DeFi World Has A New Star Called DAO – Technology
Originally published in Global Trade
Magazine on February 13, 2022. Reprinted with
permission.
As financial markets wrap up the year 2021 and launch into 2022
at warp speed, the “DeFi” world has a new star called the
“DAO”.
Decentralized finance, short-handed as “DeFi”, refers
to peer-to-peer finance enabled by Ethereum, Avalanche, Solana,
Cardano and other Layer-1 blockchain protocols, as distinguished
from centralized finance (“CeFi”) or traditional finance
(“TradFi”), in which buyers and sellers, payment
transmitters and receivers, rely upon trusted intermediaries such
as banks, brokers, custodians and clearing firms.DeFi app users
“self-custody” their assets in their wallets, where they
are protected by their private keys. By eliminating the need for
trusted intermediaries,DeFi apps dramatically increase the
speed and lower the cost of financial transactions. Because
open-source blockchain blocks are visible to all, DeFi also
enhances the transparency of transactions and resulting asset and
liability positions.
Although the proliferation of non-fungible tokens, or NFTs, may
have gathered more headlines in 2021, crypto assets have become a
legitimate, mainstream and extraordinarily profitable asset class
since they were invented a mere 11 years ago. The Ethereum
blockchain and its digitally native token, Ether, was the
wellspring for DeFi because Ether could be used as “gas”
to run Layer-2 apps built to run on top of Ethereum. Since then,
Avalanche, Solana and Cardano, among other proof-of-stake
protocols, have launched on mainnet, providing the gas and the
foundation for breathtaking app development which is limited only
by the creativity and industry of development teams.
Avalanche and its digitally native token AVAX exemplify this
phenomenon. Launched on mainnet a little more than a year ago,
Avalanche already hosts more than 50 fully-launched Layer-2 apps.
The AVAX token is secured by more than 1,000 validators. Recently,
the Avalanche Foundation raised $230 million in a private sale of
AVAX tokens for the purpose of supporting DeFi projects and other
enhancements of the fully functional Avalanche ecosystem. Coinbase,
which is a CeFi institution offering custodial services to its
customers, facilitates purchases and sales of the Avalanche,
Solana, Cardano and other Layer-1 blockchain tokens, as well as the
native tokens of DeFi exchanges such as Uniswap, Sushiswap, Maker
and Curve. So formidable is DeFi in its potential to dominate the
industry that Coinbase, when it went public in 2021, cited
competition from DeFi as one of the company’s primary risk
factors.
If DeFi were “a company,” like Coinbase, the market
capitalization of AVAX would be shareholder wealth. But DeFi is
code, not a company. Uniswap is a DeFi exchange that processed $52
billion in trading volume in September 2021 without the help of a
single employee. Small wonder that CeFi and TradFi exchanges are
concerned.
DeFi apps require “DAOs,” or Decentralized Autonomous
Organizations, to operate. DAOs manage DeFi apps through the
individual decisions made by decentralized validator nodes who own
or possess tokens sufficient in amount to approve blocks. Unlike
joint stock companies, corporations, limited partnerships and
limited liability companies, however, DAOs have no code (although,
ironically, they are creatures of code). In other words, there is
no “Model DAO Act” the way there is a “Model
Business Corporation Act.” DAOs are “teal
organizations” within the business organization scheme
theorized by Frederic Lalou in his 2014 book, “Reinventing
Organizations.” They are fundamentally unprecedented in
law.
Just as NFTs have been a game changer for creators, artists and
athletes, our legal system will need to evolve to account for the
creation of the DAOs that govern NFTs and other crypto assets.
(NFTs are a species of crypto asset.) Adapting our legal system to
account for DAOs represents the next wave of possibility for more
numerous and extensive community efforts.
A DAO is fundamentally communitarian in orientation. The group
of individuals is typically bound by a charter or bylaws encoded on
the blockchain, subject to amendments if, as and when approved by a
majority (or some other portion) of the validator nodes. Some DAOs
are governed less formally than that.
The vast majority of Blockchain networks and smart
contract-based apps are organized as DAOs. Blockchain networks can
use a variety of validation mechanisms. Smart contract apps
have governance protocols built into the code. These
governance protocols are hard-wired into the smart contracts like
the rails for payments to occur, fully automated, and at scale.
In a DAO, there is no centralized authority — no CEO, no
CFO, no Board of Directors, nor are there stockholders to obey or
serve. Instead, community members submit proposals to the group,
and each node can vote on each proposal. Those proposals supported
by the majority (or other prescribed portion) of the nodes are
adopted and enforced by the rules coded into the smart
contract. Smart contracts are therefore the foundation of a
DAO, laying out the rules and executing the agreed-upon
decisions.
There are numerous benefits to a DAO, including the fact that
they are autonomous, do not require leadership, provide objective
clarity and predictability, as everything is governed by the smart
contract. And again, any changes to this must be voted on by the
group, which rarely occurs in practice. DAOs also are very
transparent, with everything documented and allowing auditing of
voting, proposals and even the code. DAO participants have an
incentive to participate in the community so as to exert some
influence over decisions that will govern the success of the
project. In doing so, however, no node participating as part of a
decentralized community would be relying upon the managerial or
entrepreneurial efforts of others in the SEC v. Howey sense of that
expression. Neither would other nodes be relying upon the subject
node. Rather, all would be relying upon each other, with no one and
no organized group determining the outcome, assuming (as noted)
that the network is decentralized. Voting participants in DAOs do
need to own or possess voting nodes, if not tokens.
As with NFTs, there are limitless possibilities for DAOs.
We are seeing a rise in DAOs designed to make significant purchases
and to collect NFTs and other assets. For example, PleasrDAO,
organized over Twitter, recently purchased the only copy of the
Wu-Tang Clan’s album “Once Upon a Time in Shaolin”
for $4 million. This same group has also amassed a portfolio of
rare collectibles and assets such as the original “Doge”
meme NFT.
In addition to DAOs that are created as collective investment
groups, there are DAOs designed to support social and community
groups, as well as those that are established to manage open-source
blockchain projects.
As is true with any emerging technology, there is currently not
much regulation or oversight surrounding DAOs. This lack of
regulation does make a DAO much simpler to start than a more
traditional business model. But as they continue to gain in
popularity, there will need to be more law written about them.
The State of Wyoming, which was first to codify the rules for
limited liability companies, recently codified rules for DAOs
domiciled in that state. So a DAO can be organized as such under
the laws of the State of Wyoming. No other state enables this
yet.
Compare the explosion in digital assets to the creation of
securities markets a century ago. After the first world war
concluded in 1917, the modern securities markets began to
blossom. Investors pooled their money into sophisticated
entities called partnerships, trusts and corporations, and Wall
Street underwrote offerings of instruments called securities, some
representing equity ownership, others representing a principal
amount of debt plus interest. Through the “roaring
’20s,” securities markets exploded in popularity.
Exuberance became irrational. When Joe Kennedy’s shoeshine boy
told him that he had bought stocks on margin, Kennedy took that as
a “sell” signal and sold his vast portfolio of stocks,
reinvesting in real estate: he bought the Chicago Merchandise Mart
and was later appointed by FDR to chair the SEC. When the
stock market crashed, fingers were pointed. Eventually, a
comprehensive legislative and regulatory scheme was built, woven
between federal and state legislation and regulatory bodies.
Almost a hundred years later, securities markets have become the
backbone of our financial system, and investors and market
participants have built upon the certainty of well-designed
architecture to create financial stability and enable growth.
But the legislative paradigm designed in the 1930s was not
created with digital assets in mind. The world was all-analog then.
The currently disconnected and opaque regulatory environment
surrounding digital assets presents a challenge to sustained growth
in DeFi markets. Without “crypto legislation,”
government agencies have filled the void, making their own
determinations, and they are not well suited to do so. Just before
Thanksgiving, the federal banking agencies released a report to the
effect that they had been “sprinting” to catch up on
blockchain developments, that they are concerned by what they see,
and that next year they will start writing rules. Plainly,
technological development has outpaced Washington again.
Whether crypto assets should be characterized as securities,
commodities, money or simply as property is not clear in present
day America. Will entrepreneurs continue to create digital
assets and will investors buy them if their legal status is in
doubt? The SEC mantra is “come talk to us,” but the
crypto asset projects actually approved by the SEC are precious few
in number, and SEC approvals are not timely. We have clients that
have run out of runway while waiting for SEC approvals. In
decentralization as in desegregation, justice delayed is justice
denied. The recent experience of Coinbase in attempting to clear
its “Lend” service through the SEC, only to be threatened
with an SEC enforcement action (but no explanation), has caused
other industry participants to question the utility of approaching
officials whose doors might be open for polite conversation but
whose minds seem to be closed.
Similarly, DAOs are a path-breaking form of business
“organization” that are not well understood. They are not
corporations. Should they nevertheless file and pay taxes, open
bank accounts or sign legal agreements? If so, then who would have
the power or duty to do that for a decentralized autonomous
organization whose very existence decries the need for officers,
directors and shareholders? The globally significant Financial
Action Task Force, in its recent guidance on “virtual assets
and virtual asset service providers,” called on governments to
demand accountability from “creators, owners and
operators,” as it put it, “who maintain control or
sufficient influence” in DeFi arrangements, “even if
those arrangements seem decentralized.” Some observers have
characterized the FATFs guidance as an attempted “kill
shot” targeting the heart of DeFi.
This, too, we know: SEC Chair Gensler has his eye on DeFi. We
know that because he has said so, repeatedly. Trading and lending
platforms, stablecoins and DeFi are the priorities that he
mentions. SEC FinHUB released a “Framework” for crypto
analysis that includes more than 30 factors, none of which is
controlling. That framework is unworkable because it is too complex
and uncertain of application. Chair Gensler, however, apparently
applies what he calls the “duck” test: If it looks like a
security, it is one. With respect to Mr. Gensler, that simple
approach is no more useful than the late Justice Potter
Stewart’s definition of obscenity: “I know it when I see
it.” Less subjectivity and greater predictability in
application are essential so development teams and exchange
operators can plan to conduct business within legal boundaries.
What we need are a few workable principles or standards (emphasis
on “few” and “workable”) that define the
decentralization that is at the core of legitimate DeFi and the
consumer use of tokens that are not investment contracts. We also
need the SEC to adhere to Howey analysis, which it has told us to
follow slavishly, and not try to move the goalposts by misapplying
the Reves “note” case when it senses that Howey won’t
get it the result it craves.
Although futuristic DAOs are a decentralized break from the
centralized past and present of business organization, the SEC has
seen them before. Indeed it was the “DAO Report” issued
in 2017 that began SEC intervention in the crypto asset industry.
The DAO criticized in the DAO Report was unlike the DAOs seen today
for a variety of reasons, including these: that DAO was a
for-profit business that promised a return on investment, similar
to a dividend stream, to token holders; and the token holders
didn’t control the DAO. “Curators” controlled it, by
vetting and whitelisting projects to be developed for profit. DAO
participants necessarily relied on the original development team
and the “Curators” to build functionality into the
network. That sort of reliance on the managerial or entrepreneurial
efforts of others is absent in a latter-day DAO whose participants
can avail themselves of a fully functional network without reliance
on the developers and without delay. It is earnestly to be hoped
that the SEC will recognize these critical differences.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
