New York Issues New Guidance on Crypto Currency Custodial Structures

On January 23, 2023, New York Department of Financial Services (DFS) released regulatory guidance to better protect customers in the event of virtual currency insolvency. The guidance is not binding, but rather persuasive authority.

The guidance applies to entities that have been licensed or chartered by DFS to handle virtual currency assets on behalf of their customers. These handling entities, known as virtual currency entities (VCEs), are expected to have extensive processes in place, similar to those of traditional financial service providers.

Generally, New York’s virtual currency regulation requires VCEs 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

Refrain from making any false, misleading or deceptive representations or omissions in their marketing materials.

The new regulatory guidance regarding insolvency addresses the following key points, which are each explained further below:

Segregation of and separate accounting for customer virtual currency

VCEs limited interest in and use of customer virtual currency

Sub-custody arrangements

Customer disclosure

Segregation of and Separate Accounting for Customer Virtual Currency: VCE Custodian should 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.

VCEs limited interest: DFS expects that when a customer transfers possession of an asset to a VCE Custodian for the purposes of safekeeping, the VCE Custodian will take possession of the customer’s asset only for the limited purpose of carrying out custody and safekeeping services, and that it will not establish a debtor-creditor relationship with the customer.

Sub-custody Arrangements: A VCE Custodian may elect, after appropriate due diligence, to arrange for the safekeeping of customer virtual currency through a sub-custody arrangement with a third party, so long as that arrangement is consistent with the guidance and approved by DFS. 

Customer Disclosure: The Custodian is expected to clearly disclose to each customer the general terms and conditions associated with its products, services and activities, including how the VCE Custodian segregates and accounts for the virtual currency held in custody, as well as the customer’s retained property interest in the virtual currency. The VCE Custodian’s customer agreement should make clear the parties’ intentions to enter into a custodial relationship, rather than a debtor-creditor relationship.