Crypto Currently: New York Department of Financial Services Issues Virtual Currency Custody Guidance – Fin Tech

On January 23, the New York State Department of Financial Services (DFS or the Department) issued guidance clarifying expectations for New York-based virtual currency businesses regarding custody of customer funds (Guidance). The stated purpose of the guidance is to “emphasize sound custody and disclosure practices to better protect clients in the event of insolvency or similar proceedings.” The guidance applies to both New York BitLicensees and limited purpose trust companies and is effective immediately.

The guidance is not surprising given past statements and actions by DFS Superintendent Adrienne Harris, who has focused on consumer protection in the wake of the FTX bankruptcy. Since FTX filed for bankruptcy on November 11, 2022, DFS has issued guidance regarding banking organizations seeking to engage in virtual currency-related activities and has proposed new regulations to allow DFS to collect supervisory costs from licensed virtual currency businesses.

As discussed in our previous client alerts, while the full impact of the FTX bankruptcy and other virtual currency insolvency proceedings is not yet clear, particularly with respect to the treatment of client assets in the event a crypto custodian enters insolvency proceedings, regulators including DFS will continue to use their existing authorities to enforce rules to protect customers and avoid further market contagion. It is nevertheless uncertain whether and how these rules will lead to repayment for customers in the insolvency sphere.

BitLicensees and New York State limited purpose trust companies to which this guidance applies should review it, and their existing custody and disclosure practices, to ensure compliance. Other virtual currency custody entities should also review this guidance and consider whether improvements to their processes and disclosures are needed to improve customer protection.

Important points

The guidance clarifies the Department’s expectation for virtual currency entities (VCEs) acting as custodians (VCE Custodians) to hold virtual currency in a manner that protects customers’ virtual currency. Specifically, the guidance focuses on customer protection related to four areas: (i) segregation of and separate accounting of the customer’s virtual currency, (ii) limited interest in and use of the customer’s virtual currency, (iii) sub-custodial arrangements, and (iv) ) customer information.

• Segregation of and separate accounting for the customer’s virtual currency. VCE Custodians are expected to separately account for and segregate the Customer’s virtual currency from their corporate assets and those assets of their affiliated entities. VCE Custodians should clearly and distinctly disclose the manner in which they segregate Customer Virtual Currency and should maintain Customer Virtual Currency either (1) in separate on-chain wallets and internal treasury accounts for each customer under that customer’s name or (2) in omnibus on-chain wallets and internal treasury accounts containing only the virtual currency of customers held for the benefit of those customers. Altogether, VCE Custodians have the flexibility to maintain client assets in separate accounts or omnibus accounts, as long as client assets are segregated from the firm’s assets and titled accordingly. VCE managers should be prepared to demonstrate reconciliation between the VCE’s books and on-chain activity as part of ongoing monitoring, routine on-site examination, ad hoc visits or otherwise.




• Limited interest in and use of the customer’s virtual currency. DFS expects VCE Custodians to take possession of customers’ virtual currency transferred into custody for that limited purpose only. VCE custodians should not establish a debtor-creditor relationship with such customers or use such customer virtual currency for their own use, including as collateral for an obligation of the custodian. Custody conditions should preserve the customer’s fair and beneficial interest in the virtual currency.




• Sub-custody arrangements. The guidance notes that after appropriate due diligence, a VCE custodian may enter into a sub-custodian arrangement with a third party as long as the arrangement complies with the guidance. However, any such arrangement would constitute a material change in a VCE’s operations and would require departmental approval. In support of a request for approval, the Department will require, at a minimum, (i) the applicable risk assessment performed by the VCE Custodian, (ii) the proposed service agreement(s) between the parties, and (iii) the VCE Custodian’s updated guidelines and procedures reflecting the processes and controls to be implemented around the proposed scheme.




• Customer Disclosure. The guidance clarifies that VCE Custodians are expected to clearly disclose in writing the general terms and conditions relating to its products, services and activities, and obtain confirmation from the customer that such disclosure was received prior to entering into an initial transaction with the customer. The customer agreement should also clarify that the parties intend to enter into a custodial relationship rather than a debtor-creditor relationship, and should disclose any use of a sub-custodian and the material terms and risks of such an arrangement and such disclosures. The customer agreement must be easily accessible to customers on the VCE custodian’s website.

Look forward to

New York BitLicensees and limited purpose trust companies should immediately review their custody arrangements to ensure compliance with this guidance. More generally, given the continued focus on client asset protection maintained at virtual currency companies by both clients and regulators in the wake of recent crypto industry bankruptcies, other market participants should consider whether to incorporate the guidance.

Footnotes

1. DFS defines “virtual currency” as “any type of digital device used as a medium of exchange or form of digitally stored value [which] shall be broadly construed to include digital exchange entities that: have a centralized repository or administrator; is decentralized and has no centralized repository or administrator; or may be created or obtained by computing or manufacturing effort.” 23 NYCRR § 200.2(p). In the BitLicense FAQs, DFS further explains that Bitcoin and “many coins commonly referred to as ‘stablecoins'” are considered to be “virtual currencies” under the definition. BitLicense FAQs at 2, 20,

2. Virtual Currency Guidance to “Entities Licensed Under 23 NYCRR Part 200 or Chartered as Limited Purpose Trust Companies under the New York Banking Law That Custody Virtual Currency Assets” (January 23, 2023), (“Guidance”). “Custodial Services” means “the storage, custody or maintenance of custody or control of Virtual Currency on behalf of others.” 23 NYCRR § 200.2(q)(2). Note that the guidance applies to “custodial activities in general and is not intended to address in detail additional activities related to custody services such as staking or chain management.” Guidance at n.6.

3. Jon Hill, “NY Regulator Plugs Tougher Crypto Approach Amid FTX Bust,” Law360 (Nov. 17, 2022), specifically after the bankruptcy of FTX, Superintendent Harris stated, “. . . You will hear more from us on consumer protection, disclosures, advertising … many things in our authority that we’re going to look for to strengthen and expand … to clarify the expectations we already have ….”

4. “Superintendent Adrienne A. Harris Releases Virtual Currency Guidance for Banking Organizations” (15 Dec 2022),

5. “DFS Superintendent Adrienne A. Harris Announces New Proposed Virtual Currency Valuation Ordinance” (11 Dec 2022),

6. See “FTX Bankruptcy – What Could Be Next for the Industry,” “Prudential Regulators Issue New Guidance on Crypto Assets,”

7. “Virtual Currency Entities” include BitLicensees (ie, entities licensed under 23 NYCRR Part 200) as well as entities chartered as limited purpose trust companies under the New York Banking Law to engage in virtual currency activity, including custody services. New York’s BitLicense regime requires, among other things, that licensees hold virtual currency in a manner that protects customer assets. DFS imposes similar requirements on limited purpose trust companies in New York that engage in virtual currency activity, including custody services.

8. The requirements imposed by the guidance on VCE custodians are similar to those to which they will be subject as custodians of non-virtual currency. Guidance on custody structures for consumer protection in the event of insolvency, 23 January 2023,

9. In particular, while bankruptcy courts are likely to consider disclosure, disclosure alone may not be sufficient to sustain a custodial characterization in a bankruptcy proceeding and, relatedly, to protect repayment to customers in that proceeding.

The content of this article is intended to provide a general guide to the subject. You should seek specialist advice about your specific circumstances.