New York Department Of Financial Services Issues Guidance On Virtual Currency Custodial Services - Financial Services - United States

[Gunnar Larson]

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.
-------------- next part --------------
A non-text attachment was scrubbed...
Name: not available
Type: text/html
Size: 8009 bytes
Desc: not available
URL: <https://lists.cpunks.org/pipermail/cypherpunks/attachments/20230223/9b545098/attachment.txt>