On January 23, 2023, the New York Department of Financial Services released guidance with the stated goal of helping to protect customers of virtual currency businesses in the event of an insolvency or similar proceeding by imposing new custody and disclosure requirements on virtual currency entities that act as custodians. Specifically, the guidance focuses on four areas for virtual currency entities acting as custodians (or “VCE Custodians”):
- Segregation of and Separate Accounting for Customer Virtual Currency: A VCE Custodian is expected to (1) separately account for and segregate customer virtual currency from the corporate assets of the VCE Custodian and its affiliated entities, both on-chain and on the VCE Custodian’s internal ledger accounts; (2) avoid comingling customer virtual currency with any of the VCE Custodian’s own virtual currency or with any other non-customer virtual currency; and (3) clearly and prominently disclose the manner in which the VCE Custodian segregates and accounts for customer virtual currency. The guidance also requires that VCE Custodians should have clearly documented policies and procedures to evidence that these safeguards are in place.
- VCE Custodian’s Limited Interest in and Use of Customer Virtual Currency: The NYDFS expects 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. Specifically, the guidance mandates that (1) when a customer transfers possession of an asset to a VCE Custodian for the purposes of safekeeping, the VCE Custodian will take possession only for the limited purpose of carrying out custody and safekeeping services, and that it will not thereby establish a debtor-creditor relationship with the customer; and (2) under no circumstances should a VCE Custodian use customer virtual currency to secure or guarantee an obligation of, or extend credit to, the VCE Custodian or any other person.
- Sub-Custody Arrangements: While a sub-custody arrangement with a third party is allowed, assuming it occurs after appropriate due diligence and otherwise complies with the NYDFS’ guidance, the NYDFS views such arrangements as a material change to a VCE’s business. Therefore, such an arrangement would require preapproval from the NYDFS. In support of any preapproval, the NYDFS will require: (1) the applicable risk assessment performed by the VCE Custodian; (2) the proposed service agreement(s) between the parties; and (3) the VCE Custodian’s updated policies and procedures reflecting the processes and controls to be implemented around the proposed arrangement.
- Customer Disclosure: A VCE Custodian is expected to clearly disclose to each customer in writing the general terms and conditions associated with its products, services and activities; obtain acknowledgment of receipt of such disclosure prior to entering into an initial transaction with the customer; and make those terms and conditions readily accessible from the VCE Custodian’s website. In addition, the VCE Custodian’s customer agreement should make clear the parties’ intentions to enter into a custodial relationship, rather than a debtor-creditor relationship. Lastly, if a VCE Custodian makes use of a sub-custody arrangement with a 3rd party, the customer agreement should clearly disclose the terms of that arrangement and the material risks.
This new guidance applies to both New York BitLicensees and New York State Limited Purpose Trust Companies that engage in virtual currency business activity, and is effective immediately. A press release for the newly release guidance can be found here.
This guidance further highlights the renewed attention from the NYDFS on the virtual currency space since the FTX crypto-exchange filed for bankruptcy on November 11, 2022, which has seen the NYDFS release guidance regarding banking organizations who seek to become involved in virtual currency-related activities (covered in greater detail here) and proposing new regulations intended to allow the NYDFS to collect supervisory costs from licensed virtual currency businesses.