Ether Explained – Chapter 4: The Decentralized Autonomous Organisaion (DAO)
Vontobel now offers investors access to the crypto currency «Ether». But what is Ether? And why has the second best-known crypto currency gained so much popularity in such a short time? In eight chapters, we want to give you high-quality knowledge about the exciting topic of «Ether».
It all started with «The DAO», a decentralized autonomous organization that collected over USD 150 million in Ether in a public crowdsale. The DAO wanted to revolutionize the financial system by allowing investors to invest decentrally in projects. However, in 2016, someone hacked The DAO. After the attack, eventful weeks followed that went down in crypto history as the «DAO Wars». We want to explain the reason for the DAO hacker attack, how the community dealt with it and its consequences.
Before the Hack: The Foundation of The DAO
The Decentralized Autonomous Organisation («The DAO») was implemented via a Smart Contract in the Ethereum blockchain. The DAO is a company with no management and no headquarters, created through a crowdfunding campaign. Investors use Ether to receive shares in the form of «DAO token» that provide them voting rights. In digital elections, they democratically decide in which companies and projects (DApps) the DAO should invest in. It’s basically a decentralized venture capital fund that should finance all future DApps.There are no bosses. Just the code. Consequently, The DAO inspires thousands. Through crowdfunding, it sold shares worth USD 150 million within 28 days after its foundation in May 2016 and was set up like a hedge fund. At that time, 14% of all Ether issued so far were invested in it. In comparison, the crowdfunding platform Kickstarter so far just collected USD 20 million. Before the crowdsale, Ethereum had a market capitalization of USD 500 million. In the weeks during the crowdsale, the market capitalization doubled to over USD 1 billion.
The way the DAO worked was quite simple: if you wanted to have a say in a DApp that is funded, you would have to buy DAO tokens for a certain amount of Ether. The DAO tokens were indicators that the investor is now part of the DAO system. The approval and creation of a DApp then works as follows: First, it must be added to the «white list» by the curators, who are important decision-makers. After receiving the approval, it is elected by the DAO token holders. If 20% of DAO token holders approve the proposal during the vote, the DApp receives the necessary funding to start operation.
But how can you leave the DAO? What if a DApp is approved that you are not convinced with? In order to make an exit possible, there is a so-called «split function», with which you can get back the Ether you have invested and even create your own «Child DAO». However, there was a condition in the contract that you had keep your Ether for 28 days after the spin-off from the DAO before you could spend it. Many saw this as a possible security issue. However, the DAO creators did not see any problems in it. Then the hacker attack followed which ended Ethereum's success story for the time being.
The DAO hack and the vote on the «hard fork»
On 17 June 2016, someone exploited this vulnerability in the DAO and cracked Ethereum's original code in a hacker attack. Ether worth USD 50 million were stolen from the blockchain. The thieves could never be identified. It must have been an insider who knew the programming language of the Ethereum blockchain very well. The attacker abused a function that was supposed to protect investors. Whoever rejects an investment of the DAO, for which the majority has decided, can deduct his shares. They then move into a sub-account, the «Child DAO». The hacker carried out this process constantly without the system noticing that he had already deducted his shares worth USD 50 million. For some it was theft and an attack on «The DAO». For the others, it was nothing more than simply executing a programming code. But the majority of the community panicked. However, there was another protective function: The system blocks a Child DAO for 28 days before someone can finally withdraw his shares and liquidate them. The deadline was 16 July 2016, so there was time to stop the hacker.
It is important to understand that the hack happened because of a problem in the DAO, not because of Ethereum itself. Ethereum runs in the background, while DAO runs on it. Gavin Wood, co-founder of Ethereum, commented: Blaming Ethereum for the DAO hack is like saying «The Internet is broken» every time a website breaks down. While Ethereum can’t be responsible for what happened to the DAO, the event has destroyed the beliefs people had in crypto currencies in general. The price for Ether fell from USD 20 to USD 13.
After extensive debates, discussions and hate speeches, they considered how to fix the bug in the blockchain and they set up a contingency plan. There was an open voting procedure for all eligible voters. Either you save the USD 150 million investment or you accept the losses. 90% of the voters voted to make a clear cut. The old blockchain was ended and a new one was created via a «hard fork». The new crypto platform now operates under the name Ethereum (ETH). The majority has thus decided to save the USD 150 million. But until an agreement was reached, there were heated debates about possible solutions:
After the DAO hack: Three possible solutions
Although the hacker stole USD 50 million worth of Ether, they were still in the Child DAO. The attacker couldn't access it yet, because the DAO smart contract explicitly made it clear that any of the invested Ether taken from the DAO would be inaccessible for 28 days. So, the Ethereum community had time to evaluate three possible solutions:
2. Soft Fork
3. Hard Fork
1. Nobody does anything
Some Ethereum followers argued that any changes would violate the nature and underlying philosophy of Ethereum itself. The Ethereum blockchain is supposed to be unchangeable and the code is law. Many people were not satisfied with it, but the majority initially voted to use a so-called «soft fork».
2. Soft Fork
A soft fork can be imagined as an update of a software that is downward compatible. For example, you are running MS Excel 2005 and want to open a spreadsheet created in MS Excel 2016. You can still open it because MS Excel 2016 is downward compatible. But all updates that you can enjoy in the newer version are not available in the older version. That's what Ethereum had in mind with its blockchain: a soft fork where you can choose whether to update or not. The idea was to completely block the Ether that had been stolen by the hacker by ignoring and eliminating all blocks containing a transaction that would help the hacker to finally confiscate the stolen Ether.
The majority was in favor, but then a problem arose that put the community in a different dilemma: implementing a soft fork would lead to a «denial of service» (DoS). All mining activities carried out through complex calculations are rewarded in the Ethereum ecosystem. The more time-consuming and difficult the calculation, the higher the reward. Miners are thus protected from DoS attacks. If someone decides to attack the network, they flood it with transactions that interact with the DAO and require difficult calculations. The attacker can have the miners perform endlessly complex calculations for little or no reward. As a result, there was only one solution: the hard fork.
3. Hard Fork
The main difference between a soft fork and a hard fork is that it is not downward compatible. Once it is used, there is no turning back. If you don't join the updated version of the blockchain, you won't get access to the new updates. A hard fork separates a branch from the main blockchain at a certain point (in this case just before the DAO attack). Up to this point (block 1,920,000), the old chain and the new chain are the same, but immediately after the hard fork, the two chains become completely different units. The new chain was called «Ethereum» or «ETH». This hard fork was mainly done to refund all the investors through a refund smart contract. All DAO investors were able to exchange their DAO tokens at a fixed price and received 1 ETH per 100 DAO tokens. All they had to do was to update their software.
The Ethereum users, who felt that a rescue was not necessary, simply refrained from upgrading their software for hard forking. In this way, these miners have created a blockchain without "The DAO Implementation" and thus created two separate blockchains.
Conclusion: The formation of two crypto currencies
This hard fork caused a big controversy in the community. The people who were «anti-hard fork» refused to switch to the new blockchain. They decided to stay in the old blockchain and called it «Ethereum Classic» or «ETC». And here we come to the battle raging in the Ethereum community: the battle between ETC and ETH. In the next chapter you will learn the exact differences between these two crypto currencies.
This information is neither an investment advice nor an investment or investment strategy recommendation, but advertisement. The complete information on the securities, in particular the structure and risks associated with an investment, are described in the base prospectus, together with any supplements, as well as the final terms. The base prospectus and final terms constitute the sole binding sales documents for the securities. It is recommended that potential investors read these documents before making any investment decision in order to fully understand the potential risks and rewards of deciding to invest in the securities. The documents and the key information document are published on the website of the issuer on prospectus.vontobel.com and are available from the issuer free of charge. The approval of the prospectus should not be understood as an endorsement of the securities. The securities are products that are not simple and may be difficult to understand. This information contains an indication of past performance. Past performance is not a reliable indicator of future results.
This document and the information contained in it may only be distributed or published in countries where such distribution or publication is permitted by applicable law. As stated in the relevant base prospectus, the distribution of the securities mentioned in this information is subject to restrictions in certain jurisdictions. This advertisement may not be reproduced or redistributed without Vontobel’s permission.