This is a chapter from the book Token Economy (Third Edition) by Shermin Voshmgir. Paper & audio formats are available on Amazon and other bookstores. Find copyright information at the end of the page.
Since the advent of the Internet, numerous distributed online communities have formed around specific goals such as social media, e-commerce, or knowledge sharing. These communities can be viewed as modern Internet-based tribes, coordinating around shared purposes and values with the aid of increasingly sophisticated computer algorithms. In Web2, these tribes have generally been managed by private entities, with exceptions like community-governed networks such as Wikipedia or free and open-source software initiatives. In many cases, the operators of Web2-based platforms have disproportionate power over the fate of the communities contributing to and using their platforms. Web3 networks introduce a new type of Internet-based institutional infrastructure that can be collectively governed, allowing distributed Internet tribes to self-organize and coordinate in a more autonomous way.
Blockchain networks introduce a new type of Internet-based operating system that enables non-territorial coordination among people and institutions who may not know or trust each other. They facilitate the collaborative maintenance of public infrastructure without the need for traditional intermediaries or bilateral agreements. Property rights, access rights, management rights, information rights, or voting rights are enforced computationally through publicly verifiable, semi-automated mechanisms rather than traditional legal or management systems. Contributions to these networks are incentivized through purpose-driven tokens designed to steer collective action. Any type of organization—with any economic, political, or social purpose—can form on top of this infrastructure. Compared to traditional organizations, Web3-based organizations offer greater transparency regarding the flow of funds or governance processes. They are collectively managed with distinct ownership and collaboration structures. Proposals to change network rules can typically be made by any participant and are subject to voting, with rules for decision-making varying by DAO.
Since the advent of the Bitcoin network, this model of distributed organization has been described with terms such as “Digital Nations,” “Decentralized Corporations,” “Decentralized Autonomous Organizations,” “Decentralized Organizations,” “Network States,” “Coordi-Nations,” “Digital Cooperatives,” or “Infrastructure Networks.” For consistency, this book will primarily use the term DAO, while acknowledging that the degree of decentralization and autonomy varies widely, making the term "Decentralized Organization" more appropriate in many cases.
In theory, DAOs can replace the hierarchical structures of state-of-the-art institutions with more distributed and autonomous institutional structures. Governance rules are formalized through blockchain protocols or smart contracts, regulating the actions of network participants, which is why DAO protocols have also been referred to as "unstoppable code." However, even in their most autonomous form, DAOs require some human intervention for conflict resolution, handling unforeseen events, and evolving protocols.
History of DAOs
The Bitcoin network can be considered the first Decentralized Autonomous Organization, though the term was not coined until later. The Bitcoin protocol provides a collectively maintained operating system for financial networks, removing the need for traditional banks and managers. Governance is tied to the network token, BTC, which is minted and distributed as a reward for contributors through the Proof-of-Work consensus mechanism. The network operates without a central coordinator, allowing anyone to join or leave as a user or contributor without requiring permission from a centralized authority.
The open-source nature of Bitcoin's protocol enabled others to copy and modify its governance rules to create their own decentralized networks. The emergence of the Ethereum network revolutionized this process by moving the capacity to create a decentralized organization from the protocol level to the application level. Ethereum's smart contracts made it possible to program decentralized organizations with minimal code, eliminating the need to set up a dedicated blockchain infrastructure. This innovation broadened the scope of DAOs, enabling diverse use cases to be modeled and incentivized. Addressing economic, political, ethical, and legal considerations in the design of DAOs and the tokens that steer them remains an ongoing challenge.
The concept of DAOs, while popularized by the crypto community, has deeper roots in political philosophy and cybernetics. Ideas of autonomy and decentralized organizational structures predate Web3, emphasizing the distribution of rights and powers among participants of internet-based organizations. Dan Larimer and Vitalik Buterin were among the early influential voices exploring the economic and organizational potential of Bitcoin and the governance infrastructure it inspired. The terms Decentralized Autonomous Organization (DAO), Decentralized Autonomous Cooperation (DAC), and Decentralized Organization (DO) and related concepts emerged from broader discussions within the crypto community, with these figures helping to popularize and refine the terminology. While automation is often stressed and plays a significant role, the true value of DAOs lies in their ability to enable collective control or collective autonomy, a principle often summarized as “decentralization.”
Early projects like TheDAO in 2016, or MakerDAO and other DeFi DAOs later, showcased both the possibilities and challenges of DAOs. While they demonstrated the potential for decentralized governance and funding, they also exposed vulnerabilities, particularly around flawed assumptions regarding the willingness or practical feasibility of participation, as well as what can and cannot be automated. The often flawed design of early DAOs highlighted the need to account for issues such as voter apathy, free-rider problems, and bounded rationality when designing the rights and obligations associated with DAO tokens.
Rule of Law & Rule of Code
Our current social and economic institutions often rely on top-down structures and legal systems to enforce agreements. Constitutions, contracts, and trade rules all play a critical role in our legal system in providing social and economic security. They define the boundaries of social and economic interactions and prescribe sanctions for rule or contract violations. Blockchain networks complement the legal system with an internet-native governance layer that some refer to as “rule of code,” making breaches of contract economically infeasible using cryptography and financial disincentives.
- Political institutions: Before formalized legal systems emerged, social norms were communicated and enforced through mythology and religious institutions. Over time, religious laws evolved into secular institutions, from Roman times to the Age of Enlightenment, which fostered an independent legal system and eventually separated church and state. The political principles behind legal systems can vary greatly. Liberal democracies generally grant more individual autonomy to their people than authoritarian regimes. In a democratic system, the rule of law promotes transparency, uniform application, and accountability, avoiding retroactive and contradictory rules, while also ensuring that rulers must abide by the law. Checks and balances, as well as constitutional protections, ensure that these systems can adapt to progress and resolve ambiguities. Rules in the form of new legislation are implemented through collective decision-making. Since direct participation has proven impractical in large societies, representative democracies have developed, delegating decision-making to elected officials. While efficient, such delegation often leads to principal-agent dilemmas and public disenchantment with the democratic process—a phenomenon described as "Post-Democracy." Alternative forms of democratic participation, like Liquid Democracy, propose flexible delegation of voting power, but practical challenges have hindered their adoption.
- Economic institutions operate within these political systems and are regulated by the explicit or implicit rules of the social institutions they are part of. Participants in economic systems—generally referred to as “consumers” or “producers”—interact with each other, forming a market for goods and services that may be more or less regulated by the political institutions that govern them. The autonomy of market participants depends on the degree of explicit or implicit rules and regulations and is a product of market design. The larger a social group, the bigger its political institutions and generally also the body of laws that govern the market through laws and policies, ensuring property rights and economic stability. But there is a tradeoff: the larger the body of laws, bureaucracy, and norms, the less autonomy individual market participants have. Weak rule of law, on the other hand, fosters corruption, deterring investment and market activity. In recent decades, Web2 platforms have facilitated global market-making mechanisms at lower transaction costs, creating new organizational models. However, these platforms remain controlled by private companies that dictate the rules of the network and terms of participation while retaining ownership of user data.
- Web3 protocols offer a technical operating system for a new type of socioeconomic institution that transcends the boundaries of nation-states and private corporations. Their rules are codified in computational constitutions of Web3 protocols (hence the term “rule of code”) and secured by cryptoeconomic mechanisms. Rights and obligations are enforced collectively by blockchain node operators, replacing reactive legal systems with proactive, automated mechanisms that make breaches of contract prohibitively expensive. While decentralized organizations can use the legal system for some protection of digital property rights, such usage is secondary to the preemptive security mechanisms that blockchain protocols and smart contracts can offer. However, this is only true for Web3-native digital assets. In the case of tokenized real-world assets, blockchain networks can only secure the tokenized digital certificates of the respective property rights. A physical management system of the physical asset and a functioning legal system will still be necessary to protect physical property and provide solutions that prevent and sanction physical theft or damage. Beyond property rights, tokens can also represent voting rights to participate in the governance process of creating and managing a Web3 network. The crypto community has experimented with a range of novel voting mechanisms, from delegated voting to quadratic voting, for steering the collective decision-making process. Given the nature of blockchain networks, forms of “Liquid Democracy” have also become much more feasible and have been implemented in the form of “delegated Proof-of-Stake” in some blockchain networks. However, decentralization through participation is not only a technical issue. It is also a social issue concerning how much users of a Web3 network are willing to participate, given actual time constraints and knowledge gaps that practically prohibit them from participating in the decision-making process.
DAOs as Internet-based Institutions
With their institutional structure and complex dynamics, DAOs resemble nation-states and markets much more than they resemble companies. To a certain extent, a blockchain protocol could be comparable to the constitution and other governing laws of a nation-state. The autonomous actors in the network represent the sovereigns of the network and are therefore subject to the network constitution—i.e., the blockchain protocol or smart contract code. However, unlike nation-states, individuals can opt in or out as users, contributors, or decision-makers at any time, without needing permission from a central governing authority. The monetary policy and voting rights are codified in the protocol, governing what rights are attached to the native network tokens and under what conditions they are minted or burned. Network fees act as the network's fiscal policy, which can be predetermined by the protocol or a result of the supply-and-demand dynamics among infrastructure suppliers and infrastructure consumers of the network. While Web3 networks share certain similarities with nation-states, significant differences remain. DAOs can function on a local, regional, national, or global level.
Similarities to nation-states, while important to outline, can also be misleading. Unlike nation-states, which provide infrastructural services for all necessary social and economic interactions of their citizens and residents, DAOs are usually limited to one infrastructural service only. Nation-states are restricted by their geographical boundaries, while DAOs can act globally—unless they are specifically localized. Furthermore, nation-states have a fiscal and legal monopoly over their citizens and residents, who cannot easily opt in and out of their citizenship or residency status. DAOs, on the other hand, have so far made it relatively easy to opt in and out at any time (aside from sunk costs of investments). While one can be an active or passive participant in an unlimited number of DAOs, one can rarely be a citizen of more than one country.
Authors like Balaji Srinivasan have proposed concepts such as “Network States,” suggesting DAOs as digital alternatives to nation-states. Critics, including researchers like Primavera de Filippi, have countered with terms like “Coordi-Nations,” describing voluntary networks of communities with shared values and participatory governance. These frameworks emphasize collaboration rather than replacement, reflecting the potential for DAOs to complement existing institutions rather than replace them. I personally think that instead of renaming already under-defined terms such as “Decentralized Autonomous Organization” (DAO), “Decentralized Autonomous Cooperation” (DAC), and “Decentralized Organization” (DO)—replacing them with new words such as “Network State” or “Coordi-Nation”—we might benefit from trying to understand what institutional opportunities such Web3-based organizations can provide.
The comparison to existing institutions, while important, can only be a first step. One has to be careful not to get stuck in comparisons, as DAOs cannot replace existing institutions. They introduce completely novel forms of coordination that can transcend the possibilities of state-of-the-art political and economic institutions. By focusing on specific infrastructural services, DAOs can be much more effective in their coordination attempts. If designed well, their token-based economic incentive systems and voting systems can be adapted to a specific and singular purpose.
DAOs can denationalize certain services—such as currencies or telecommunications—by providing globally maintained alternatives that complement national systems. Citizens and residents of nation-states increasingly have digital alternatives to state-provided services, a trend that began with multinational corporations, accelerated with the internet, and is now advancing further in Web3. While Web3-based infrastructure networks are unlikely to replace nation-states entirely, they will challenge them to adapt.
DAOs as Complex Systems
From a systems theory perspective, DAOs are complex systems comprising three interdependent networks: (i) a network of computers, (ii) a network of people, and (iii) a network of token flows. Human agents in these systems can have different roles. They can actively participate by maintaining network services as infrastructure producers. They can use network services as infrastructure consumers, contribute to the network's code as infrastructure developers, and vote on system upgrades.
In the Bitcoin network, for example, mining node operators maintain and secure a P2P payment system (explored further in the “Bitcoin” chapter). In Steemit, curators and content creators sustained a decentralized social network (explored further in the “Steemit” chapter). In MakerDAO, vault operators and vault keepers collectively manage the P2P stable token DAI (explored further in the “DAI & MakerDAO” chapter).
A unique aspect of DAOs is the flexibility for service providers to opt in and out at will, adding a layer of complexity absent in centrally managed systems such as companies. This is important because complex systems, unlike simpler systems, exhibit behaviors that cannot be easily predicted or deduced from individual actions, as they dynamically adapt over time. Any individual action of a participant can ripple through the entire system, influencing the state of the whole network. Participants continuously adjust their behavior in response to others, creating feedback loops that shape the system’s overall activity. This interplay of dynamic and adaptive elements highlights why DAOs require careful design and governance to balance participant incentives, ensure stability, and maintain functionality despite their inherent unpredictability.
DAOs as Tech-Driven Public Goods
Public blockchain networks, such as Bitcoin, exhibit the characteristics of “public good” or “common good.” In economics, the term “public good” refers to goods and services that are available to everyone, and one person’s use does not reduce their availability to others. Common goods, on the other hand, are also considered publicly available and commonly provisioned but are scarce—often to varying extents. For example, natural resources: if water, air, forests, etc., are exploited or polluted beyond their sustainable capacity, it prevents others from consuming them. The same applies to public transport and its capacity limits. In the general population as well as in the crypto community, the terms “public good” and “common good” are often mixed up, and even academic scholars disagree about their exact definition.
Depending on one's definition of public goods and common goods, the Bitcoin payment network and other Web3 networks could either be seen as a new form of tech-driven public good, albeit an impure one, as they may have certain capacity limits. In times of congestion, the network becomes rivalrous, with users competing in a fee market that prioritizes transactions for validation. Alternatively, they could be defined as tech-driven common goods, since they are collectively provisioned, publicly available, but can have capacity limits. For consistency, I will refer to blockchain networks as “public goods,” also because the crypto community predominantly uses this term in the context of Web3 networks.
While the Bitcoin network itself is public infrastructure that anyone can use, Bitcoin’s currency represents private property and is therefore a private good. P2P social networks (such as Steemit), P2P telecommunication networks (such as Helium), and P2P data-sharing networks (such as Ocean) are also tech-driven public goods. Just as with Bitcoin, their tokens represent private property rights and are therefore private goods that are used to incentivize individual infrastructure contributions. Federated blockchain networks, on the other hand, can be categorized as club goods, where only members of the federation (club) have read, write, and/or execution rights on the distributed ledger.
- Negative externalities & tragedy of the commons: The provision of both public and private goods can generate “negative externalities,” where the costs of production or use are passed on to society or the environment. The so-called “tragedy of the commons” occurs when individuals withdraw resources for their own short-term profit, disregarding the collective dynamics of individual behavior and the long-term consequences for the common good or public good. For example, private companies often externalize costs such as CO2 emissions, biodiversity loss, or social instability—while privatizing profits. Blockchain networks are prone to the same problems, introducing new externalities. Bitcoin’s Proof-of-Work mechanism, critical for maintaining the network, consumes significant energy, creating environmental costs. Alternative consensus mechanisms, such as Proof-of-Stake, aim to reduce these negative impacts. Similarly, poorly designed DeFi protocols can be exploited by a few, creating spillover effects that harm the broader ecosystem.
- Purpose-driven tokens that mitigate negative externalities: Tokens can also be designed to offer potential solutions to negative externalities. For example, CO2 tokens or biodiversity tokens could be intentionally designed to incentivize individuals and organizations to contribute to sustainability efforts, addressing environmental challenges like carbon emissions and biodiversity loss. While such systems can mitigate the externalities of current economic institutions, their success depends on careful design, robust adoption, and clear alignment with collective goals.
- Free-Rider Problems: Open-source software in general, which is considered to be a public good, often suffers from so-called “free-rider” issues. Many use the software for free, but few contribute to its development or upkeep. Blockchain networks, which also build on open-source code, face similar challenges. For example, while Bitcoin rewards mining node operators with tokens, protocol developers lack direct incentives. Better-designed economic incentives, such as direct tokenized rewards for protocol developers, could mitigate such free-rider problems. Some alternative blockchain protocols, such as Tezos and Dfinity, have tried to address this issue in their incentive design. Other Web3 protocols, with different purposes and incentive mechanisms, also face substantial free-rider problems that need to be anticipated when designing their network tokens. Examples will be discussed in the analysis of the use cases at the end of this book.
DAOs as Non-State Actors
As their significance grows, Web3 networks and the decentralized institutions that emerge from them increasingly influence global political and economic systems, becoming relevant subjects in the field of international relations. International relations historically focused on interactions between nation-states, dealing with concepts like national interest, foreign relations, sovereignty, and global power dynamics. With industrialization, globalization, and the Internet, so-called “non-state actors”—such as multinational corporations, NGOs, and social movements—began shaping the international political landscape. Social media fragmented traditional institutions further, empowering individuals like influencers to wield global influence. In this context, DAOs represent a new category of Internet-based non-state actors with growing influence on an international stage.
- Foreign policy & national interest: In nation-states, foreign policy governs actions toward other states or non-state actors to protect national interests, employing tools like diplomacy, sanctions, and even warfare. For DAOs, the equivalent is "network interest," which focuses on maintaining asset and network security and autonomous policymaking. As DAOs grow, they will likely require representatives or automated mechanisms to enforce their interests, particularly in interactions with national and international policymakers. However, internal power asymmetries within DAOs could lead to disproportionate influence by powerful stakeholders, shaping both internal and external actions of a DAO.
- Sovereignty in the context of international relations refers to the absolute authority of a nation-state over its territory. In Web3, sovereignty relates to control over digital assets and data, enabled by blockchain protocols. While Web3 systems offer proactive security for digital assets, they remain vulnerable to regulatory interference by state actors, especially over the people and physical assets they govern.
- Power, polarity & balance of powers: In international relations, "power" describes the resources and influence of state and non-state actors. Power can be hard (coercive, such as military force) or soft (economic or cultural influence). DAOs lack coercive power, relying instead on economic and cultural mechanisms. Polarity refers to the distribution of power between different actors on a global level. In Web3, power structures can arise from monopolistic tendencies and the lack of interoperability among blockchain networks. Unchecked dominance by a single protocol or lack of interoperability can create unipolar systems with significant lock-in effects.
- Power blocks & alliances: In international relations, alliances form power blocs that pursue common objectives. Similarly, Web3 protocols can form alliances to collaborate or consolidate influence, both within Web3 and beyond. For instance, stable token DAOs might align with exchanges or DeFi protocols to create ecosystem lock-ins.
- Interdependencies: Globalization, free trade, and the Internet have deepened interdependencies between nation-states and non-state actors. Similarly, the modularity of Web3 protocols has created interdependencies between protocols, particularly within the DeFi ecosystem. These interconnections increase the potential for complex attack vectors and vulnerabilities of DeFi protocols. As more and more real-world assets like currencies, stocks, and bonds are tokenized, Web3 protocols are likely to also develop inter-dependencies with traditional state actors, corporations, and other institutions.
DAO Governance
The act of designing a protocol entails the choice of political, social, and economic structures. The governance design is a question of political principles and depends on the intention behind the DAO's creation. The rules are encoded into the DAO contract and serve as the computational constitution. As stated previously, smart contracts are not truly smart; they are only as smart as the people and AI agents designing them. They auto-execute predefined rules created by a small group of humans. Future conditions are—to a certain extent—unpredictable and emergent and cannot be fully engineered in advance. Algorithmic governance can only manage known variables, but unforeseen events, human error, and changing conditions require human intervention. DAO governance, therefore, needs a human component in addition to its automated constitution. It consists of (i) algorithmic administration, which automates predefined policies in a transparent and enforceable manner, and (ii) social governance, which is the process of human stakeholders discussing and deciding on policy changes.
- Algorithmic governance automates rule enforcement through protocol policies encoded in machine-readable code. These policies can trigger semi-automated market mechanisms or enforce rules for protocol updates. They can be rigid or designed to auto-adapt to predefined parameters. Tokenized incentives play a key role in coordinating economic activity. By automating bureaucratic functions and institutional rules, Web3 protocols reduce administrative overhead and enhance transparency. However, the process for updating the protocol remains subject to social governance.
- Social governance involves human decision-making processes about changing a DAO’s protocol, including the timing and method of protocol updates. It is shaped by public debate and collective action among network stakeholders. The process is iterative. Discussion usually occurs “off-chain” (on social media or forums) and is later formalized through “on-chain” voting mechanisms. Depending on the protocol, social governance rules may be well-defined or loosely defined within the protocol. Key questions include: (i) How stakeholders access and evaluate information for decision-making; (ii) Who is eligible to vote on rule changes; (iii) The process for pre-vote discussions; (iv) The voting mechanisms used for different decisions; (v) How voting outcomes are implemented; and (vi) Mechanisms for resolving contentious decisions. Open access to information is essential for this process, but navigating and verifying the authenticity of this information can be challenging and must be accounted for in governance design.
Early blockchain networks like Bitcoin and Ethereum operated under the assumption that “code is law,” embedding few explicit social governance rules in their design. Social governance practices evolved informally and were mostly conducted “off-chain” based on the social norms that developed in the early developer communities of those networks. Later Web3 protocols encoded explicit social governance rules into their protocols, recognizing the limitations of a “code-is-law” mindset. The balance between algorithmic and social governance remains a controversial topic. The ideal governance design depends on the DAO’s type, purpose, and the political principles it seeks to embody. A hybrid approach combining algorithmic efficiency with human adaptability may be the most effective for complex, multi-stakeholder environments. As AI applications become more sophisticated and AI agents emerge in Web3, DAO design, execution, and collective decision-making will also evolve to be increasingly AI-assisted:
- AI at the edges of a DAO: Automated agents, or bots, already play a significant role in decentralized applications. Bots interact with networks as mining nodes (Bitcoin), Keeper bots (MakerDAO), or optimization bots (Steemit). These bots execute tasks autonomously based on predefined instructions. Humans can also use AI for decision support while retaining final control over operations.
- AI on protocol level: AI agents can also be integrated into DAO protocols, allowing AI to manage governance feedback loops, update states, and actuate outputs autonomously, making protocols more adaptive and less rigid. In such scenarios, AI could complement the human decision-making process for protocol upgrades. Alternatively, AI agents could use DAOs as institutional frameworks to operate independently, provided they control economic resources (e.g., tokens) necessary to sustain an AI-controlled DAO.
DAO Economics
While DAOs share some similarities with the political and economic dynamics of nation-states, they are different in many ways and require tailored approaches to economic design. Understanding these distinctions is crucial for adapting nation-state tools to Web3 protocols effectively.
- Monetary Policy: DAOs are steered by network-native tokens, which are designed to be purpose-driven and usually minted or issued upon some proof of network contribution. Token supply policies, similar to monetary policy in nation-states, are codified in smart contracts and vary widely depending on the network's purpose. In nation-states, monetary policy is governed by centralized entities such as central banks in interplay with political institutions, using tools like interest rate adjustments, reserve requirements, and open-market operations to manage macroeconomic objectives. Similarly, DAOs can use protocol-defined mechanisms to regulate token supply. Token supply could be fixed, as is the case with the Bitcoin network; more loosely defined, as was initially the case with the Ethereum network; or adaptive, as in the case of certain types of stable tokens. In the case of flexible design, policy rules can be adjusted within a predefined range that can be enforced by a combination of human interventions and automated mechanisms when conditions change. Adjustments may require a protocol upgrade by majority vote of all network stakeholders. Economic mechanisms that maintain the exchange rate of a token stable by issuing or removing new tokens from circulation might be important in the context of a network currency to avoid extreme exchange rate fluctuations and keep network prices and income opportunities within a predictable range. Stability mechanisms are not relevant for other types of tokens where a stable exchange rate is unnecessary, or where one could use an existing third-party stable token.
- Fiscal Policy: Fiscal policy in nation-states encompasses taxation and government spending to stimulate economic activity. DAOs mimic the process of taxation and government spending through mechanisms like transaction fees, treasury contracts, reserve pools, and grants programs. For example, in Proof-of-Work-based blockchain networks like Bitcoin, fees are paid for the transfer of tokens over the network—for the settlement, attestation, and notarization of transactions. In Proof-of-Stake networks, “fiscal policy” mechanisms are reflected in protocol variables such as (i) staking fees, (ii) vesting periods, and (iii) reserve pools that fill or are depleted based on various economic mechanisms. These fees must be paid by the transaction initiator(s) in network tokens. In early blockchain networks, 100 percent of these fees were collected by miners and similar eligible market participants, who did not have to pass on any of the collected fees for the research and development of the network. The respective blockchain communities had to find other ways to fund protocol development. Newer blockchain ecosystems (such as Polygon) have defined fee distribution mechanisms that allocate a certain percentage of transaction fees to protocol development. In application-level DAOs, such as DeFi protocols, a percentage of network fees is collected in a treasury smart contract, and the collected funds are used for ongoing operations and protocol development. Policies governing treasury distribution are usually formalized in the protocol. While DAOs lack centralized tax authorities, fee structures and redistribution mechanisms function similarly to fiscal policies, though adapted to the decentralized and voluntary nature of network participation.
To evaluate the economic activity level of DAOs or quantify the economic and social inequalities within a DAO, one can take micro- and macroeconomic metrics, which are usually applied in the context of nation-states, and adapt them to the needs of DAOs. The list below is a collection of the most important metrics. They are not listed in the order of their importance, nor is this list complete, but they serve as a starting point for further thinking. More refined quantitative methods that consider the particularities of different types of DAOs need to be developed and are the subject of the emerging disciplines of token economics or cryptoeconomics.
- Economic productivity: At the time of writing, crypto markets predominantly measure market value in terms of “market capitalization.” But this metric was developed to measure the total value of publicly traded companies. Alternative metrics like “Gross Network Product,” “Gross Network Value,” or “Gross Crypto Product” have been proposed for the crypto space, measuring tokenized goods or services transacted over a Web3 protocol or across multiple protocols in a given period. These metrics could reflect the economic output of both foundational blockchain networks and application-level protocols built on them. Gross Network Product can be measured as all tokenized goods or services that are issued by a protocol and purchased or rented by users during a given period. This can be extended to measure and compare economic activities across multiple Web3 protocols that are active in the same sector. The question of how metrics such as Gross Network Product or Gross Crypto Product can be measured has not been conclusively answered and probably depends on the application scope and purpose of a network. For example, the economic productivity measures of a first-layer blockchain network will also depend on the number of second-layer protocols and tokenized applications that build on top of the blockchain network.
- Gini coefficient: The Gini coefficient, traditionally used in economics to measure inequality within a socioeconomic space, can also be applied to Web3 protocols to assess fairness in token distribution, inclusiveness of income opportunities from network contributions, and accessibility of network services. As explored in the use case chapters of this book, economic fairness is essential for the sustainability of decentralized applications. Unlike nation-states, Web3 networks lack coercive mechanisms to retain users. If participants do not benefit—whether as users or service providers—they can leave at any time. This makes fairness in token distribution and economic opportunities a critical factor in a protocol’s long-term viability. Three key metrics could be used to evaluate economic inclusiveness in Web3 networks: (i) Token distribution fairness, which measures the concentration and distribution of native network tokens. (ii) Inclusiveness of income opportunities, assessing how accessible earning opportunities are for those providing network services. (iii) Inclusiveness of service accessibility, which evaluates the ease of access for users who wish to utilize network services. The specific metrics depend on the protocol's purpose and use case, though barriers to entry and disproportionate first-mover advantages are a common theme. While many Web3 networks claim to be permissionless, practical entry barriers often exist, particularly in the form of knowledge and technical expertise. These barriers affect both sides of the protocol: the difficulty of becoming a contributor and earning network tokens, and the complexity of accessing and using network services. Addressing these barriers is crucial to ensuring equitable participation and preventing the concentration of power within Web3 ecosystems.
Challenges of DAOs
There is no universal governance solution that fits all decentralized organizations. Each protocol operates with unique objectives, stakeholder dynamics, and governance needs, often requiring customized governance frameworks. At the time of writing this book, blockchain networks and other Web3 protocols have only existed for fifteen years. Although Web3-based organizations have great potential to provide a governance infrastructure for local and global coordination, many questions regarding optimal protocol design remain unresolved, while at the same time, new institutional challenges emerge.
- Initial conditions matter: In Web3, initial conditions matter much more than one might assume. Protocol designers have significant influence over how the system is created and how sustainable it will be over time. Unlike the “develop first, iterate later” approach seen in Web1 and Web2, Web3 protocols face the risk of irreversible consequences from poorly designed initial rules. Protocol rules collectively governed by an independent network of stakeholders are difficult to revert without the consensus of all network actors and the risk of splitting the network. The Bitcoin scaling debate of 2016 and 2017 is one of many examples of how initial protocol rules—potentially insufficiently considered or simulated—can lead to unintended long-term consequences that are difficult to reverse or change due to system inertia. The design failures of the purpose-driven tokens that steered the decentralized social network “Steemit" or the decentralized telecommunication network “Helium" are other examples and will be analyzed in greater detail in later chapters of this book.
- Power distribution: Decentralization is not binary but exists on a spectrum. Inclusion, or decentralization, is influenced by token creation and distribution rules as well as social, economic, and political realities. Decentralization can be analyzed across four dimensions. (i) Architectural (node operations). (ii) Geographical (jurisdictions of stakeholders). (iii) Economic (distribution of token ownership). (iv) Political (distribution of voting rights and policymaking powers). Power imbalances can arise if stakeholders are concentrated in any of these dimensions. Decentralization claims are difficult to validate without robust definitions of what is considered decentralized and clear distribution metrics to measure it.
- Measuring power: The pseudonymous nature of blockchain wallets makes it difficult to measure token distribution accurately. Wallet-based metrics do not reflect actual distribution, as individuals or institutions can own multiple wallets. Web3 protocols lack egalitarian voting systems, as voting rights are tied to pseudonymous identities or token holdings. Addressing these challenges requires adequate identification systems or better token distribution analyses.
- Centralization around code: The governance rules encoded in a Web3 protocol will always be a point of centralization and loss of direct autonomy. The question of how to upgrade the protocol—when and if necessary—is often delegated to a set of experts who understand the technical, legal, economic, or political intricacies of the code. These experts represent a centralization point in these systems. While smart contracts can mitigate certain principal-agent problems through automation and radical transparency, the community of stakeholders who decide on protocol updates must trust the design judgment of human experts and increasingly also artificial intelligence algorithms. While Web3 experts are more distributed—none of whom have executive decision-making power in a DAO—they still concentrate power around their expertise and have become the new quasi-agents in these distributed networks where code is considered law. The lack of distributed incentives in many early blockchain protocols is one of the greatest challenges in decentralized protocol development. This leaves the maintenance of these networks under the control of a small group of core developers, who are either paid by private companies (Bitcoin) or a foundation (Ethereum). In both cases, the development of public infrastructure is limited to a relatively small group of people, making the entire network vulnerable to principal-agent problems, potential bribery, and social attack vectors.
- Yes, it’s open source, but how many people can understand it? Currently, only a handful of software developers and system architects understand the ins and outs of specific blockchain protocols well enough to make educated decisions about protocol upgrades. The same is true for Web3 protocols with other purposes. A stable token system, such as MakerDAO, requires a deep understanding of financial markets and monetary policy. Given that coding skills and financial literacy are still not part of mainstream curricula in schools, educated decision-making in a machine economy remains a distant illusion. While in theory, anyone can contribute to protocol evolution, the required economic and engineering expertise required creates practical entry barriers, introducing new principal-agent problems—the very issues early Bitcoin developers and other blockchain network creators sought to eliminate.
- Conditions that change over time are why code can never be absolute law and why protocols must be adapted to emergent circumstances. This is not unique to Web3 and has been the subject of numerous legal studies, specifically “contract theory” which analyzes social contracts from the perspective of completeness or incompleteness. Unforeseeable events and changing social and economic conditions are why we have a judicial system and why laws must be constantly updated. These changing conditions must also be accounted for in Web3 protocol design.
- Protecting minority rights: Democratic systems protect minority rights. Web3 protocols lack similar protection mechanisms, leaving system exit or secession (network forks) as the primary options for dissenting minorities. Innovative approaches are needed to balance majority decision-making with minority protection
- Risks of overengineering: Overengineering Web3 governance risks creating a new form of tech-driven bureaucracy, lacking human discretion. This could lead to inefficiencies and rigid systems, echoing the challenges of traditional bureaucracies.
DAO governance frameworks provide a smart contract-based modular Web3 toolset designed to simplify the process of building decentralized organizations while addressing many of the challenges mentioned above. These frameworks often include user-friendly interfaces that allow individuals without technical or legal expertise to establish their own decentralized organizations. Features typically provided by these tools include constitutional templates, dispute-resolution mechanisms, voting systems, and more. They can reduce the technical and operational costs of setting up a decentralized organization, enabling founding teams and protocol designers to focus on tailoring token governance rules to align with their organization’s purpose and goals.
← Previous: Tokenized Derivatives, Synthetics & Insurances
Footnotes
[1] The following two chapters are partially based on my 2017 paper: Voshmgir, Shermin: “Disrupting governance with blockchains and smart contracts”, Journal for Strategic Change. A previous version was published on blockchainhub: https://blockchainhub.net/blog/blog/disrupting-organisations-with-blockchain/. My writing here is also based on my 2020 paper: Voshmgir, S.; Zargham, M.: “Foundations of Cryptoeconomic Systems,” Cryptoeconomic Systems Journal, March 2020, retrieved from: https://assets.pubpub.org/sy02t720/31581340240758.pdf
[2] In some countries, like Austria, there are trends in the legal literature to see DAOs as a civil law partnership, as “Gesellschaften bürgerlichen Rechts (GesBR)” pursuant to §§ 1175 ABGB. A civil law partnership is an association of individuals or enterprises which unite to achieve a joint purpose. While a written partnership agreement is recommended, it is not mandatory. All partners are jointly liable with their private assets for debts incurred by the joint enterprise. Even if one would classify DAOs as GesBRs, many unsolved problems (for example, the solidary liability) persist.
[3] “Governance”is a political science term that refers to the – formal or informal – rules, norms, and manners of how people interact within a community or organization.
[4] A vulnerability in one of the smart contract functions, designed to represent minority rights, was exploited and used to drain 3.6 million ETH (roughly 50 million USD at the time) from TheDAO smart contract. A controversial hard fork was conducted on July 20, 2016 (block number: 1,920,000): The malicious transaction was retroactively censored, which led to a splitting of the network. This incident exposed the lack of dispute settlement and governance mechanisms for edge cases induced by unforeseen events, both on a smart contract level, i.e. in (the token governance rules of TheDAO) and on the level of the Ethereum network itself. The incident revealed the limitations of pre-defining and pre-regulating all possible human interactions – and the concept of “unstoppable code”--including potential attack vectors of bad actors, with complex lines of code.
[5] The free-rider problem refers to members of a group taking advantage of access to a common resource, or collective good, without contributing to it.
[6] Behavioral economics assumes that the rationality of individuals and institutions is “bounded” and that 90 percent of their decisions are based on mental shortcuts or rules of thumb. People tend to rely on anecdotal evidence and stereotypes to help them understand and respond to events more quickly, especially under pressure and in situations of high uncertainty.
[7] This subchapter is based on collective research that was published together with Michael Zargham and Jeff Emmet. Source: https://medium.com/primedao/conceptual-models-for-dao2dao-relations-ac2b2d3cc84d
[8] Source: https://medium.com/token-kitchen/conceptual-models-for-dao2dao-relations-bfbf2efcd2bd
[11] https://bitcoinmagazine.com/technical/bootstrapping-an-autonomous-decentralized-corporation-part-2-interacting-with-the-world-1379808279
[12] https://bitcoinmagazine.com/technical/bootstrapping-an-autonomous-decentralized-corporation-part-2-interacting-with-the-world-1379808279
[13] https://medium.com/token-kitchen/conceptual-models-for-dao2dao-relations-bfbf2efcd2bd
[14] Religion comprises a wide variety of disciplines, including theology, sociology, anthropology, philosophy, or mythology. So far, academic scholars and religious practitioners have not been able to agree on a common definition of what religion is. The modern concept of “religion” from a secular point of view does not always have an equivalent term in other current and past cultures. My personal definition of religion is that it “roots in the uncertainty of decision-making between what is right and wrong. It can be defined as a social-cultural belief system that is based on morals and ethics, where socially accepted practices may or may not be codified in text form, and can be more or less formalized or institutionalized. Religion tries to explain the meaning and functioning of life and the rules of human interaction with each other and with oneself. In societies where the rules of human interaction (politics) and the explanation of life itself (science) has emancipated from religion, we often refer to religion as “spirituality” and reduce it to that which cannot be explained by science or regulated by politics.”
[15] https://medium.com/primedao/conceptual-models-for-dao2dao-relations-ac2b2d3cc84d
[16] https://theblockchainsocialist.com/otns-the-rise-of-coordi-nations-phase-2-has-begun/
[17] Neoliberalism in the context of the late 20th century refers to the political resurgence of free-market capitalism, which had been replaced by more controlled or social market approaches after World War II in many countries.
[18] Copyleft is a legal concept that grants certain freedoms to use a copyrighted work for any purpose, and the ability to modify, copy, share, and redistribute the work, with or without a fee, but requires that the same rights are preserved in derivative works. Various types of licenses have been created over the decades that might limit the scope of freedoms of use, modification or redistribution. The concept was developed for software and adapted for creative industries. Source: en.wikipedia.org/wiki/Copyleft
[19] Similar to copyleft, patentleft describes the legal practice of being able to auto-license patents for royalty-free use, requiring that those who adopt the license subsequently license their improvements under the same terms. It is predominantly used for biological patents.
[20] In economics, the term “externalities” refers to costs or benefits that affect a person or community who did not choose to incur that cost or benefit. “Negative externalities” are a result of activities of people and institutions that cause an indirect cost (negative effect) on other people or institutions. Pollution is one example. Consuming goods with a positive CO2 footprint is another. Manufacturing can cause air pollution, which imposes health-related and clean-up costs on society. If those costs are not internalized through government regulation, those who create the externalities will likely continue to do so. “Positive externalities” can arise if, for example, two neighboring farmers have positive ecological effects on each other. Incentivizing CO2 emission reduction with a token could be another example of a positive externality that would contribute to a common good, like improved air quality of a city.
[21] This subchapter is based on collective research that was published together with Michael Zargham and Jeff Emmet. Source: https://medium.com/primedao/conceptual-models-for-dao2dao-relations-ac2b2d3cc84d
[22] Governance is a political science term that refers to the formal or informal rules, norms, and processes of how people interact within a community or organization such as a government, market, family, tribe or a computer network. The governance rules of an organization or group of people regulate the process of decision-making among all stakeholders involved. This is achieved through laws, norms, force, or language.
[23] The reserve requirement refers to the money banks must keep in their vaults or with the central bank overnight. A low reserve requirement allows banks to lend more of their deposits, increasing credit volume. A high reserve requirement decreases credit volume.
[24] Open-market operations define how and when central banks buy or sell securities from and to private banks to regulate the amount of credit private banks can issue to customers and businesses.
[25] A bonding curve is a smart contract that defines a relationship between price and token supply via a mathematical curve. Bonding curve contracts issue their own tokens through buy-and-sell functions. They are an emerging cryptoeconomic primitive that can enable price discovery and autonomous markets. In their simplest form, they act as an automated market maker. The contract can accept collateral and issue its native token. in return, and vice versa. They have debt and equity qualities, and can incentivize collective contribution to projects.
[26] As more people started to use the Bitcoin network, the capacities of the network became insufficient. Various proposals were made, in this “scaling debate” or “block size debate,” by different groups of developers, but consensus among the factionalized community was hard to reach. One part of the community suggested allowing bigger blocks, which would allow for more transactions to be included, but also lead to more centralization, as better hardware was required to compute such blocks. Another proposal suggested preserving decentralization by finding off-chain solutions like the lightning network. As the discussion got more heated, a contentious hard fork resulted in a network split, giving birth to Bitcoin Cash in 2017.
[27] In the case of the Bitcoin network, for example, 3.06 percent of addresses (Bitcoin wallets) held 95.66 percent of the total supply by early 2020. In May 2016, from a total of 11,000 investors, the top 100 holders held over 46 percent of all TheDAO tokens. In cases where one’s voting power correlates with the number of tokens held, and in the light of such wealth inequalities within the network, using the term “decentralization” could be perceived as cynicism.
[28] Extremely unpleasant, frightening, and confusing bureaucratic nightmares similar to situations described in the novels of Franz Kafka. Source: https://dictionary.cambridge.org/dictionary/english/kafkaesque
References & Further Reading
This link leads you to a page that contains all the references to the source materials used for the research of the chapters and should also provide a reading list for those who are interested in a deeper dive into the topics presented in this chapter. Where possible, the links will be updated on a regular basis to prevent the issue of broken links.