New York Tightens Encryption Custody Rules: Even in Bankruptcy, Client Assets Must Be Protected

On October 1, the New York State Department of Financial Services (NYDFS) released the latest guidelines outlining how licensed crypto asset custody entities (VCE) should construct their custody structures to ensure that the actual ownership of digital assets remains with clients, even in the event of bankruptcy. This update reflects the surge in demand for virtual asset custody from retail and institutional clients and reiterates the department's expectations for sound custody and information disclosure practices across the industry. The new regulations also establish guardrails for the operational framework of sub-custodians to ensure that client interests are protected throughout the asset lifecycle (from deposit and custody to withdrawal and transfer), while minimizing the risk of asset shortfall in the event of the custodian or sub-custodian's bankruptcy. Equally important, the guidelines reaffirm the department's stance on the permitted uses of custodial client assets. Companies may not allocate client assets in a manner that could undermine the client's ownership or priority in the event of bankruptcy. The SEC emphasizes that the structure of custody arrangements should ensure that clients' beneficial interests remain clear and enforceable in the event of bankruptcy. This includes clear and prominent disclosures explaining how assets are held, any third parties involved, and the actual impact on clients during stress events.