On January 23, 2023, the New York Department of Financial Services (NYDFS) published a short but important notice to virtual currency asset custodians containing guidance on custodial structures in order to protect customers in the event of a custodial insolvency (the Guidance). In custodial arrangements, both equitable and beneficial interests should always remain with the customer and not with the custodian or exchange.
Who is subject to the Guidance?
Virtual Currency Entities (VCEs) that act as custodians are subject to the Guidance. VCEs are defined as entities that conduct “virtual currency business” with at least one New York resident or otherwise involve New York. A virtual currency business includes any of the following: receiving or transmitting virtual currency; storing or custodying virtual currency on behalf of others; performing exchange services for customers; or controlling, administering or issuing a virtual currency. Custody services include storing, holding, or maintaining custody or control of virtual currency on behalf of third parties.
Does the Guidance change the regulations?
Title 23, Chapter 1, Part 200, Rule 200.9 already requires that custodial VCEs do three things: (i) maintain an adequate bond or trust account; (ii) hold virtual currency of the same type and amount as owed to customers; and (iii) not lend or sell virtual currency unless directed by the customer.
What does the Guidance indicate about segregation?
The Guidance provides that a custodial VCE should separately account for, and segregate customer virtual currency from, its own virtual currency in either separate customer-by-customer wallets or internal ledger accounts or in omnibus accounts. Omnibus means that one customer’s virtual currency may be comingled in an account with another customer’s virtual currency. The custodial VCE also is required to have detailed and thorough policies and procedures regarding segregation. This does raise the question of whether a custodial VCE can contribute its own “excess” virtual currency into the customer comingled account in order to bolster customer protection.
How can a custodial VCE use your virtual currency?
Only for the limited purpose of safekeeping and custody so as to avoid a debtor-creditor relationship. Customers’ virtual currency should not be sold, lent, or pledged to secure a loan to the custodial VCE or any other entity unless the customer directs the sale, transfer, or assignment of such assets.
Can a VCE use a sub-custodian?
Yes. The guidance does provide that the use of a sub-custodian is subject to NYDFS approval and VCE due diligence concerning certain specified factors.
What are the rules concerning disclosure?
Rule 200.19 already requires extensive disclosure including material risks, general terms and conditions, and transactional terms and confirmations. The rule also already requires that the disclosures be acknowledged by the customer and that the rule contains anti-fraud policy requirements. The Guidance clarifies that the disclosures should be clear that the parties intend to enter into a custodial relationship and not a debtor-creditor relationship.
Why is this Guidance important?
It is clear that this Guidance comes about in response to the insolvency proceedings of Celsius and FTX where legal determinations as to the custodial nature of the customer relationship are central to the determination of whether virtual currencies are bankruptcy estate property, or instead should be promptly returned to the customer. Virtual currency entities should in particular note the breadth of NYDFS’ jurisdiction and the detailed nature of the requirements, including the policies and procedures requirements.
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