The last crypto winter which started in 2018 lasted around 18 months, characterized by little to no levels of interest and engagement. Many of the top DeFi applications that brought the market back to life in early 2020 were built during this time. Looking at the narrative in today’s market, it seems highly likely that the projects that will lead the next bull run will be those dedicated to NFTs, the metaverse, GameFi, and the broader Web3 economy.
Decentralized autonomous organizations, or DAOs, are at the heart of the Web3 movement. These organizations are created to provide an improved management structure for business and projects led by dispersed communities in which any member can vote on proposals and make decisions.
DAOs span across DeFi protocols, social clubs, grant-makers, play-to-earn gaming guilds, NFT projects, venture funds, charities, metaverse platforms, and more. But in terms of raw numbers and treasury sizes, DeFi-related DAOs have a giant lead. The DeFi category accounts for 83% of all DAO treasury value held and 33% of all of the DAOs by count.
Typically, DAO founders create a governance token that is distributed among users, early backers, and anyone else that buys these tokens on crypto exchanges. Each token represents the voting power within a given organization, meaning that a user with more tokens has more voting power. The idea is that this structure democratizes voting power across a global community, although it seems that in practice, many of the top-tier DAOs still have uneven distribution governance tokens.
Balanced governance token distribution
For users holding a governance token, there are 3 main functions enabled by the governance token: voting, creating a proposal, and passing it. While the rules are different across DAOs, the top organizations generally require that a user must hold between 0.1% and 1% of the outstanding token supply to create a proposal and a user must hold between 1% and 4% to pass it.
The reason for these thresholds is to maintain a certain degree of quality. If too many holders can create a proposal, the average quality may fall which could weigh the DAO down in spam. If too few users can create a proposal, the community may not back the DAO as it doesn’t live up to the expected degree of decentralization. The trick is finding a balance between effective operations and sufficient decentralization.
As it stands today, across several major DAOs, less than 1% of all holders have 90% of the voting power. That is seemingly at odds with the tenets of decentralization on which the entire Web3 movement is built. Just recently, we saw a good example of what can happen in DAOs with uneven voting power distribution.
The Solend Incident
In June 2022, lending protocol Solend faced a big problem during the intense market downturn: the protocol’s biggest whale was at risk of facing a margin call that could render Solend insolvent, send $20 million worth of SOL onto the market, and potentially tank the broader Solana ecosystem. The DAO governing Solend called a vote to take control of the whale’s holdings and liquidate the position through OTC desks in a bid to contain the risk.
The proposal passed quite easily, with over 1.1 million votes for the proposal, and only 30,000 votes against. That sounds fine at first. But it turns out that more than 1 million votes that voted for the proposal came from a single user. Without the participation of that single user, the motion wouldn’t have even passed the 1% participation rate.
The event triggered a lot of backlash from the crypto community. Not only did it reveal the uneven power distribution within the DAO, but the action itself also goes against the core value proposition of decentralized financial applications. How could a platform wave the banner of decentralization and then take ownership of a user’s funds? Then again, if the DAO did nothing to protect the protocol they are supposedly governing, what is the point of creating the DAO in the first place?
DAOs in the Future
It is all but certain that DAOs will play a key role in shaping the crypto industry over the next decade. But building the decentralized world is a complicated process, filled with experiments that reveal what works and what doesn’t.
Effective DAOs that balance governance with sufficient decentralization are a key part of the puzzle, as they are the organizations actively creating the Web3 economy.
It is one of the fundamental challenges many major DAOs still need to solve. But as we find solutions and improve the way DAOs operate, we are on the path to regaining ownership of the digital world and securing our decentralized future.