New York Regulator Clarifies Rules on Sub-Custodians and Customer Asset Segregation

Emphasis on Customer Protection and Sub-Custody

The New York State Department of Financial Services (DFS) has released an updated guidance concerning customer protection for virtual currency assets in the event of an insolvency. This new guidance supersedes the previous one issued on Jan. 23, 2023, offering added clarity, particularly regarding sub-custodians, while continuing to emphasize “sound” custody and disclosure practices to protect customers in the event of an insolvency.

In a Sept. 30 industry letter, DFS Superintendent Adrienne A. Harris stated that the guidance is intended to offer greater clarity regarding standards and practices that will help ensure that virtual currency entities (VCEs) are structuring their asset custody framework correctly.

Harris, who set leave the DFS in October, underscored the department’s role in the sector, saying:

The Department’s nation-leading digital asset and consumer protection regulatory standards have set clear and transparent expectations to protect New Yorkers since 2015. Guidance is a particularly important regulatory tool, allowing the Department to respond to new and evolving circumstances.

She added that the updated guidance specifically provides additional clarity on the emerging sub-custodial relationships in the digital asset space.

Material Change and New Requirements for Sub-Custody

The DFS views a VCE custodian entering into a sub-custody arrangement with a third party as a material change to the VCE’s business, requiring the department’s approval prior to implementation. To grant approval, the DFS expects to receive the applicable risk assessment performed by the VCE Custodian as well as the proposed service agreement between the parties.

The Department also requires that the service agreement with the sub-custodian must include specific customer protection measures. The agreement must mandate that the sub-custodian segregate all customer virtual currency from the corporate assets of both the VCE and the sub-custodian.

Furthermore, the proposed service agreement must explicitly state that customer virtual currency cannot be used as “collateral for the VCE’s own proprietary debts, nor can the sub-custodian claim any right of set-off or lien against these assets, except for customary ordinary fees and expenses.”