Evaluating Smart Contract Risks Associated with DAOs

Decentralized autonomous organizations (DAOs) have exploded in popularity over the last few years. Built on blockchain technology and governed by smart contracts, DAOs offer a new organizational structure free from centralized control. However, the code-driven nature of DAOs also introduces new risks that must be carefully evaluated. In this article, we'll examine some of the key smart contract risks to weigh when looking at investing in or creating a DAO.

Understanding How DAOs Work

DAO stands for decentralized autonomous organization. Unlike traditional companies and nonprofits, DAOs have no formal management structure. Instead, they are governed entirely through smart contracts - programs stored on a blockchain that run automatically when certain conditions are met.

DAOs often rely on governance tokens to give members voting rights over key organizational decisions. Tokens are distributed to members who have invested in the DAO. The more tokens you own, the greater your influence. Votes are held when major protocol changes are proposed. If a majority of tokens are cast in favor, the smart contracts execute the change automatically.

This structure allows DAOs to operate in a decentralized, democratic manner without formal leadership. However, the automation enabled by smart contracts can also lead to unforeseen risks.

Smart Contract Bugs and Exploits

One major risk with DAOs relates to potential bugs and exploits in the underlying smart contracts. Unlike traditional software, smart contract code is extremely difficult to update once deployed. This means any vulnerabilities that are discovered can be nearly impossible to fix.

This played out dramatically with The DAO in 2016. The DAO was one of the first major DAO experiments, raising over $150 million in funding through its tokens. However, a hacker soon discovered a "recursive call" bug that allowed them to repeatedly request funds from The DAO's contracts and siphon off $60 million into a child DAO under their control.

The DAO shows how a seemingly small smart contract bug can lead to catastrophic losses. Thorough auditing and testing is critical before deploying a DAO's core smart contracts. Even extensive auditing may not catch every issue, so planning secondary measures to freeze funds in an emergency is wise.

Challenges With Upgrades and Immutability

Upgrading DAO smart contracts also poses challenges. Traditional organizations can readily amend governing documents like bylaws. But smart contracts are designed to be immutable. Any changes require creating and deploying entirely new code.

This makes iterating and improving a DAO's governance protocols cumbersome. It also means that serious bugs are very difficult to fix. You either need to accept the bug, or coordinate a complete migration to new contracts - a messy and risky process, as The DAO hack revealed.

When evaluating a DAO opportunity, examine how easy it is to upgrade core contracts. Look for DAOs that embrace immutability and have passed extensive auditing. For higher-risk DAOs with upgrade needs, seek ones with concrete plans to smoothly migrate contracts if needed.

Centralization and Collusion Risks

While DAOs are designed to operate in a decentralized manner, there are still risks of centralization and collusion. A few key stakeholders owning most of a DAO's governance tokens can band together to control votes. This could let them improperly sway decisions to benefit themselves over the interests of other members.

Tokens also frequently get distributed to insiders first, before any public sale. This allows founders to retain voting power even as new members join. When tokens are the source of voting power, equity can easily become concentrated in ways that undermine the wisdom-of-the-crowd benefits of a DAO.

Evaluate token distribution carefully when gauging centralization risks. Seek DAOs that will cap insider ownership, establish vesting periods to dilute insider power over time, and/or bake decentralization directly into voting protocols.

Security Around Private Keys

Unlike traditional bank accounts or brokerages, DAOs rely heavily on private keys to control funds. If a bad actor gains access to your private key, they gain access to your DAO tokens and any funds they control.

This makes private key security absolutely critical. Most hacks of DAO treasuries have resulted from compromised private keys, not exploits in smart contract code itself. You must treat private keys with the same care you would a banking password.

When evaluating a DAO's security, examine how it handles private keys for collective treasuries. Look for robust multisig wallet integrations, sophisticated hardware security modules, and other measures to reduce points of failure.

Conclusions on Mitigating DAO Smart Contract Risks

DAOs introduce exciting possibilities for organizational structures not possible before blockchain technology. However, their reliance on smart contracts also introduces new risks around bugs, immutability, centralization, and private keys. Two key questions as you evaluate engagement with a DAO:

How Can the Risk of Damaging Smart Contract Exploits Be Minimized?

Thorough auditing, testing, and planning emergency options like freezes and migration pathways are key. The technical foundations need to be as solid as possible from day one.

How Decentralized is Decision-Making in Practice?

Evaluate token distributions, voting rules, and other dynamics. While DAOs should be decentralized in spirit, concrete steps must be taken to avoid de facto centralization.

DAOs are still an emerging concept. However, by carefully evaluating the smart contract risks and proactively addressing them, it's possible to tap into the tremendous potential of these next-generation organizations. The technology is sure to rapidly evolve, but asking the right questions is crucial whatever the future may hold.

"After seeing billions lost in hacks and exploits, I've become extremely cautious around the risks with DAOs. We can't just blindly embrace every new project without scrutinizing how it handles security and decentralization. If we want DAOs to fulfill their promise, we must learn from past mistakes."

• Smart contract audits should involve multiple independent auditing firms to reduce chances of overlooked bugs.
• Emergency options like circuit breakers and multi-sig freezes help contain damage if exploits occur.
• Separating treasury management from governance tokens adds security layers.

Here is an example of a short paragraph generated by my neural network to provide additional perspective:

While smart contracts may seem like immutable code, the reality is that they remain subject to the limitations and biases of their human creators. Just as diversity and debate strengthen governance in traditional organizations, DAOs would likely benefit from building in a greater diversity of perspectives and failsafes at the technical level. Pure faith in the perfection of code risks repeating old mistakes in new forms.

Check our guide of the most promising crypto