New York Department Of Financial Services Issues Guidance On Virtual Currency Custodial Services – Financial Services

In Short

The Situation: Following a string of
bankruptcies among virtual currency firms, the New York Department
of Financial Services has issued guidance on the practices and
procedures it expects from certain state-regulated entities
providing virtual currency custodial services.

The Result: These entities should review their
current arrangements regarding customer safeguards in the context
of the guidance, including how their customers’ assets are
segregated and whether they are treated solely as the property of
their customers, as well review their due diligence and disclosure
procedures with respect to customer assets under custody.

Looking Ahead: The guidance is designed to
clarify the relationship between a virtual currency custodian and
its customers to ensure the latter are better protected in the
event of bankruptcy, particularly in situations where ownership of
the virtual currency is at issue. New York has long been a first
mover in virtual currency, and this guidance may influence future
actions at the federal level.

New York Department of Financial Services Issues Guidance for
Virtual Currency Custodians

On January 23, 2023, the New York Department of Financial
Services (“NYDFS”) issued guidance to certain New
York-regulated virtual currency entities on proper disclosure and
custody practices. The Guidance on Custodial Structures for
Customer Protection in the Event of Insolvency (the “Guidance“) applies to entities that
provide virtual currency custodial services as either holders of
New York’s BitLicense or its Limited Purpose Trust Charter. The
Guidance sets forth NYDFS’s expectations for virtual currency
entities (“VCEs”) that provide custodial services
(“VCE Custodians”) on standards and procedures “to
better protect customers in the event of an insolvency or similar
proceeding … [by] providing a high level of customer protection
with respect to asset custody under the BitLicense.” Notably,
the Guidance is not a statute or a regulation with the force of
law.

The Guidance sets forth NYDFS’s expectations in four
areas:

• Segregation of and Separate Accounting for Customer
  Virtual Currency: NYDFS expects that VCE Custodians will
  hold the virtual currency of customers in either “separate
  on-chain wallets and internal ledger accounts for each
  customer” or omnibus wallets containing only customer virtual
  currency held by the VCE Custodians as agents or trustees. That is,
  VCE Custodians should not commingle proprietary digital assets with
  customer assets. If a VCE Custodian holds customer virtual currency
  in an omnibus wallet-comingling customer assets with other customer
  assets only-it must uphold appropriate recordkeeping and internal
  audit trail procedures such that it is able to promptly and
  accurately identify each customer’s beneficial interest.




• VCE Custodian’s Limited Interest in and Use of
  Customer Virtual Currency: The Guidance restricts a VCE
  Custodian’s interest in the assets under its control, directing
  VCE Custodians to “structure their custodial arrangements in a
  manner that preserves the customer’s equitable and beneficial
  interest in the customer’s virtual currency.” Further, the
  Guidance advises VCE Custodians to treat all customer assets under
  their control as solely the property of the customers, and to avoid
  handling customer assets as if they were the property of the VCE
  Custodians. NYDFS expects that customer assets will not be used to
  secure or guarantee an obligation of, or extend credit to, the VCE
  Custodian or others.




• Sub-Custody Arrangements: VCE Custodians may
  enter into sub-custody arrangements with third parties, provided
  that they conduct appropriate due diligence and obtain prior
  approval from NYDFS.




• Customer Disclosure: VCE Custodians must
  disclose their terms of service to customers, including their
  procedures for segregating customer assets, what property interest
  customers will retain, and how the VCE Custodians can use the
  virtual currencies they hold. VCE Custodians must also obtain
  customers’ acknowledgment of such terms. For VCE Custodians
  that offer digital asset staking and lending programs, more clarity
  may be needed on how these disclosure provisions interact, if at
  all, with NYDFS’s expectation that VCE Custodians will not make
  extensions of credit using customer assets.

Significance of the Guidance

NYDFS issued the Guidance subsequent to a string of bankruptcies
in the virtual currency space. Customer rights have been a central
issue in these recent bankruptcies, particularly in regards to
whether ownership of customer virtual currency held by a custodian
lies with the customer or with the custodian (and therefore the
bankruptcy estate). In such situations, one way that some VCE
Custodians have attempted to protect customer rights to their
assets is to include language in customer agreements permitting the
parties to “opt-in” to Article 8 of the Uniform
Commercial Code (the “UCC”), which, by electing to treat
the VCE Custodian as a “securities intermediary” and the
virtual currency as “financial assets” under the UCC, can
provide a customer with greater protections in the event of
bankruptcy. The Guidance, however, does not mention this option.
See UCC, Article 8, Sections 8-103, 8-303.

The question of how customer digital assets held by failed VCE
Custodians should be treated is still playing out in bankruptcy
courts, although a recent ruling in the Celsius Network
bankruptcy proceedings indicates that the answer hinges on the
nature of the custodial relationship. On January 4, 2023, the
Bankruptcy Court for the Southern District of New York ruled that
customer assets in certain Celsius accounts belonged to the
bankruptcy estate, not to Celsius customers, as the customers had
“entered a contract which contained unambiguous and clear
language regarding transfer of title and ownership of assets”
to Celsius. Celsius Network LLC, et al., Case No:
22-10964, Docket No. 1822, at 39 (Bankr. S.D.N.Y. 2023). The
Guidance could help to prevent similar future situations by
ensuring customers retain equitable and beneficial interest in the
virtual currencies stored with VCE Custodians, and by setting an
expectation of clear disclosures to customers regarding the
property interest maintained by customers in digital assets stored
with custodians.

Three Key Takeaways

1. NYDFS has taken notice of issues customers face when VCE
   Custodians file for bankruptcy and, as a result, has provided
   clarifying guidance to BitLicensees and New York limited purpose
   trust companies that provide custodial services for customer
   digital assets.




2. The Guidance lays out customer protections that NYDFS expects
   VCE Custodians to provide, including procedures for segregation of
   funds, a clear custodial relationship (as opposed to a
   debtor-creditor relationship), properly vetted and approved
   sub-custody arrangements, and appropriate disclosure
   practices.




3. If a VCE Custodian maintains procedures as outlined in the
   Guidance, customers may enjoy greater protections in the event of
   the custodian’s insolvency.

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