NFDFS makes another move, can crypto-friendly banks continue to stay friendly?

The New York Department of Financial Services (NYDFS) issued regulatory guidance on 1/23, which explicitly outlines the standard procedures and disclosure requirements for custodial structures of crypto assets, reminding cryptocurrency custodians of their responsibility to ensure that customer funds are not commingled with their own assets. With tightening regulations and the prolonged crypto winter, can crypto-friendly banks continue to remain friendly?

Who is Regulated?

New York State has the strictest cryptocurrency regulations in the United States, which not only apply to companies operating in New York but also extend to the financial activities of New York residents. In June 2015, the Department of Financial Services issued the Virtual Currency Regulation 23 NYCRR Part 200 under the New York Financial Services Law, which regulates companies engaged in virtual currency business activities in New York State, requiring them to apply for:

• BitLicense: A business license specifically for virtual currency activities, currently held by companies like Circle, Ripple, and Coinbase.
• Operating as a New York limited purpose trust company or New York bank under the New York Banking Law and obtaining approval to engage in virtual currency business, with crypto-friendly banks like Signature and Silvergate falling into this category.

Although the authorization forms for virtual currency business activities under the above two may seem similar, the charter of a New York limited purpose trust company may offer some additional benefits. For example, a limited purpose trust company can exercise fiduciary powers, which BitLicense holders cannot. Additionally, a limited purpose trust company can engage in money transmission activities in New York without the need for an additional New York money transmitter license.

What is Regulated?

The newly released guidelines more clearly define the standard procedures for asset custody to enhance customer protection:

• Segregation and Separate Accounting of Customer Virtual Currency: Customer virtual currency should be held either in wallets and internal ledger accounts in the customer's name or in one or more omnibus wallets and internal ledger accounts. If the custodian chooses to hold customer virtual currency in omnibus accounts, clear internal audit records should be maintained.
• Limited Rights and Use of Customer Virtual Currency by Custodians: When customers transfer ownership of assets to the custodian for custody purposes, the custodian can only take possession of the assets for the limited purpose of providing custody and safekeeping services, thus should not establish a debtor-creditor relationship with customers. Under no circumstances should the custodian use customer virtual currency as collateral.
• Sub-custodial Arrangements: Custodians may opt to custody customer virtual currency through sub-custody arrangements with third parties, subject to approval by NYDFS.
• Disclosure of Terms: Custodians should disclose in writing to each customer the terms related to their products, services, and activities, and obtain confirmation before engaging in initial transactions with customers.

These regulations appear to be aimed at preventing the creditor issues that arose from Gemini Earn, where in the future, related income products must not only register with the SEC, but custodians like Genesis are also prohibited from pledging or using custodied virtual assets for other purposes.

When Crypto is Unfriendly

Signature Bank and Silvergate Bank have long been recognized on Wall Street as the most crypto-friendly banks. Following last year's bankruptcies and mass withdrawals from crypto customers, Silvergate incurred a $900 million loss for the year, while Signature Bank announced that it would no longer support transactions for exchange customers under $100,000 starting from February 1.

In the fourth quarter of last year, Signature Bank intentionally reduced its crypto-related deposits by $7.35 billion, accounting for half of the total outflow of $14.2 billion in deposits, with the company's financial statements indicating this as a planned risk diversification.

Signature Bank CEO Joe DePaolo also stated during an investor conference that:

We are not just a cryptocurrency bank; we want to make that loud and clear.

It seems that with tightening regulations and the ongoing crypto winter, crypto-friendly banks can only reduce their exposure in the crypto space and pave alternative paths for themselves!