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

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.

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.

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

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.