On Jan. 23, 2023, the New York State Department of Financial
Services (“NYDFS”) issued guidance to entities licensed
under 23 NYCRR Part 200 (“BitLicensees”) and entities
chartered as New York limited purpose trust companies (together
with BitLicensees, “Virtual Currency Entities” or
“VCEs”), on custody and disclosure practices to protect
customers in the event of an insolvency or similar proceeding
(“Guidance”).1 The Guidance applies to VCEs
that act as custodians (“VCE Custodians”) and discusses
the standards the NYDFS expects VCE Custodians to adhere to with
respect to asset custody.2 The Guidance focuses on four
areas of customer protection, each of which is further discussed
below: (i) segregation of and separate accounting for customer
virtual currency; (ii) VCE Custodian’s limited interest in and
use of customer virtual currency; (iii) sub-custody arrangements;
and (iv) customer disclosure.
Segregation of and Separate Accounting for Customer Virtual
Currency
NYDFS expects VCE Custodians to separately account for and
segregate customer virtual currency from their own assets,
including from assets of their affiliates, both on-chain and on the
VCE Custodian’s internal ledger accounts. Customer virtual
currency must not be commingled with the VCE Custodian’s own
virtual currency. Such segregation and accounting should also be
fully disclosed to the customer as further discussed below.
Specifically, customer virtual currency3 should be
maintained in either (i) separate on-chain wallets and internal
ledger accounts for each customer under that customer’s name;
or (ii) in one or more omnibus on-chain wallets and internal ledger
accounts that contain only virtual currency of customers held under
the VCE Custodian’s name as agent or trustee for the benefit of
its customers. If customer virtual currency is held in one or more
omnibus accounts, the VCE Custodian must maintain appropriate
records and a clear internal audit trail to identify customer
virtual currency. VCE Custodians should have clearly documented
policies and procedures to evidence that these safeguards are in
place. VCE Custodians should also be prepared to reconcile their
books and records and on-chain activity upon the NYDFS’
request.
VCE Custodian’s Limited Interest in and Use of Customer
Virtual Currency
When customers transfer virtual currency to a VCE Custodian for
custody services, the NYDFS expects that the VCE Custodian will
only take possession for the limited purpose of carrying out
custody and safekeeping services. Particularly, the VCE Custodian
should not establish a debtor-creditor relationship with the
customer and use customer virtual currency for its own use,
including using customer virtual currency to secure or guarantee an
obligation of, or extend credit to, the VCE Custodian or any other
person. VCE Custodians are also expected to act upon the
instructions of their customers (or authorized representatives) and
not acquire general discretion over custodied assets beyond those
terms clearly expressed in the VCE Custodian’s agreement with
its customer.
Sub-Custody Arrangements
To the extent the VCE Custodian engages a sub-custodian for the
custody of its customers’ virtual currency, it may do so only
after appropriate due diligence and obtaining prior approval from
the NYDFS.4 As part of the request for approval, the
NYDFS expects the VCE Custodian to provide (i) the risk assessment
performed by the VCE Custodian with respect to the new
relationship; (ii) the proposed agreement(s) between the parties;
and (iii) the VCE Custodian’s updated policies and procedures
reflecting processes and controls to be implemented for the
proposed arrangement.
Customer Disclosure
VCE Custodians should clearly disclose to their customers in
writing the general terms and conditions associated with their
products, services and activities, as well as obtain acknowledgment
of receipt of such disclosures prior to entering into an initial
transaction with the customer. The customer agreement should also
clearly disclose (i) how the VCE Custodian segregates and accounts
for customer virtual currency; (ii) the property interest the
customer retains in custodied assets; (iii) how the VCE Custodian
may use virtual currency while in its possession; and (iv) what
limitations on the use of custodied virtual currency by the VCE
Custodian apply. If the VCE Custodian uses a sub-custody
arrangement, the customer agreement should clearly disclose the
terms of that arrangement and the material risks presented by such
arrangement. Further, the customer agreement and disclosures must
be readily accessible to customers on the VCE Custodian’s
website.
Conclusion
Given the current virtual currency market, including the recent
bankruptcies of cryptocurrency exchanges and platforms, the
Guidance indicates that the NYDFS is taking a strong stance to
ensure the protection of customer assets, particularly in the event
of an insolvency of a VCE Custodian. Currently regulated VCEs, or
those seeking to apply to become a VCE, should carefully review the
Guidance to ensure compliance.
Schulte Roth & Zabel’s lawyers are available to
assist you in addressing any questions you may have regarding these
developments. Please contact the Schulte Roth & Zabel lawyer
with whom you usually work, or any of the following
attorneys:
Donald J. Mosher – New York (+1
212.756.2187, donald.mosher@srz.com)
Betty Santangelo – New York (+1
212.756.2587, betty.santangelo@srz.com)
Melissa G.R. Goldstein – Washington, DC
(+1 202.729.7471, melissa.goldstein@srz.com)
Kara A. Kuchar – New York (+1
212.756.2734, kara.kuchar@srz.com)
Adam J. Barazani – New York (+1
212.756.2519, adam.barazani@srz.com)
Jessica Romano – New York (+1
212.756.2205, jessica.romano@srz.com)
Jessica Sklute – New York (+1
212.756.2180, jessica.sklute@srz.com)
Noah N. Gillespie – Washington, DC (+1
202.729.7483, noah.gillespie@srz.com)
Hadas A. Jacobi – New York (+1
212.756.2055, hadas.jacobi@srz.com)
Rebecca A. Raskind – New York (+1
212.756.2396, rebecca.raskind@srz.com)
Jesse Weissman – New York (+1
212.756.2460, jesse.weissman@srz.com)
Footnotes
1. Guidance on Custodial Structures for Customer
Protection in the Event of Insolvency, N.Y. Dep’t Fin.
Servs. (Jan. 2023), available at https://www.dfs.ny.gov/industry_guidance/industry_letters/il20230123_guidance_custodial_structures
2. Under 23 NYCRR Part 200, BitLicensees are required to,
among other things, hold virtual currency in a manner that protects
customer assets; maintain comprehensive books and records; properly
disclose the material terms and conditions associated with their
products and services, including custody services; and refrain from
making any false, misleading or deceptive representations or
omissions in their marketing materials. Analogous requirements on
New York State limited purpose trust companies that engage in
virtual currency business activity have been imposed by the NYDFS
pursuant to supervisory agreements or through its authority to
order the trust company to discontinue unsafe and unsound
practices. See, e.g., NY Banking Law §§ 10,
39.
3. The Guidance notes that to the extent a VCE funds
transaction costs (e.g., gas fees) on behalf of its
customers, the VCE should consider these funds as customer funds
subject to the Guidance.
4. The NYDFS notes in the Guidance that it views the
establishment of a new sub-custody arrangement as a material change
to the VCE Custodian’s business, which requires prior approval.
Applicants can seek the required approval during the de
novo license / charter application process, while currently
regulated VCE Custodians can submit requests as a material change
in business.
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.
