Building Web3 Internet of Finance
The distribution of custody between multiple crypto custodians who control each other’s actions and risk with their funds in case of misbehavior will help achieve higher security and eliminate fraud.
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.
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
We thoroughly discussed centralized crypto custody in the recent
However, the relevance of the centralized custody model has been the subject of much debate within the crypto community. Here is why:
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-proofalgorithm. 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.
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.
Now let’s move to the meaty part and see how decentralized custody works. To simplify, we will assume that:
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.
Now we create the rules according to which our collective custodian will function. Among other things, the rules should cover:
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.
Now I will refer to a tremendous scientific work on decentralized asset custody and 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
I still can’t stop thinking of a DAO here…
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.
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:
Some time ago, I wrote an article on
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:
Here I don’t know any other players but
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.
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.
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 enables to make 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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