Headline: MMMmmmmm… DAOnuts!!!!

Date: 11/18/2021

Body:  First of all, with apologies to Homer Simpson, “D’oh!!”  What the heck is a DAO?    Is it:

  1.   A stock index (following the Dow.)
  2.   A strain of Eastern Philosophy (E.g. Taoism)
  3.   An exclamation one employs when one hurts one’s self in a totally avoidable manner.

A DAO is none of these things.  DAO stands for decentralized Autonomous Organization.  It does sound kind of funny, but stay with me.  This type of financing came to my attention when looking at Twitter, and there was an announcement that a group of investors had just purchased an original edition of the Constitution.  In this case, a DAO had pooled virtual currencies from several different parties, to purchase the very real document.  

Think of this like an IPO.  When a company decides to “go public”, they issue stock and then find an investment bank.    That bank, in turn, finds a bunch of partners to purchase the stock, and this is called the underwriting syndicate.   The DAO is simply another kind of underwriting syndicate, and they use (likely Ethereum)  virtual currencies to buy assets, thus forming a decentralized group.   No one government or Bank is in charge.  Apparently, the concept for a DAO was invented all the way back in 2016 in an effort to eliminate human error or manipulation by placing decision power in the hands of the computer, using human-written rules.  (Come to think of it, the investment function seems to act like an index mutual fund.)  Although the initial DAO expected to be out of business at the end of 2021, there seems evidence to suggest that other DAOs are possible in the future.

So, what the problem is?

In a word, hackers.   In a few words, the DAO framework has some well-known baked in vulnerabilities, and in 2016, hackers gained control of the equivalent of $50 Million USD. 

The other problem is that of who regulates it.   It was found, in July 2017, that the DAO sold securities, so it was illegal under SEC regulations.  Under the Securities Act pf 1934, in order to sell securities, the issuing entity must go through registration, which is an onerous process.  (There are a few exceptions to this registration, but this is the general regulation.)  The SEC found that the DAO was offering securities, and did not qualify for an exception, so registration was mandated.  For the record, though, the report did suggest that future determinations would be based upon the facts and circumstances of each case.  They go on to suggest that they are intrigued by the possibilities:

The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us,” said SEC Chairman Jay Clayton. “We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.

So, it would appear that in this one case, the DAO was on the wrong side of regulation, but, with subtle tweaks, there might be a tenable position.   Instead of placing anybody in prison, the SEC is instead focusing upon education of investors to make an informed choice.

History does have a way of repeating itself…

Just last year, a DAO set their sights on buying 1 of the 2 remaining original copies of the Constitution (the other 11 are owned by museums and governments.)  With only $5.5 Million, they secured the prize.  Said one expert,   “I’ve found it increasingly fascinating to watch this Cambrian explosion of cool web projects over the last year. The opportunity to actually build one out was something unique,”   This was said by Graham Novai, one of the  organizers of the DAO that purchased the Constitution.  “The Constitution is incredible,” he says, bidding for it “is this once-in-a-lifetime thing.”  But, it gets even more interesting, and potentially darker.

We also saw the potentially darker side of DAO-style activities when we saw the activity within AMC and GameStop.  People have an understandably difficult time shedding a tear for billionaires trying to get even bigger by putting their money with hedge funds… and getting squeezed like an orange.  But, if one reflects for just a moment, what if that DAO decides to turn their investing firepower on the investments I have?  Then, your reaction might be a bit different.  In many ways, a DAO is a super-charged mix of the elements that have recently interwoven finance and the internet: A previously unknown group of young people are today able to raise millions of dollars overnight, a task that would’ve once fallen to pedigreed financiers embarking on a multi-week, if not multi-month, sales trip.

The check we have on this new system of finance running amuck is, frankly education.  Even within a hedge fund, there are some legal protection.  (e.g. if there is a Bankruptcy, etc.)  Within a DAO model, there is NO legal protection at all.  Ever heard of the Squid Games?  The hucksters floated a token called Squid, and it rose in valuation FAST!!  When it became manifest that it was not connected with the Netflix program, the hucksters disappeared overnight with $2.5 Million.  If we can educate our young investors just how volatile this area is, perhaps we can also teach them how to lower the temperature, and calm the volatility, a little bit.

But, that speed and instability seems to be the really important attribute of the DAO.   It is FAST!  The Constitution DAO was convened and organized mainly over Twitter and Discord, and within less than a week, had the $5.5 Million in financing from 11,000 people.  Interestingly, the organizers are not paid.  Often, after a successful project, members will choose to give the organizers a “tip.”  Despite this lack of assured compensation, the organizers are very motivated.  “Candidly, it’ll be fun to be bidding against those people,” says another Constitution DAO organizer, Brian Wagner, 30. As a day job, Wagner is cofounder of Roadtrip FM, a music streaming startup. “They’re billionaires—old collectors who just want to lock this stuff away and keep it to themselves. That’s why everyone wants to get involved with this because people can actually collectively own this and decide what to do with it.”  So, given this enthusiasm level, I think we are likely to see more of these in the future.

The Verdict

Do I think that the mighty corporation is the best, most optimal business structure?   Not always, and not at all times.   But, it does certainly seem central to our economy.   In a similar sense, the DAO organizations just seem inevitable, and powerful.     For this reason, we must come to understand them, and perhaps regulate their most egregious potentially damaging  attributes.   Perhaps there will be a Federal agency given the role to learn about these organizations and in turn, educate taxpayers.  Only if we are fully informed can we make good investment decisions, both individually and collectively.






Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

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