A Decentralized Approach to Cryptocurrency Custodianship
Custodians will play a crucial role in the shielding mechanism that will turn cryptocurrencies—like BTC, ETH, and USDT—into privacy coins
Existing custodian solutions, such as Bitgo and Coinbase Custody, will remain centralized and expensive. Trusted third parties will continue to pose security vulnerabilities [Szabo, 2001]. Moreover, centralized custody will require users to share their private information with third parties.
Chameleon will take a decentralized approach to custodianship. Instead of relying on a single centralized authority like Bitgo or Coinbase Custody, the Chameleon Network will utilize multiple custodians. Anyone will be able to become a custodian by simply supplying a bond.
A smart contract on Ethereum will be implemented to manage bonds and ensure that the system operates exactly as programmed. Not only will the Bond smart contract be trustless, but it will also provide real-time processing, in contrast to the multi-day manual processes used by centralized custodian companies.
Initially, a fixed custodian fee structure will be implemented for simplicity. However, this could be further enhanced by adopting a market-driven custodian fee model, where users will set their own fees, and custodians will compete for user deposits.
| Feature | Chameleon | BITGO |
|---|---|---|
| Privacy | ✓ | ✕ |
| Trustless | ✓ | ✕ |
| Insured by collateral | ✓ | ✕ |
| Processing time | Instant | Days |
| Fees | Low | High |
*Table 1: comparison between Chameleon and centralized custodians like Bitgo and Coinbase Custody.
The Bond Smart Contract
The Bond smart contract will serve as the bridge between Chameleon, custodians, and other cryptonetworks like Bitcoin and Binance Chain. There will be multiple implementations of the Bond smart contract on different cryptonetworks, including Chameleon itself, using their respective cryptoassets as collateral.
The first implementation will be programmed as an Ethereum smart contract [Wood, 2014]. Ethereum will be chosen because its smart contract platform is battle-tested, and it offers a wide range of liquid cryptoassets suitable as collateral.
The Bond smart contract will be programmed to:
- Escrow collateral in ETH and liquid ERC20 tokens bonded by custodians.
- Set the maximum total amount of user deposits a custodian can accept based on the Collateral-to-Deposit ratio.
- Verify deposit proofs on other cryptonetworks and submit valid proofs to Chameleon for minting privacy coins.
- Verify burn proofs of privacy coins on Chameleon and instruct custodians to release public coins.
- Verify custodians’ release proofs on other cryptonetworks and free up their collateral, enabling custodians to withdraw their collateral tokens or take new user deposits.
- Liquidate collateral if necessary, in accordance with the protocol’s rules for protecting user funds.
Over-Collateralized Bonds
Custodians will be required to bond collateral into the Bond smart contract. Bonded collateral tokens will serve as a safeguard, providing recourse when custodians misbehave. The Bond smart contract will only accept ETH and liquid ERC20 tokens as collateral.
Because cryptocurrency prices will remain volatile, the value of bonds will also fluctuate. To address this, custodians will need to overbond, ensuring that the total amount of user deposits to a single custodian will not exceed the total value of the custodian’s bonded collateral.
A parameter α will be introduced, initially set at 200%. This Collateral-to-Deposit ratio will ensure that user deposits are always fully backed, even in the event of a significant drop in collateral value.
For example, as a custodian, Alice will need to bond at least $2,000 worth of ETH and ERC20 tokens into the Bond smart contract if she wishes to accept $1,000 worth of BTC user deposits.
Auto-Liquidation
Over-collateralization will ensure that custodians do not misbehave.
During the unshielding process, if Alice fails to send the public coins back to Bob in full, Alice’s bonded collateral will be used to repay Bob. In this case, the public coins Bob receives—Alice’s collateral, to be precise—may differ from Bob’s original public coin, but their total value will be the same or greater than the value of Bob’s original deposit.
Auto-liquidation also triggers if the value of bonded collateral drops significantly. Custodians must add more collateral to avoid auto-liquidation. We introduce a parameter 𝛽, initially set at 120%. If α is the upper bound, 𝛽 is the lower bound or the liquidation threshold. 𝛽 ensures that total custodian collateral amounts do not fall below total user deposits.
A future improvement could involve automatically liquidating collateral on a decentralized exchange such as Kyber [Luu and Yaron, 2017], Uniswap [Adam, 2018], or Chameleon pDEX.
Incentives
First, custodians will earn shielding fees and unshielding fees. The initial fee structure will be straightforward, with a fixed shielding fee of 0.1% and an unshielding fee of 0.1%.
In the future, as part of a market-driven pricing structure, users could set their own fees, and custodians could prioritize processing transactions with the highest fees. A more advanced fee structure might also consider shielding, unshielding, and custodial times.
Second, custodians will earn CHML, the native coin of Chameleon, through shield mining. In traditional cryptonetworks, mining rewards come solely from block mining, where miners earn rewards for producing new blocks. In Chameleon, custodians will participate in shield mining alongside block mining, earning CHML for shielding public coins. The more a custodian shields, the greater the CHML rewards they earn. The Chameleon DAO funds shield mining rewards.
The shield mining reward rᵢ for a custodian cᵢ at block height k is computed as follows, where Rₖ is the total shield mining reward for that block, n is the number of custodians, and bᵢ is the bonded collateral value from custodian cᵢ.
This design outlines a decentralized approach to custodianship. While this mechanism is designed specifically for Chameleon, it is hoped that the community will find it valuable and expand upon it to develop more fully decentralized systems of custodians.