Is Decentralization in Danger: How Will DAOs Survive the Crypto Bear Winter

On May 17, 2022, Vitalik Buterin tweeted out his thoughts on some contradictions in his value system that he was yet to resolve fully.

In his words, one such contradiction was:

Contradiction between my love for things like decentralization and democracy and my realization that, in practice I agree with intellectual elites more than "the people" on many (though definitely far from all) specific policy issues.

Although he might not fully realize it, the co-founder of Ethereum unwittingly voiced out what is starting to emerge as a major contentious issue as the cryptocurrency industry continues to experience a significant downturn in capital and funding.

How will democratic, community-owned crypto organizations and protocols survive a market where spectacular black swan events such as 3AC's liquidation and the LUNA debacle have shaken investor confidence to the bone, and market sentiment signals extreme fear?

What are DAOs

Before we delve into discussing how market conditions might impact the governance of DAOs, it is instructive to define what DAOs are properly.

DAOs have been cheekily described as "group chats with a wallet” and "the arch-nemesis of  Chairman Mao," a definition that, in fairness, succinctly captures the essential philosophy underpinning the cryptocurrency industry in general.

Officially called Decentralized Autonomous Organizations, a DAO, in plain language, is an entity with NO central leadership.

It is basically an organization that is run and managed by its community members. Unlike traditional companies, there are no hierarchies or 'pecking order' in DAOs. There is no CEO or board of trustees in a DAO, and decision-making is wholly democratized.

In his groundbreaking white paper, Vitalik Buterin, co-founder of the Ethereum blockchain, envisaged how blockchains might be used to create a functional but decentralized organization and how authority and leadership may belong to everyone, and no one.

Buterin described a Decentralized Organization as:

“a set of humans interacting with each other according to a protocol specified in code, and enforced on the blockchain”

that control a treasury and, a Decentralized Autonomous Organization as

“an entity that lives on the internet and exists autonomously, but also heavily relies on hiring individuals to perform certain tasks the automation itself cannot do”

Because centralized bodies do not run DAO organizations, decisions get made from the bottom-up. Or at least they are supposed to be.

Whether these idealistic concepts match up with DAO governance in real life is another matter. For example, after the famous LUNA death spiral debacle, some online investigators have claimed that Do Kwon allegedly used his secret bagholder wallet to influence voting decisions and sway things to his outcome.

The running of DAOs differs from conventional organizations in several ways. For one, most DAOs often have built-in treasuries that no one has the authority to access without the approval of the group.

This essentially means that everyone, from the developers to the average team member, will have a say in the operation and design of the company.

There are multiple models for membership entry into a DAO. Token-based membership is often the most common way. Membership can determine voting rights and other vital rights and options for a DAO.

Decisions in DAOs are governed by proposals, which are subject to the group's approval by vote. For most DAOs, the more tokens you hold, the more significant your vote is.

Clearly, this membership model means that large token holders, or "whales,” have disproportionate power and influence when it comes to approving proposals. And they do. In fact, a single community member with many tokens can invalidate thousands of members' opinions. This raises the question of how decentralized DAOs really are.

Smart Contracts, Unwise Members

Companies worldwide operate on standard civilized principles and laws, or "social contracts.” Some are enshrined by law, and others by peculiarities and tradition.

In a regular conventional organization, the company's backbone is often a set of legal rules and documents, guidelines all company employees must follow.

So what is the backbone of a DAO? Well, the social contract for DAO...is a smart contract.

Smart contracts are computer-written programs stored on a blockchain that runs whenever specific criteria are met. They are used to automate the execution of an agreement so that all participants can be immediately certain of the outcome. Smart contracts have many applications in the blockchain industry and are often used to establish a DAO's rules.

The smart contracts of DAOs are ostensibly tamper-proof and often publicly accessible. You can't adjust the codes without anybody noticing. This is because all the smart contract information is public.

The smart contract cannot be altered unless there has been voting to do so. If anyone tries to change something, it will fail. The same goes for trying to access the treasury. If community members vote against it, it would not be allowed to happen.

Of course, this is ideally what should happen. In reality, DAOs have been somewhat vulnerable and have been prone to security exploits due to bugs and errors in their code.

 In fact, the first DAO ever created was hacked barely three weeks after it was created, and $60 million was lost to hackers who exploited a bug in its smart contracts. More recently, DAOs such as Rari Capital, EasyFi, and ForceDAO have had their treasuries drained due to code exploits.

DAO Governance in Bear Markets

The very decentralized nature of DAOs poses unique opportunities and problems. The very decentralized nature of power gives everyone a voice, but this also comes with the risk of large players disproportionately drafting proposals that are inimical or downright harmful to the protocol's success and voting them in.

A snake with a thousand heads might not be able to be killed. However, it may bite itself to death.

Although DAOs are wonderful tools to bring about inclusivity and diversity of thoughts in a way never thought possible, the plurality of opinions and general uncertainty of community members in uncertain times might harm, rather than help, the development of DAOs. A ship without a captain might sail just fine in pleasant weather, but how will it fare in stormy seas?

Bear markets are periods when treasury funds dry up, and liquidity is expected to be on the low side. Many DAOs have had their governance tokens lose significant value, and many of their community members have probably experienced significant losses.

What will DAO governance look like in these stressed conditions?

Already, there are notable incidences of DAOs engaging in shady and almost downright illegal behavior due to, in the words of one such protocol, "extreme prevailing market conditions."

Here are two notable cases

Merit Circle vs. YGG

Merit Circle is a metaverse play to earn gaming protocol that sponsors and educates gamers interested in blockchain P2E games. It does this by lending them items in its treasury. The protocol also aims to increase general public participation in blockchain gaming by delivering educational content and sponsoring scholarships, among other efforts.

 Merit Circle is governed by Merit Circle DAO, a DAO that employs token-based membership. Decisions are made via votes from owners of $MC.

Merit Circle raised a hefty $4.5m in its private seed round. One of its significant investors was YGG, a similar play to earn gaming protocol, which had donated $175,000 in seed contribution, in exchange for a SAFT agreement and seed tokens with a  36-month linear unlock.

 A simple agreement for future tokens (SAFT) is a legal agreement between cryptocurrency developers and accredited investors, promising them discounted crypto tokens at a future date in exchange for capital. A linear unlock, as the name suggests, is the time it takes for all tokens to be unlocked

On May 20, after the $MC token had taken a significant beating due to market conditions, a member of the DAO drafted a proposal to cancel YGG's SAFT agreement, refund their initial investment, and remove their MC seed tokens. In essence, the DAO wanted to return their money and hold on to their tokens.

Although this proposal was contrary to the agreement between Merit Circle and YGG, had no legal backing, and would have led to a long protracted legal battle should  YGG choose to pursue it, the proposal was overwhelmingly voted in.

While the drafter of the proposal claims the reason for passing the proposal was due to YGG providing a clear "lack of value", and it aimed to get rid of "poor Angels and VCs who do not care", it is instructive to note that the proposal came about at a time when initial seed token unlocks were about to begin, and also when $MC token fell in value by a significant amount, making it much easier to buy out any VC's seed tokens without the DAO's treasury's finances taking much of a hit.

Although both DAOs agreed to an amicable split after a counter-proposal that allowed Merit Circle DAO to buy out YGG's token at record low prices was passed, it raises the question about how DAO governance can conceivably clash with traditional laws and how community members might choose to void contractual obligations with an investor for the simple reason of self-gain.

 After all, as noted by the proposal drafter himself, YGG was also a P2E gaming protocol, and despite the push for collaboration in the space, they were "competitors" not partners.

When the wishes of the majority clash with legally backed, agreed-upon arrangements, who should win? Well, for Merit Circle, the answer is the DAO.

SOLEND vs. anonymous whale

Solend is an algorithmic decentralized lending protocol built on the Solana blockchain. The protocol is a standard defi venture that aims to let you earn interest on deposits and borrow assets.

In June 2022, the protocol faced a serious crisis.

The value of Solana was tanking due to extreme market conditions, and many loans were getting dangerously close to being margin called.

While this was bad, the worst was yet to come. One loan, in particular, opened by the protocol's biggest whale had the power to cause waves of liquidation and possibly render the protocol insolvent, was edging dangerously close to being margin called as the price of Solana continued to dip.

To counter this, the protocol set up a DAO and drafted a proposal that, if passed,  grants the protocol "emergency power" to temporarily take over the whale's account and liquidate it OTC so as to avoid "pushing Solana to its limits."

This decision raised quite some furor amongst the crypto faithful but what made the entire affair even murkier was that the DAO seemed to have been specifically created because of this issue.

Despite the incredibly controversial nature of the proposal, it was approved with little difficulty, as there were over 1.1 million votes in favor of it and only 30,000 votes against it.

However, unlike in the case of Merit Circle, support for this proposal was not unanimous in the community. In fact, more than one million of those votes originated from a single user who held a significant quantity of governance tokens. Without this whale's support, the motion would not have been able to reach the 1.1 million vote threshold and would definitely not have passed.

An outcry erupted in the cryptocurrency world after this decision, with top leaders of the space like the founder of Avax and the CEO of FTX  asking how a platform could claim to be decentralized while taking control of a user's cash against their choice.

In response to the unwavering criticism, the Solend DAO invalidated their first proposal and cast a second one that just merely extended the time to vote for or against the proposal to one day to allow for "further participation."

At the end of the day, the whale user in question eventually decided to move their funds from Solend and unwound their holdings. This, plus the combination of favorable market conditions, gave the whole scenario a happy, if not ideal, solution.

Even though a crisis was averted in this particular instance, the actions of Solend DAO during the entire scenario raise doubts about the capability of a decentralized autonomous organization (DAO) to operate in the best interest of all members when some voters control such a disproportionately large number of governance tokens.

 As earlier stated, only one user-contributed 1 million votes, or 90% of the YES votes, while thousands of other "small fish" were vigorously against the proposal. And in the discussion for the second governance proposal, the user affirmed he would vote "yes” again as he was more interested in saving funds rather than some "vague Defi Ethos."

This raises a serious question.

In an event where bad faith actors working in concert manage to accumulate a significant number of governance tokens, draft a terrible proposal, and use their tyranny of surplus funds to pass such a proposal, who or what can stop them? Even if the protocol developers conceivably could stop them, by what right would they do so?

They would still need the support of the DAO to go after these bad-faith actors, and who can influence voting decisions significantly if not these bad-faith actors that they are trying to stop in the first place!

These are the issues that governance DAOs have to grapple with. And they had better find the answer hard and fast.

Conclusion

The Blockchain industry is an ever-innovative and ever-evolving field, and DAOs are the latest and most successful large-scale attempt at disrupting organizations that have ever been attempted.

DAOs exploded into popularity with the rise of Decentralized finance (Defi) and after the 2020 bear market. In essence, most DAOs currently in existence have not witnessed a standard Crypto Bear winter.

As prices continue to plunge and projects continue to lose revenue and bleed liquidity, how will these structureless organizations handle and navigate terrible market conditions? Are DAOs here to stay, or will they simply be another failed blockchain experiment?

That is the million-dollar question, and like many crypto believers and faithful out there, I can't wait to find out the answer.