Decentralized Crypto Custody Explained

Julie Plavnik -

Custody has always been one of the core financial services tailored to protect clients from losing their assets or having them stolen.

As we know, crypto is a favorite target of hackers and other malicious actors. That’s why the proper custody here gets even increased importance. It is also a necessary prerequisite for institutional mass adoption in the space.

So far, we have several outstanding custody services in the crypto market. However, most of them have a centralized design that conflicts with the DeFi standard.

In this article, I will walk through the current state of crypto custody services and explain the concept of a decentralized custodian, which I believe will be a hot trend in crypto in the foreseeable future.

Somewhere in the article, I will use “deCustody” as a relevant shorthand. So don’t get confused by it.

Now let’s dive in and learn from each other.

Please, don’t be shy to leave your comments and correct me if I missed something.

The current state of crypto custody

Today, crypto custody is performed mainly by centralized organizations. These crypto custodians have many similarities with their traditional (non-crypto) counterparts. Like a regular custodian, a crypto one

  • is a trusted third-party that specializes in assets safe-keeping, and
  • must follow the applicable regulatory requirements unless it’s registered somewhere in a free-of-rules banana republic.

We thoroughly discussed centralized crypto custody in the recent custodial vs. non-custodial crypto trading article. It’s highly recommended to check out👌.

So far, we have a bunch of reputable centralized players on the crypto market: Fireblocks, Coinbase Custody, BitGo, and the like. They are trusted by institutions and have impressive client flows.

However, the relevance of the centralized custody model has been the subject of much debate within the crypto community. Here is why:

  • a centralized architecture is highly exposed to a single point of failure and doesn’t provide sufficient protection against hacker attacks;
  • in case of funds loss, it is difficult for customers to distinguish whether this loss was caused by a real hacker attack or that was internal fraud of a custodian;
  • the regulatory framework is still in its development and not strong enough to back up assets owners in cases when things go wrong; and
  • the centralized design doesn’t align with the crypto mission that, among other things, promotes disintermediated, trustless, and tamper-proof ways of interacting.

The listed above doesn’t mean that the centralized custodian model is entirely wrong at its core. This model can work pretty well for certain users, like institutions, who want the services in crypto to be similar to those offered by traditional markets.

On the other hand, crypto is an exceptional asset class. The technology behind it unlocks non-trivial ways to overcome the flaws of traditional solutions. So why not take advantage?!

In the context of custody, crypto allows to have multiple custodians at a time and also to subject their work to a tamper-proof algorithm. The main benefits of such design can be better safety of assets, the absence of a single point of failure problem, and the decreased risk of custodians’ malicious behavior.

This vision is what essentially constitutes the concept of a decentralized custodian.

What does decentralized custody mean?

Simply put, decentralized custody means that instead of having only one entity to store our crypto assets, we have a group of custodians, where each :

  • keeps custody of a particular fraction of assets portfolio
  • can move assets only if other custodians authorize it
  • shall act according to the rules established for the group members, and
  • has its skin in the game, as it provides collateral and may lose it in the case of its fraudulent actions.

Therefore, the concept of decentralized custody aims to replace the single-entity storage model with distributed (collective) assets’ safekeeping and management.

Doesn’t it remind you of DAO or multisig? If so, I’m with you.

How does a decentralized custodian work?

Now let’s move to the meaty part and see how decentralized custody works.

To simplify, we will assume that

  • our digital asset portfolio is homogenous, i.e., everything is in the same crypto (let it be ETH).
  • we have n custodians (let’s take 5), and
  • every custodian provides an equal amount of collateral which is denominated in the same currency as the portfolio.

Mapping (clusterization)

Next, we apply an asset mapping technique. In this context, mapping stands for clustering assets and custodians in several groups, where each group consists of a few custodians and fully controls a particular portion of all assets under custody.

By doing so, we distribute control among several players and therefore avoid a single point of failure that was discussed earlier.

Creating rules

Now we create the rules according to which our collective custodian will function. Among other things, the rules should cover:

  • how we authenticate custodians (there will always be custodians coming and leaving). For example, the authentication of each custodian group can require the consent of ⅔ group members (like ⅔ of votes), which can be obtained through voting or signatures collecting;
  • what would be the conditions precedent for moving assets (sorry for my legal jargon here);
  • what would be the protection against an assh… a malicious custodian,
  • what would be a custodian’s responsibility in case of fraud, etc.

Algorithmisation

The collective work of the custodians can be facilitated by self-executing tamper-resistant algorithms to exclude any malicious interference. The use of smart contracts apparently seems organic here.

A theoretical case study

Now I will refer to a tremendous scientific work on decentralized asset custodyand give a summary of the scheme proposed there:

  • Custodians are assigned to overlapping groups. Each group is fully controlled by its members and holds a fraction of the total assets under custody, including custodians’ collaterals and customer assets. The in-safekeeping assets are evenly distributed to custodian groups since an uneven distribution naturally leads to degradation of security and capital efficiency.
  • A custodian’s collateral exceeds X-time the fraction of assets in custody and will be confiscated for compensation in case of misbehavior.
  • The scheme should involve the mechanism of protection against a rational adversary — a bad actor that assumably would initiate an attack only if it would be economically beneficial. In other words, the adversary would try to corrupt other custodians to launch an attack only if its potential profit outweighs expenses.
  • The scheme should involve sufficient incentives to motivate the custodians involved to do their job in good faith.

I still can’t stop thinking of a DAO here…

What type of users is decentralized custody tailored for?

Custodian services are primarily wired for institutions that work with large amounts of funds. Herewith, in some particular cases, institutions are even required by law to store their holdings with a custodian.

A fair question here can be: why do I need a deCustody if I can store my funds with a non-custodial wallet?!

If you are not an institutional user, you may not need to. It all depends on how much money you operate and your ability to manage the private keys on your own.

Today custodian services are indeed more relevant to large-scale players.

However, I believe that there will be some retail-oriented custody solutions in the foreseeable future.

Examples of decentralized custodians

By the time of this writing, there are not so many decentralized custody solutions out there. So the field is not crowded and is yet to be developed.

Here is what we have so far

1. Decentralized custody in token wrapping

Some time ago, I wrote an article on wrapped tokens. There I mention that the token wrapping process generally involves a custodian that stores original tokens and “wraps” them in other tokens through a process known as minting.

Depending on the case, a custodian can be centralized or decentralized.

When decentralized, a custodian may be a smart contract, multisig wallet, or a DAO.

Examples of projects involving custodians in the wrapping process:

So two nuances here:

  • we have a specific case of decentralized custody as a part of the token wrapping process, and
  • it is far from being a financial service of institutional scale.

2. Decentralized crypto custody as a financial service

Here I don’t know any other players but Qredo. If you do, please share in the comment.

Qredo offers decentralized crypto custody for institutional investors. On the technology side, Qredo leverages Layer 2 technology and multi-party computation (MPC) model.

Basically, MPC stands for a cryptographic protocol that distributes computation across multiple parties where no individual party can see the other parties’ data. In other words, MPC enables to securely and privately compute on distributed data without ever exposing or moving it.

As Qredo states, decentralizing custody and securing it with MPC allows investors to trade crypto between different exchanges without constantly logging on or working through crypto’s complex back-end system. They can quickly place more complicated trades, allowing them to respond to shifts in the market.

Marriage of decentralized custody with Web3 multi-chain crypto trading

As a Web3 multi-chain trading ecosystem, Yellow Network sticks to the DeFi standard. It seeks to provide its users with the possibility to explore decentralized solutions at every step of their journey.

Yellow’s users may choose between centralized and decentralized custodians. If users are keen to explore deCustody, they can do it through Qredo — the Yellow’s strategic partner.

Final thoughts

If we want to reach a high DeFi standard in finance, we should apply the decentralization framework in a holistic manner. That means that to explore decentralization effects to the fullest, we have to extrapolate the DeFi standard not only on the core processes but also on their complementary parts. Otherwise, half-measures wouldn’t work here.

The concept of a decentralized custodian makes the DeFi standard more viable. It helps preserve all the benefits of decentralization and creates favorable conditions for large-scale players to step onto the crypto scene.

There will be a lot of experiments with decentralized custody design and improvements ahead. However, we are lucky to have a working model already now. Let’s keep an eye on how it pans out.

Something tells me that decentralized custody has a tremendous potential to stimulate the crypto market to grow exponentially.

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