The World Economic Forum (WEF) delivered its latest January report on the decentralized autonomous organization (DAO) landscape in the last couple of years. In 2021, DAO participants increased by a factor of 130x. However, with DAO maturity come legal challenges.

The Decentralized Autonomous Organization Toolkit

The World Economic Forum’s latest January 2023 insight is titled “Decentralized Autonomous Organization Toolkit.”

The progress in the DAO arena is especially of interest because these smart-contract platforms have the potential to revolutionize governance through open-source automation. Under the WEF umbrella, the 38-page DAO report was crafted by WEF’s Crypto Impact and Sustainability Accelerator (CISA) in collaboration with the Wharton Blockchain and Digital Asset Project (BDAP).

Aiden Slavin contributed as WEF’s CISA project lead based in the US. From the side of the Wharton School, University of Pennsylvania, Bianca Kremer and Kevin Werbach added their legal perspective on DAOs.

By relying on the underlying smart contracts, which are hosted on a public blockchain, all DAO activity is inherently transparent. Likewise, there are no operating costs involved as there is no need for third-party services to serve as expensive watchdogs and facilitators.

As such, DAOs can alleviate massive organizational and financial burdens for any type of activity that relies on coordination with other people. In short, DAOs push the envelope on the most cost-effective allocation of capital simultaneously as they alleviate counterparty risk (malicious behavior).

In practice, however, WEF researchers identified some major issues that need consideration in creating DAOs.

Highlights of the WEF’s Report on DAOs

Tracking the progress of blockchain adoption since 2020, the WEF notes an 18x increase in smart-contracts’ total value locked (TVL), going from $670 million to $13 billion. The following year, in 2021, DAO TVL alone increased by 40x, from $380 million to $16 billion.

During that bull run year, DAO participants increased by 130x, from 13,000 to 1.6 million. Predictably, after the Federal Reserve’s liquidity reversal with interest rate hikes in 2022, DAOs total treasury decreased to $11.5 billion.

The WEF report isn’t concerned with DAO growth as it is with operational, technical, governance, and legal challenges facing DAO deployment. Hence, this is why the report has “toolkit” in the title. As the first point, WEF researchers established criteria by which organizations could be classified as DAOs:

• They have to leverage public blockchain networks, which give DAOs access to digital assets for governance and incentives.
• They have to coordinate action through capital allocation to deliver a goal. DAOs’ goals are highly flexible, such as one-off projects such as ConstitutionDAO or ongoing management of funds for various services.
• They have to facilitate decentralized governance to make them more resilient to risks coming from central points of failure.

The WEF report used several DAO examples to illustrate the scope of DAO variety and their challenges.

The Biggest Problems With DAOs

Smart contracts may offer equitable access and transparency, but these are not necessarily valuable DAO components. After all, to be successful, DAOs still have to rely on human capital, which smart contracts facilitate.

The WEF report points to imbalance risk if DAO attracts contributors without “institutional knowledge.” Then, those DAO participants would have disproportionate voting power, infusing the organization with incompetency risk.

Likewise, DAOs can introduce imbalance if high-quality talent is not correctly incentivized. The report points to widely different compensation practices across CabinDAO, Lido Finance, and Gitcoin as examples. To avoid blended compensation that leads to improper incentives, researchers suggested that DAOs should segment compensations based on different contributor groups.

For example, Yearn Finance DAO uses a tiered compensation model by awarding funds according to participants’ contribution level. This would also solve the problem of pseudonymous DAOs, which run the risk of blending genuine contributors with inauthentic users.

The Lack of Legal Wrappers as DAO’s Acute Problem

The WEF considers legal and regulatory clarity as DAOs most acute problem. For DAOs to be fully on par with traditional organizations and for DAO contributors to have equal legal rights, they need a “legal wrapper.”

In addition to providing partial liability, a legally wrapped DAO would also be able to enter contracts, hire employees, own property, pay taxes, and even file lawsuits. In other words, without a legal wrapper, DAOs rely on individuals, or associated third parties, to perform all those functions.

In turn, registering DAOs to have legal wrappers would exert legal counsel costs. But without one, there is a risk of clashing with the law. Specifically against the Corporate Transparency Act (CTA) of 2020, which voids DAOs pseudonymity. There have already been several cases in which enforcement agencies acted even without DAOs legal wrapping:

• Commodity Futures Trading Commission (CFTC) CFTC sanctioned bZeroX DAO’s two founders for offering unregistered margin trading.
• The agency also sanctioned Ooki DAO, as an unincorporated successor to bZeroX.

WEF pointed to open-source Tribute Labs DAO as the optimal approach to legal wrapping. Providing customized smart contracts for DAOs, Tribute Labs is registered as an ordinary Delaware LLC entity. Limited liability companies (LLC) do not require boards, so the governance structure can be as flexible as DAO contributors want.

This morphed Tribute Labs DAO into LAO – an autonomous legal organization that enables the aforementioned functions. However, there is still some ambiguity about whether the SEC would consider membership-based interest as security. To avoid such scrutiny, Tribute Labs limited its LAO membership count to 99 investors, who must be accredited investors.

There Is No Universal Recipe for a Good DAO

In conclusion, WEF researchers advocate for a case-to-case approach to DAOs. Founders must know which goals the DAO should serve and how to implement them. From this perspective, DAOs objectives should be made clear from the planning stage.

This applies to the concept of governance itself. Instead of unfiltered access, WEF authors propose that “good governance” is better served with administrators who remove proposals that “appear to be fraudulent, spam-oriented, defamatory, hateful or otherwise inappropriate.”

Likewise, DAOs should create an effective legal strategy less if they find themselves delegating costs to individuals. Nonetheless, all DAO problems don’t detract from their value as flexible governance treasuries.

This article originally appeared on The Tokenist

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