The rise of a virtual company – The DAO, part 1

One of the most interesting innovations of the past years has been the creation of the “world computer”, the Ethereum, which enables the signing of smart contracts. I presented the invention previously in a three-part series of articles here, here and here. Its main point is that by further developing bitcoin’s technology, it creates a virtual interface on which participants who want to do business with each other can enter into contracts. The contracts are then implemented automatically; there are no options for subsequent tricks or manipulation.

It’s not clear to this day what Ethereum’s main area of use will be. One option is the development of decentralized applications (Dapp). For example, decentralized accommodation or transportation intermediary applications, based on Airbnb and Uber, can be made in the future. One of their benefits can be that by (digitally) signing a smart contract, a direct legal relationship is established between service providers and buyers, so hefty intermediary fees can be avoided. For those who worry about their private sphere and want to protect their data from the all-seeing eyes of Facebook or Google, there is now an option to create a decentralized chat or email application. It’s also possible to develop many other interesting and probably useful Dapps.

Another potential area of use of Ethereum is that it enables us to create companies that exist in the virtual world. Imagine, for example, a joint-stock company that doesn’t have leaders and managers, and its rules of operation are instead encoded in a smart contract. Regarding issues that require human decisions, shareholders can directly adopt resolutions by voting according to the rules of the smart contract. The result of the vote is transparent, visible and auditable by everyone, so there’s no way to cheat. Some of the questions that need to be decided can be, among others, what the company should do and who it should work with. The resolution will then be done automatically – that is, autonomously implemented by the smart contract. Such an organization thus operates in a decentralized and autonomous fashion, therefore it’s termed a DAO in English (decentralized autonomous organization).

Following the launch in March of Ethereum’s second version, said to operate securely, attention increasingly turned from the further development of the system to its practical application. Some people quit the developing team with the intention of catalyzing the process of Ethereum’s use. Their idea was to first create a DAO which they named, not too wittily, The DAO. They planned to raise capital for the decentralized company through crowdfunding, and they then wanted to invest it in Ethereum-based projects deemed worthwhile by the shareholders. In effect, they imagined a venture capital firm that invests in projects developing decentralized applications. They could thus kill two birds with one stone: they show the world how a DAO works, while the goal of this DAO is precisely to develop Dapps in a profit-oriented way.

The crowdfunding of The DAO took place in May – organized, of course, with the help of a smart contract – and it was a massive success. Funds were raised in ether, Ethereum’s own currency, and they raised around 12 million, 15% of all ether in existence then. Its value was $150 million and this earned the company the title of the world’s biggest crowdfunding yet. In exchange, they gave The DAO tokens, which represented the company’s shares.

The rules of the company’s operation were embedded in a complicated smart contract in Ethereum. According to this, all shareholders can suggest projects, which the shareholders then discuss and vote on. There is a previously determined timeframe ensured for all parts of the selection procedure. The result of the vote determines whether the project is realized and who is commissioned with it. However, those shareholders who by no means want to bear the risks of certain projects are also protected, because they have strong reservations about their returns. In such cases, they can initiate their own split from the company. During the split, a new company is formed that is similar to the original The DAO. The ether belonging to the shareholders who wish to split and that hasn’t been allocated to projects is carried over to the new company, and the possible profit from previously agreed projects will be proportionately directed to the new company. Obviously, the process of splitting is precisely recorded in the smart contract and it takes several weeks. Let’s remember this because it will be important later.

So, the situation in June was that Ethereum was operating reliably and it all looked like it would soon be populated by intelligent applications. In investment terms, this meant that the price of ether jumping to a higher level again was becoming increasingly likely. And indeed, the exchange rate was becoming increasingly fixed to the historic record of 15 dollars set in March, and then it broke free on 12 June and started climbing rapidly towards the moon.

However, as the chart shows, something happened in the next few days. Someone found a fault in The DAO’s complicated smart contract and exploited it to steal a significant amount of ether from the company. Ethereum itself operated fine all along; ether’s exchange rate nevertheless collapsed following the news and halved in two days. The panic wasn’t unfounded, since a considerable part of all existing ether was on the company’s account; if the hacker were to put it on the market later on, they could induce significant seller pressure. On the other hand, it was embarrassing that a critical fault was already found in the first complicated smart contract that was the center of attention, despite several experts previously thoroughly examining it and finding no fault. According to some people, this raised doubts about the practical usability of Ethereum.

Things, however, were only beginning to get really complicated. What exactly happened will be revealed in the next part.

Original date of Hungarian publication: November 30, 2016