020 saw the  decentralization of on-chain lending protocol Compound, with the protocol’s core developers handing over the operation and ownership of the protocol to the community. Unlike previous DAOs, Compound’s governance DAO gives community members control over the protocol’s reserve assets , which are generated by charging borrowers a fee. For on-chain protocols, these cash flows were (at the time) the highest revenue the protocol generated.

Compound proposes a novel token distribution model  (editor’s note, also known as liquidity mining that aims to both incentivize capital (liquidity) growth within the protocol and provide users with better loan pricing. The model involves the continuous distribution of Compound’s native token, COMP, to users who provide liquidity to, or make loans from, the protocol. Every user of Compound immediately became a shareholder of the protocol, and some of them became active contributors and voters.

These economic incentives are critical for controlling some key parameters such as margin requirements and lending rates. The way Compound is distributed gives a glimpse into the dream of decentralization, where users of the protocol control the protocol (and the protocol’s cash flow) . As the Compound protocol has billions of dollars in assets and collateral to govern, the basic setup for a new type of DAO has been set – participants have a clear reason to use their time, assets and votes to act in the protocol’s best interest , because the growth and success of the network can benefit them personally.

2) Yield farming

By distributing governance tokens to protocol users, not just investors and development teams, this creates a design space for many new models to emerge. The first is to create various incentive actions on the protocol, also known as ” yield farming “. Yield farming occurs when users are rewarded for actions such as borrowing, staking, or providing other forms of asset liquidity, and these rewards are issued in some form of tokens that represent ownership of the protocol itself . Reward recipients can either accumulate the ownership and hope that the value of the protocol will grow, or they can sell the reward on the open market, thereby compounding their own earnings farming behavior and increasing their earnings. Imagine if the big banks gave you a fraction of their stock every time you saved money – that would make you more willing to save, which would be good for you and the bank.

For example, users of Compound can earn some form of income by locking up their capital in the protocol (that is, using assets as collateral for lending transactions in the protocol) and earning designated DAO governance tokens. That is, assets are traded as collateral in the protocol by borrowing and lending) and earning designated DAO governance tokens to achieve some form of income. In this way, Compound is able to use COMP tokens to incentivize protocol growth and create a user base for the protocol who are incentivized to vote and contribute to the protocol as these benefits attract more users.

A liquidity race was underway throughout the summer of 2020 to drive DeFi through DAO governance token distribution when developers realized they could use this “yield farming” approach to attract capital to new DeFi protocols Development of the agreement. The catalyst for growth in the DeFi space last summer was the launch of DeFi yield aggregator Yearn Finance  (YFI), which through its “ fair distribution ” (i.e. all yield tokens are distributed to liquidity providers and not to the protocol) developers), shifting the DeFi narrative from “VC-funded projects” to “community-funded projects.” When Yearn Finance launched and saw rapid growth, a number of competitors launched clones and knockoffs of the protocol, promising slight improvements, but more importantly, the launch of a new DAO governance token.

Yearn Finance proves that adoption of the protocol can be guided by the commitment of governance alone . The “fair distribution” model it uses, and the use of initial token distributions to target ideal future users, has since become commonplace.

3) Retroactive Airdrop

Several new protocols have built on these incentive models to further incentivize users. A prominent example is airdrops, where tokens are dropped into the wallets of current or former users to spread awareness, build (protocol) ownership, or retroactively reward early users. For example, the UNI tokens launched by the decentralized exchange protocol Uniswap  are distributed retroactively to all users who have used the  Uniswap protocol. The airdrop gave some early users tens of millions of dollars worth of UNI.

More importantly, airdrops and token offerings have proven to be an effective capital (liquidity) protection weapon, quickly becoming a must for new DeFi protocols seeking to gain market share. The increase in token issuance also brought about changes in governance rights – early users didn’t know that their participation would bring them governance rights, and they started to own a large part of the governance rights of the protocol, driving a more decentralized protocol Governance .

Retroactive airdrops became a tool to increase token distribution and active user participation in governance.

Cultural DAO & Game Guild

The development of the aforementioned economic incentives has contributed to the exponential growth of DeFi protocols in 2020. But in addition to DeFi DAOs, other types of DAOs are emerging , with different cultures, incentive models, and governance structures. Recently, we have seen the rise of DAOs whose token distribution model is not tied to protocol usage or participation like DeFi DAOs.

These are Collector DAOs , a group of people who collectively decide to buy art or other digital items. An example of this is  PleasrDAO , a DAO group formed after pplleasr (Emily Yang) created a commemorative video for the release of Uniswap V3 (I am a founding member of PleasrDAO). The video is seen as iconic art that captures the spirit of DeFi 2020, and the video was minted as an  NFT  (Non-Fungible Token)  and auctioned, with the proceeds going to charity. The auction, and the collective spirit surrounding the artwork, eventually drove some longtime DeFi developers and entrepreneurs to create PleasrDAO to buy art.

The advancement brought about by PleasrDAO is a unique mechanism for fragmenting NFTs , which makes collective ownership of individual artworks more feasible. This vision portrays PleasrDAO as an art museum, just like MoMa (Museum of Modern Art)  , except that all artworks in the PleasrDAO museum can be collectively owned by funders.

Another culturally significant Collector’s DAO group is  FingerprintsDAO , born in the fall of 2020 (of which I am also a member). Unlike PleasrDAO, FingerprintsDAO focuses on building a collection of generative and on-chain art. What is unique about NFT-based generative art is that it allows the artwork to change every time there is a change in ownership. For example, for a generated artwork like $HASH (Proof of Beauty), every time the artwork is transferred, its underlying metadata changes randomly according to the blockchain state. FingerprintsDAO collects these artworks and has some of the largest collections of generative artworks, including  Autoglyphs, Bitchcoins, and the 0xDEAFBEEF series, among others.

Building and Running a DAO: Why Does Governance Matter?

Above : Several artworks from the Production Artwork  Autoglyphs  collection

FingerprintsDAO and PleasrDAO utilize their DAO governance tokens to manage their vaults, perform asset sales (including proceeds from NFT fragmentation), and asset management. DAO token holders have the right to vote on these events, and in many cases the results of these votes are  algorithmically enforced directly on-chain using DeFi protocols such as Fractional or Uniswap .

Since token allocations for such collector DAOs are not as tied to protocol usage or participation as DeFi DAOs, and economic incentives are generally not as aligned as DeFi DAOs, this may lead to an increasing burden on early such DAO organizers The greater the obligation to keep the DAO running efficiently, and the complex dynamics between DAO members . This sexual challenge is specific to cultural DAOs, and builders in this field should use different types of governance decisions to keep DAOs functioning effectively.

For collector DAOs, one strategy is to hire full-time engineers and product managers who can be directly incentivized through the DAO governance token (while ensuring this organizational structure maintains the DAO’s decentralized governance and operations). By ensuring that those who work for the DAO receive an increasing share of the DAO’s assets, a stable balance can be created between early token holders and those involved in the day-to-day management of the DAO.

The last type of DAO is a gaming guild , which has its own culture, incentive model, and governance structure, a DAO-like version of a gaming clan (a team of players). These decentralized unions collectively own game items and/or collectibles (NFTs) and share the rights to use and sell them .

Unlike traditional player guilds, the “ play and earn ” mechanism in blockchain games such as Axie Infinity can encourage cooperative strategies and revenue sharing among players. These mechanisms make game guilds more like DeFi DAOs, that is, participating in the network can be rewarded and can also improve the prospects of the network, but the governance of the network is not so dependent on purely economic indicators, but more on game performance and social metrics. These DAOs are worth watching because as they evolve, they may find new mechanisms to increase their decentralization in ways that other DAOs have not used.

When do you need a DAO

The general growth of DAOs and the enormous success of some of the most innovative DAOs has inevitably led to the perception that a DAO structure is required both to enable growth and to drive robust network participation. During times of high market sentiment, market forces make it easy to assume that every organization, community or project needs a DAO, as we saw with the rise of Crypto tokens during the 2017 ICO (Initial Coin Offering) boom.

But that’s not necessarily true. DAOs work best when the governance burdens associated with management, security, and risk can be reduced faster than the natural increase in coordination costs that require members to participate in every decision-making process . This is why it is important for protocol builders to assess the true goals of the organization when deciding whether to form a DAO.

Common governance areas for all DAOs include:

  1. Ownership and management of collective assets . A DAO’s treasury and balance sheet should function like a decentralized corporation, considering assets and liabilities, liquidity, revenue, and where to allocate financial resources.
  1. Asset risk management . Volatility, prices and other market conditions require continuous monitoring.
  1. Asset Curation . From art collected to collateral for lending, all DAO assets should benefit from the goals and processes surrounding curation.

A DAO should be formed and formed only when it is clear that the community needs all of these areas of governance.

It’s important to note that while a DAO may only 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 the DAO suddenly has the opportunity to earn money from it, and if the DAO has completely ignored risk management until then (e.g., only focused on asset curation), then it is selling the asset challenges in asset risk management.

One of the most prominent examples of such events was the sale of $DOG tokens by PleasrDAO for $225 million, each of which represented fractional ownership of the original Dogecoin (Dogecoin) image NFT. But prior to this, PleasrDAO has only focused on asset curation, ignoring risk management issues. The need to issue the token via Sushi’s Miso platform forced PleasrDAO to understand different token distribution mechanisms and economics, especially as the NFT fragmented market structure is just getting started. In addition, PleasrDAO must also ensure that community members are feeling ownership of the NFT by establishing a community development fund.

Building and Running a DAO: Why Does Governance Matter?

Above: The NFT based on the DogeCoin (Dogecoin) prototype image was purchased by PleasrDAO for 1696 ETH, and then PleasrDAO fragmented the NFT through the Fractional Art platform and minted 17 billion DOG tokens representing the ownership of the NFT (ERC-20) and auctioned 20% of the total amount of the token (nearly 3.4 million DOG tokens) on the decentralized fundraising platform Miso. PleasrDAO still retains ownership of most DOG tokens.

The lesson from the PleasrDAO case is that DAOs  will need to add new collective skills and governance processes as their activities change, and that successful DAOs need to quickly realize their shortcomings .

Three key governance areas

DAOs on the rise are likely to reach the point where their communities need governance structures that address all three of these key governance areas. Below, I will detail each of these three governance areas to help DAO builders/protocol developers clearly define where they should focus if they want to build a successful DAO.

1) Collective asset management

All DAOs have some initial capital, including governance tokens held by the DAO smart contracts and assets used to purchase governance tokens. For example, if a DAO initially mints 1000 governance tokens and sells 500 of them to genesis members for 100 ETH, the DAO’s initial treasury consists of 500 governance tokens and 100 ETH.

However, as DAOs grow in terms of users or accumulated cash flow (such as Compound), the community will need to manage these capital in the same way that companies manage capital , since corporate governance best practices are well suited for DAOs, although at the same time increasing The conundrum is the reduction in privacy.

2) Risk management

Since a DAO’s balance sheet typically consists of risky assets , it is especially important to manage the DAO’s currency exposure to secure funding for future operations . Many DeFi DAOs and NFT DAOs have vaults consisting of hundreds of millions or billions of dollars in assets that are used to fund development and audits, provide insurance if the underlying protocol fails, and spend on user growth and acquisitions. To achieve these goals, DAOs need to manage their coffers to meet specific metrics or key performance indicators (KPIs), such as, “Can we survive a 95% price drop for these assets?” or “If we assets earn X% interest, can we still buy high-value NFTs?”

There is a recent example of this situation: Recently, network participants of the decentralized money market protocol Aave discovered a potential vulnerability in the use of xSushi as collateral in the protocol due to oracles misquoting CREAM  Finance protocol That is, $130 million stolen by attackers due to oracle pricing vulnerabilities  Gauntlet, an on-chain risk management simulation platform, ran simulations to assess the threat and found that under current market conditions, it is unlikely that a potential attacker could successfully manipulate xSushi. As an extra precaution, Gauntlet made a proposal in Aave governance  (see screenshot below) to ban certain types of borrowing to reduce risk, which received overwhelming support from participants. (Aave’s DAO is  a client of the Gauntlet platform.)

Building and Running a DAO: Why Does Governance Matter?

Above : A proposal by Gauntlet in Aave governance to ban certain types of borrowing to reduce risk

There are three key governance factors at play here – a community that can detect potential risks in a timely manner, modelling to assess the true nature of the threat , and governance process that is prepared to make necessary changes  (especially in security aspect).

3) Asset Curation

The most natural place to do asset curation is NFT  collectible DAOs , such as PleasrDAO. These DAOs are inherently curators of art and culture , while using DAO governance tokens to vote on the addition or removal of assets.

However, DeFi DAOs  often face this problem as well. While some DeFi DAOs (like Uniswap) allow people (liquidity providers) to add assets in a permissionless way (i.e. anyone can create a trading pool with an entirely new asset), others use leverage DeFi DAOs do not allow people to do this. In particular, lending protocols like Aave and Compound use governance to decide which assets can be added or removed , as many parameters must be chosen for each asset , including margin requirements, interest rate curves, insurance costs, etc., and these decisions Crucial to the security of the protocol.

Let’s provide a simple example of what can go wrong. Suppose we mint a new asset, TarunCoin, and I hold the full supply of that coin. Now suppose I create a lending pool that allows me to borrow at 100% of its value by staking TarunCoin. If I control the USD price of TarunCoin (for example through a Uniswap pool where I am the only liquidity provider), then I can make TarunCoin a very high market cap (say $100 million) and then use TarunCoin to Borrow $100 million. However, since TarunCoin has little liquidity, my loan will inevitably default and those borrowers will suffer.

This example illustrates that the quality of an asset —measured by token distribution, liquidity/price manipulation ease, and historical trading volume—is critical for DeFi DAOs utilizing leverage . Since many of these DAOs use their governance tokens as an implicit or explicit insurance fund to be able to repay borrowers in the event of an adverse event , it is important for such DAOs to be prudent in their selection of assets and It ‘s critical to have reasonable parameters . And as the space evolves, insurance products are likely to help improve and reduce the amount of governance intervention required for asset curation in DeFi.

How to run the DAO

Based on the above information, a natural question that follows is: “How can our community really do these three tasks? Our community only cares about X.” As DAOs have matured, there has been a growing An ecosystem of companies and protocols designed to help closely with asset and parameter selection through automated analysis and monitoring, reducing the burden on DAO members. There are also strategies to reduce complexity within DAOs and allocate resources more efficiently. Here are some steps DAOs can take:

1) Use governance tools

First, quantitative tools have emerged that allow the community to visualize the risk of DAOs (and possibly related protocols) based on market conditions, and allow DAO members to understand what it means to vote for lower collateral/margin requirements or higher interest rates. This increases overall transparency about the risks posed 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 protocol Aave and Compound’s vaults effectively act as an insurance backing for the underlying lending protocol. For example, if there is a massive price swing that causes a large number of loan defaults, causing losses to the lenders in the protocol, these DAOs can use their vaults to cover the lenders’ losses (e.g. DAI in the Compound protocol). liquidation event).

Adjusting parameters in the protocol  (such as adjusting collateral requirements) can help reduce the likelihood that the DAO will have to spend funds on such contingencies. Below is an example of a real-time dashboard of the Gauntlet platform for monitoring risk in different markets on Aave (disclosure: I’m the founder and CEO of the Gauntlet platform that provides these services). These tools for quantifying risk include simulation tools that combine algorithmic trading and those used in artificial intelligence such as AlphaGo.

Building and Running a DAO: Why Does Governance Matter?

Building and Running a DAO: Why Does Governance Matter?

Screenshot source: https://gov.gauntlet.network/aave

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

By helping users simply explain the complex behavior hidden in DAOs, visualizations help make it easier for newcomers to onboard . For example, tools allow all members to understand what they are voting on without needing to understand the underlying technical complexities. Each DAO tool or service can then specialize in providing descriptive, easy-to-understand dashboards that reflect the health of the DAO from a technical, financial, and community perspective.

In DeFi, the main issues DAOs tend to deal with involve financial and technical risks , so their token holders have tools to assess these risks. These tools can also help proxy voters (such as those who delegate voting power to others) to assess how well their proxies are doing in improving protocol performance.

2) Divide the DAO into smaller “subgroups”

Another potential strategy to help expand the membership and scope of the DAO is to divide the DAO into “subdgroups”, each of which operates independently and focuses on a specific task (such as development, marketing, etc.). Yearn Finance was one of the first DAOs to successfully separate itself into subgroups: Yearn’s rapid growth and product evolution led to the need to split the team into separate teams dealing with front-end UX, core protocol development and marketing, etc. Task. Early Yearn contributors  tracheopteryx, zemm, and zakku created a tool called Coordinape (see image below) to help with contributor coordination, a product that allows DAOs to smoothly manage payroll for anonymous contributors, regardless of whether they are in which region.

Building and Running a DAO: Why Does Governance Matter?

Source of the above image: https://coordinape.com/

Another more decentralized approach is to use DAO smart contracts to explicitly divide a DAO  into multiple teams. This can be achieved by allowing certain subgroups (called “child DAOs”) to call certain functions in the DAO’s smart contracts. For example, Orca Protocol has built tools to automate this process (see image below), so those with no development experience can easily create “child DAOs”. The protocol allows you to create authorized groups that can manage certain functions within a DAO, allowing different subgroups of the community to operate each task independently.

Building and Running a DAO: Why Does Governance Matter?

Source of the above image: https://www.orcaprotocol.org/

3) Hire employees

One final note on DAO governance Once a DAO has a large enough community and assets, it must hire people who can devote all of its energy to maintaining, communicating, and managing the DAO . However, DAOs must be careful not to create any “active participants” that token holders may rely on to drive the value of the underlying token. Therefore, decentralization must be considered when adding service providers.

DAOs that fail to hire full-time developers, community managers, and other employees often find themselves at crossroads as their assets dry up or they need help. The once-hot DeFi protocol will lose steam as the DAO coffers dry up, while no DAO member will think they have enough incentive to keep the protocol running  (e.g. through protocol improvements or asset reallocation).

While PleasrDAO has a committee (much like a company’s board of directors) to help guide the DAO’s long-term direction, a few key contributors ensure that the DAO’s launch, fundraising, and curation are flawlessly executed. In this way, DAOs can often also borrow best practices from regular organizations (companies).

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/building-and-running-a-dao-why-does-governance-matter/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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