Following a host of notable bankruptcy filings in the digital asset industry, the New York State Department of Financial Services (DFS) recently issued guidance (the DFS Guidance) to emphasize sound custody and disclosure practices for firms providing digital asset custody services to better protect customers in the event of an insolvency or similar proceeding. While the Guidance applies only to DFS-regulated digital asset firms, it picks up on a common concern from other U.S. regulators, like the Securities and Exchange Commission (SEC), regarding custody of customers’ digital assets. In this respect, the DFS Guidance reflects the application of well-established regulatory concepts to firms custodying digital assets.
Overview of the Guidance
Under New York’s virtual currency regulation, BitLicensees are required to 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. Similar requirements apply to New York State limited purpose trust companies that engage in virtual currency business activity.
The DFS Guidance seeks to clarify the guidelines for virtual currency entity custodians (VCE Custodians)—which covers both BitLicensees and limited purpose trust companies—including:
- requiring segregation of and separate accounting for customers’ custodied virtual currency;
- limiting the VCE Custodian’s interest in and use of customers’ custodied virtual currency;
- prescribing minimum due diligence, agreement and policies and procedures expectations for VCE Custodians entering into third-party sub-custodian arrangements; and
- ensuring customers receive and have ready access to clear disclosures for all of the above, including through customer agreements and standard disclosures.
Implications for DFS-Regulated VCE Custodians and Beyond
The Guidance sets forth detailed expectations and requirements for VCE Custodians regulated by the DFS. However, the concepts articulated in the Guidance should also be familiar to firms acting as VCE Custodians under the jurisdiction of other regulators. For example, each of the SEC and FINRA, for the securities industry, and the OCC and FRB, for the banking industry, have cautioned firms engaging in virtual currency custody, noting these same or similar obligations and expectations. Although the Guidance, at first blush, may seem limited in scope due to the limited jurisdictional reach of the DFS, all VCE Custodians should consider the Guidance and other regulator statements in reviewing their crypto custody disclosures, agreements, and policies and procedures. We expect the regulatory scrutiny to continue to grow, and customers are asking more questions about the structure of digital asset custody arrangements.