The Chromatic Demon is a tanar'ri demon imprisoned in Watcher's Keep. He was forced to help servants of Helm in securing the Imprisoned One in the Keep. To protect the Keep, the Helmites gave him a key to get to the third level whilst also trapping him inside a magical cage. First, four scepter keys would have to be collected to free the demon, and then the demon would have to be killed to get the key, hence guarding the level.
You will meet the Chromatic Demon on the second level of Watcher's Keep. He will give the offer of giving you the key to the next level in return for his freedom. You will have no choice but to accept. After gathering the four scepter keys, he will be freed and become hostile. When he is dead, you can collect the portal key from his body.