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Oh no, where's my crypto? What happens to crypto assets when a custodian fails

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23 June 2022

Recent turbulence in the crypto asset market and comments by certain regulators raise the critical question of what happens to crypto assets held by a crypto custodian if the custodian becomes insolvent. Custodians include those only providing custodial services and other crypto ecosystem participants, such as an exchange that holds assets to facilitate trading.

More particularly, who can make a claim to assets under custody if such a custodian fails? For example, are those assets the property of the custodian? Are they available to satisfy the claims of its general creditors? Or are they property to which the custodian’s customers have a preferred claim or a greater legal interest?

The answers to these questions can affect not only the direct customers of a crypto custodian, but also end users of services that integrate third-party custody services. Often, such end users do not know that they may be indirectly dealing with parties beyond their immediate counterparty. Consequently, there are important considerations:

  • Regulatory Supervision: Many crypto custodians are not currently subject to regulatory supervision comparable to the supervision over broker-dealers and banks, which commonly hold financial assets for others. Such supervision may specifically regulate how such organizations must hold securities or, at the very least, help ensure that they have a disciplined approach to compliance and operational certainty. The Securities Investor Protection Act provides some protection against loss even where an insolvent broker-dealer has failed to properly maintain a security for its customer, and while the Federal Deposit Insurance Act affords no similar protection when a bank fails to maintain securities for its customers, bank customers nevertheless benefit from the regularity of supervised bank activities.
  • Historical Treatment of Assets Under Custody: No significant U.S. crypto custodian has failed to date. [1] Note, however, that with respect to non-crypto custodians, there is a long history of courts respecting the rights of third-party custody customers of both regulated and unregulated custodians that fail while holding assets for others. This precedent should apply to crypto custodians as well.
  • For instance, when a custodian holds and deals with the property of a customer for a specific purpose as, essentially, bailee or agent, the customer can usually be expected to remain the owner of the property, with an entitlement to its return, even if the custodian files for bankruptcy. [2]  These principles can apply even where the property is fungible, or close to fungible, and held in a commingled fashion for multiple customers, such as in the case of grain, natural gas, and bonds. [3]
  • Moreover, many crypto custodial firms elect to treat crypto assets as financial assets credited to securities accounts in accordance with Article 8 of the Uniform Commercial Code (which is applicable via legislation that has been adopted in every state and that serves as the basis for the indirect holding system for securities in the United States). While most commonly applied to securities, Article 8 can be extended to the custody of other types of financial assets and provides that crypto assets held by a firm to satisfy customer entitlements ultimately belong to the customers rather than to the firm.
There is no merit to the assertion that property interests in crypto assets are different because the property type is novel, held through possession of private keys, or subject to new technological challenges.
  • Operational Controls: That said, regardless of the legal construct that applies, the results will depend on, among other things, how a custodian has actually held and dealt with the crypto assets in its possession. Not only should the legal terms by which the firm holds the assets for its customers clearly delineate the lines of ownership, but the firm’s operational arrangements and procedures should match the documented legal terms. For example:
  • In the case of the bailee/agent approach, it must treat the assets as if they are held for the benefit of customers and not held by the custodian as an owner, and in the case of the Article 8 approach, the custodian must act in accordance with its duties under Article 8.
  • Technological challenges, the lack of oversight, and the relative inexperience of many crypto custodians may also aggravate operational risks which could lead to customer losses, including:
  • the risk that the custodian’s records do not track transactions in a way that allows assets to be identified to customers;
  • the risk that the custodian commingles its proprietary assets and its customer assets in a way that does not allow the two to be separately identified;
  • the risk that crypto assets are stolen or lost, whether because the assets are hacked or because the custodian has inadequate safeguards; and
  • the risk that the custodian uses customer assets in a way that is not disclosed to customers and creates credit risk.
  • There are therefore a number of important questions that parties should consider asking with respect to crypto custodians that, whether directly or indirectly, may be holding crypto assets on their behalf:
  • Is the custodian holding the crypto assets for safekeeping on behalf of its customers, or is it borrowing or otherwise using them in its business?
  • What is the legal structure of the custodian’s custody operations, and do they ensure that the custodian will maintain sufficient crypto assets to satisfy the claims of its customers?
  • Has the custodian made appropriate legal undertakings to hold the crypto assets on behalf of its customers, or are documents describing the service silent on that subject?
  • Jurisdictional Considerations: Finally, parties should also be aware that the specific laws that control will depend in each case on the jurisdiction where a crypto custodian is organized and licensed, as well as the governing law of its contractual arrangements with its customers.
  • Local laws and regulations may provide additional protections. For example, in New York, a crypto custodian that has a virtual currency business license must maintain a surety bond or trust account for the benefit of its customers in an amount deemed to be acceptable to the New York Superintendent of Financial Services, and is subject to various constraints on how it may use or deal with virtual currencies held on behalf of other parties.
  • In the case of a custodian located outside of the United States, this may be foreign law, which may be less protective of customer interests.
The cross-disciplinary team at A&O seamlessly advises clients with interests and legal issues across the spectrum in the current crypto crisis and keeps abreast of all of the material developments in this area as they occur. 

 

Footnotes
1. Although there have been several exchange insolvencies in other jurisdictions, such as Mt. Gox (Japan), QuadrigaCX (Canada), and Wemovecoins (Denmark).
2. Corn Exch. Bank v. Blye, 101 N.Y. 303, 306, 4 N.E. 635, 635 (N.Y. 1886) (custodial property held by insolvent bank exempt from attachment by creditors of the bank); In re Carnegie Tr. Co., 162 A.D. 76, 77, 147 N.Y.S. 180, 181 (App. Div. 1914) (New York Superintendent of Banks returning warrants for capital stock held by insolvent trust company “for safekeeping”).
3. Marchant v. Summers, 79 F.2d 877, 879 (4th Cir. 1935) (“Bonds, of course, are not fungibles, but there is no difference between one bearer bond and another, where both are of the same issue, denomination, and value; and the effect of the provision in question was to impart to the bailment of the bonds the advantage of a bailment of fungibles, i.e., the right of the bailee to return similar articles without the burden of keeping separate and returning the identical articles bailed.”).