Good, Bad, and Ugly of Decentralized Governance

DAO governance has been a prominent topic of discussion after Yield Guild Games & Merit circle were recently caught in governance strife. The two eminent names in the play-to-earn industry found it hard to set foot in an agreement after a member of Merit Circle DAO proposed to remove Yield Guild Games (YGG) as an investor. With the emergence of DAOs and governance frameworks to enable trustless decision-making, maybe we should take a step back, understand the evolution of governance, and contemplate the need for more experiments that help us improve the existing DAO governance structures. 

Background

As play-to-earn (P2E) crypto gaming caught fire last year after Axie Infinity’s sudden popularity surge(June 2021), guild organizations gained prominence by supporting “scholars” with NFT assets and investing in up-and-coming games and startups.

Play-to-earn rocketed in the next few months, leading to a 2000% increase in Blockchain-based game playing within a year from Q1 2021(1). And at the center of this revolutionary phenomenon were guilds. For those unfamiliar with this term, crypto gaming guilds are organizations that consist of investors, gamers, and managers. They act as facilitating intermediaries by purchasing in-game assets as NFTs and lending them out to thousands of players to play and earn yields. These gaming guilds not only support ‘scholars’ with NFT assets but also invest in up-and-coming games and startups(Why would anyone want to miss out when in Q1 2022 alone, 128 blockchain-based gaming companies received a whopping US$ 1.2bn in funding)

With the advent of blockchain gaming and guilds, we saw multiple gaming guilds pop up across the world like Yield Guild Games(YGG), Merit Circle, Good Games Guild, Railings University(RU), GuildFi, Blackpool, Indigo, SnackClub, and many more. Amongst them, YGG & Merit Circle have managed to hold the top positions both in terms of the number of scholars and their token FDVs (Merit Circle & YGG have an FDV of US$ 725mn & US$405mn, respectively, as of June 16, 2022). 

The YGG vs MC saga

On October 7th, 2021, Merit Circle announced their Seed round of US$ 4.5mn raised from multiple investors, including YGG. And thus the story began.. 

YGG invested a total of US$ 175k in the seed round to support Merit Circle and help propel the guild landscape and get MC Tokens at a discounted rate. On May 20, 2022, when the MC token was trading at about US$ 1.04 (6000% from  YGG’s initial investment price), a member of the Merit Circle DAO going by the name HoneyBarrel issued a proposal (MPI-13) asking the community to vote on refunding Yield Guild’s original investment, canceling the Simple Agreement for Future Tokens (SAFT) between the DAOs, and removing YGG’s share of MC tokens. 

Why? The DAO member believed that YGG did not provide enough support to Merit Circle. The 2,000-word post on the Merit Circle DAO forum communicated that the Merit Circle team had made it clear to the community and DAO that the seed investors were selected based on the value they could bring to the guild. HoneyBarrel, in the post, provided links to posts on contributions from Maven-11 Fund, Mechanism Capital & DeFiance Capital. It then went on to list down the contributions of YGG (website articles, social media posts, and retweets) and stated that these were not enough to constitute as “value”. In addition, it also pointed out a reply from a discord mod in YGG’s server stating Merit Circle as one of the top competitors to YGG. 

The improvement proposal passed on May 28, but the passing of MIP-13 may not have honored a legal agreement(simple agreement for future tokens (SAFT)) between Merit Circle and YGG, which would see YGG receive tokens in return for its financial contribution toward Merit Circle. Merit Circle Limited wrote that canceling the seed funding agreement “could have serious adverse effects” on the DAO’s reputation but that it also wants to cede to community-led governance. “As an ltd, we would like to honor all agreements, however, we have to balance that with the power of the DAO,”(2) they wrote. 

“The DAO holds the ultimate power here.”

YGG issued a statement that its agreement with Merit Circle did not include any stipulations regarding “‘value-add’ services,” only the “investment of capital.” YGG also responded to MIP-13, saying that it wasn’t clear what legal authority the DAO has to nullify a contract Merit Circle Ltd signed on its behalf and that no condition existed for Merit Circle to cancel the contract “regardless of how this has been presented by them to the community.” To respect Legal obligations and stay true to its community-led governance, Merit Circle agreed upon a counterproposal with YGG to honor the legal agreement. It was posted and unanimously passed on June 9, and the DAO bought out YGG’s fund allocation at $0.32/token giving a 1000% to YGG on their initial investment. Both YGG & MC stated that they recognized the “danger a precedent like this could set for the Merit Circle DAO and the industry as a whole if agreements are not upheld and investors are not respected.”

There has been ambient anxiety among venture capitalists. “If a DAO successfully reneges on a SAFT, it will embolden other DAOs to do the same, resulting in greater levels of politics and a chilling effect on future investments into DAOs,” crypto fund Galois Capital tweeted.

(..story ends)

But let’s look at a few more details and discuss the need for better legal structures around DAOs and the need for a more informed governance structure. 

DAOs and Legal uncertainties

DAOs have become increasingly eminent by investing in companies and employing people, but some vitally important questions still don’t have clear answers. 

  • What if someone wants to sue a DAO? 
  • Which nation is the DAO domiciled in? 
  • Are DAO members individually responsible for a DAO’s liabilities (A lot of members are just known from their anonymous wallet addresses)? 
  • Can DAOs enter into legally binding contracts with other DAOs or organizations?

 In this particular case, as Tim Connor mentions in his tweet, ‘The investor agreement transferred authority of the tokens to the DAO, so “Merit Circle LTD” was apparently not legally on the hook. ‘ We are still unsure how the legal liabilities of Merit Circle Ltd are impacted with such a transfer of authority on the assets. 

Some lawyers think there ‘is a risk that a DAO could be considered a general partnership or unincorporated association,” which “might expose its members to personal liability for any of the DAO’s actions and obligations and discourage businesses, institutional investors, or other vulnerable or regulated entities from participating in DAOs.’

To get around this problem, some DAOs have adopted an “LLC Wrapper.” A limited liability company (LLC) is a business structure that protects its owners from personal responsibility for its debts or liabilities. But not all DAOs adopt this structure. The cited worry is that forming an LLC takes away the decentralization that is a key element of a DAO. And uncertainty can remain, which can hinder innovation. But lawmakers from several countries have tried to fill the gap. Last year, Wyoming enacted a statute allowing a new legal entity—a DAO LLC—to be formed. Tennessee passed a similar law recently in an effort to make “Tennessee the Delaware of DAOs.”

And Vermont earlier had enacted a law that, while not specific to DAOs, allows the creation and registration of a blockchain-based limited liability company, a “BBLLC.”(4)

It is evident that it’s still quite early in the legal lifecycle of DAOs. The structures, uses, and functions of DAOs may change in ways we have not thought about yet. 

Had the original MIP-13 been enacted, it would have very certainly resulted in legal action. Both parties(MC & YGG) acknowledged the danger a precedent like this could set for the Merit Circle DAO and the industry as a whole if legal agreements are not upheld and investors are not respected.

While the legality might likely be debated, the organizations added, all sides felt it was wiser to compromise. This saved both parties money and time by avoiding a costly and time-consuming legal process with unknown outcomes. 

The need for a better Governance system

The growth of DAOs and the massive success of some of them has inevitably resulted in the perception that the path to development and vigorous network participation requires a DAO structure. But DAOs would work best when: cost(involving DAO members in EVERY decision that is made) < burden (curation, security & risk.) 

Governance today has significant coordination costs, surfacing from the desire to have network participants involved in voting on every decision made. But is this the best way to do it? DAO governance as of today is not decentralized (contrary to our innocent assumptions that it is).

Numbers time! 

Emre Caliskan, an engineer at Electric Capital shared a tweet highlighting some insights from his analysis of Snapshot labs’ data. Few takeaways-

  • 65% of all proposals are from just 10% of the DAOs (FYI there are more than 6000+ DAOs)
  • 60% of these DAOs have had voting on 3 or fewer proposals
  • 50% of the users have just voted once
  • 75% of users have voted for just 1 DAO (few DAOs do average more than 10 votes/member though-> 10 of the 6000+)
  • The top 5 users have 2000+ votes in a single DAO
  • On calculating the Gini coefficient (1= very centralized | 0= very decentralized), he found out that 25% of all proposals have a Gini coefficient greater than 0.8 (Not so decentralized, huh?)
  • The avg Gini coefficient has improved from 0.81 to 0.61 in the past 2 years though

Analyzing the above numbers we see that the vision for decentralized governance is far from achieved. But are we even approaching this in the right way or do we need to take a step back and think about governance from first principles?

Learning from the past

Humanity is on the acumination of another great transformation. We need to learn by taking a look at the path we took to reach here.

How did people get from a condition of early humans roaming in the ancient grasslands to building architectural novelties like the Burj, Taj Mahal, or the Warisan Merdeka? Beyond engineering supremacy and technological advancements, there were a few invisible forces driving the growth of mankind and its supremacy. Sitting at the core of this transformation was the evolution of governance &if we can begin to see the historic patterns in coordination of these communities, we could find clues to hint us at where we’re going.

Underscoring the idea further, Future.com mentions in their article on the importance of Governance is DAOs –

“Coordinated efforts to form decentralized internet institutions that own assets are sometimes viewed as a “wild west” of uncharted territory. But many of the problems and solutions found in traditional systems — where humans also coordinate — can inform and guide DAOs; they’ve been pressure-tested for centuries and can be adapted for this new world. In many ways, learning both from the past, and the recent history of DAOs may help new builders find and adapt ideas for the future of online institutions.”

Let’s look at the 6 stages in the evolution of mankind and governance –

  • Clans – Living in small groups (families) often part of extended clans
  • Kingdoms – As agriculture became a part of lives, people settled and started aggregating resources. With the need to protect these resources against barbarians, the era of Kingdoms and leaders emerged
  • Empires – Dominant Kingdoms went on to conquest and expand into new territories. The system became complex and a hierarchy of governors was needed to manage these empires
  • Democracies – Some 3000 years ago, a more participatory system emerged in which power was given to people in the form of votes. This led to the rise of demagoguery where things were done to seek the support of the majority by appeasing them, rather than using rational thought. 
  • Republics – With the expansion of civilizations more power had to be delegated and political power became submissive to laws.
  • Constitutional Republics –  Combining the features of democracy with those of republics, states emerged where the chief executive and representatives were elected, and the rules were set down in a written constitution.

We are broadly into the late phase of stage six. But what’s next?

Concepts like startup nations, cloud governance and the revolution of rules without rulers are starting to develop with the idea of building more inclusive, flexible & self-organized societies; but we are far away to test these systems and see how society demands and adapts to them. 

But let’s look at the journey of a DAO on the evolution timeline:

  •  Most DAOs start as clans – A small group of people who decide to work on an idea to build a community or a product. 
  • The group expands as the community grows into its own small kingdom where DAOs start aggregating assets (treasuries) and some self-motivated leaders emerge who start overlooking various aspects of the organization. 
  • Some DAOs go on to become large enough to be called empires as they collaborate (the beauty of web3.0 is more collaboration than conquest), and people start taking on more responsibilities within the DAO. Leaders, functional heads, mods, treasury managers, etc emerge from within the DAO, and the hierarchical complexity increases. 

While DAOs try to avoid hierarchy to adhere to the ethos of ‘no-one-rules’, we are yet to see truly decentralized DAOs. But, in an effort to stick to this ethos, DAOs introduce the governance system. Democracy! 

DAO members are allowed to put up proposals for any change in tech, product, and community activity as well as how the DAO treasury should be spent and managed. But is ‘allowing everyone to vote on every decision the right approach? Probably not and that is the reason governance for our civilization evolved to a more republic constitutional system. 

Imagine for every financial decision a country or state’s finance ministry takes, each citizen had to vote for it to be executed? Is it right for us to expect each citizen to have the knowledge on each matter be it legal, political, financial, or developmental? 

Probably not. 

That is the reason a republic constitutional system has emerged to shape our societies and enable better governance. Is it the perfect model? 

Probably not again.

The traditional governance system comes with its own challenges primarily emerging from the lack of transparency and audit. But we have a solution to solve exactly this problem, remember? 

Blockchain based governance systems address the problems that exist by bringing transparency and accountability for each decision that is taken. But today, we use blockchain governance like the early stages of democracy, where we expect each proposal to be voted on by all DAO members. Apart from the coordination challenges we discussed above, this system fails to address the fact that – 

  • Not everyone is a subject matter expert for everything
  • DAO members don’t have the time to read, understand and vote on all proposals put up by multiple DAOs they would be a part of

Let’s briefly go back to the YGG & MC problem and evaluate how the proposal was voted upon – 

  • Just 122 out of 6500+ MC token holders participated in the voting
  • Very few DAO members like these with the username BambinoValue and Neisigreen went beyond the popular sentiment of the proposal to touch upon the legal issue or propose a mutually agreeable solution
  • The top voters were probably the whales and/or team wallets who skewed the voting sentiment and decision

DAO Governance as of today is still centralized because the majority of token holders are either team or investors and they skew the decisions by their voting powers, simply by the number of tokens they hold. We saw in the data from Emri’s tweet above that the Gini coefficient of more than 25% of proposals is as high as 0.8 (very centralized) and the top 5 voters have more than 2000+ votes in a DAO. Does this hint at something? The emergence of Governors!

We need to establish a system of people who take the responsibility for governing these massive DAOs and treasuries. Just like elections in our national democracies, anyone should be allowed to stand in the DAO governance elections and ask token holders to delegate their voting rights to them. To be eligible and receive the delegated voting power, the representatives need to share their past work, and experience and define an agenda (mission statement) on why the community should trust them with their vote. Once these governors are elected, the DAOs can establish internal checks, write down a set of rules (constitution), and develop a governance system that allows the token holders to have a proper check on the actions of these governors. If a decision is being viciously enacted by the governors, the community members should have an option to collectively oppose the decision. The work and contribution along with the governors’ voting history should be checked by the DAO members at regular intervals and there need to be mechanisms to allow token holders to start a notion for the impeachment of any governor as and when required. Trying to mimic the republican constitution system with added transparency enabled by blockchain could be our first step towards democratizing the current DAO governance system and forming the base for evolution into a much more comprehensive, complex yet self-sustaining system in the future. 

In the coming days, I’d like to share some more thoughts on how the sub-dao structure could fit well with the above-proposed governance structure and how by following a pod model like Orca, one could not only have a better alignment of tasks and responsibility but also a better governance structure.

Till then, vote responsibly and if you feel you can’t, delegate it to the right person!

Author – Jaskirat Singh, Product and Ecosystem at Woodstock Fund.

References

  1. https://finance.yahoo.com/news/blockchain-gaming-usage-explodes-2-133247799.html
  2. https://decrypt.co/101450/ethereum-gaming-daos-yield-guild-merit-circle-dispute
  3. https://future.com/building-and-running-a-dao-why-governance-matters/
  4. https://www.heritage.org/government-regulation/commentary/the-legal-status-decentralized-autonomous-organizations-do-daos

Disclaimer: All the views in the article are of the author, and the fund does not endorse any such views. Every financial product, asset class, or investment has risk. A cryptocurrency (also known as digital tokens, digital coins, or crypto(s)) is no different. That is why it is important for users and limited liability partners to be aware of the potential risks present in cryptocurrency and blockchain projects. You should not invest funds in the cryptocurrency market that you are not prepared to completely lose, i.e., only allocate risk capital to digital tokens. Furthermore, we will not accept liability for any loss or damage that may arise directly or indirectly from any such investments.

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