Report Sets Out Best Practices for Digital Assets Custody
Posted by Colin Lambert. Last updated: June 21, 2023
A new report from Clifford Chance, in association with digital asset custody provider Komainu, seeks to establish a set of best practices for market participants that can help ease the regulatory and legal picture around crypto custody services.
Observing that the provision of custody services for cryptoassets has been under heightened scrutiny following high-profile insolvencies in the crypto industry, Clifford Chance says the resulting insolvency proceedings have demonstrated that determining what type of claim clients of custodian wallet providers have in respect of their cryptoassets is crucial.
In the absence of what it terms a clear regulatory framework for cryptoasset custody, the report says the product offerings of custodian wallet providers varies significantly with the effect that, in practice, services provided under the label of crypto custody services, may not involve true “custody” and instead fall under an alternative legal regime. “This has important consequences for a customer’s claim to the “custodied” assets, including on insolvency,” the firm says.
The report contains a detailed analysis of the legal position of custodial wallet services across nine jurisdictions and makes eight key recommendations for what it terms the “ideal regulatory framework for custodial wallet services”.
- A clear and specific definition of what constitutes custodial wallet services, and the underlying legal basis for these, is imperative. This should clarify the different types of possible service provision, from true custody to other offerings that involve title transfer arrangements.
- Prudential requirements, including mandatory regulatory capital and allocation of ring- fenced wind-down funds, could practically support favourable outcomes for clients of custodial wallet services.
- Mandatory arrangements to support the argument that cryptoassets are not available to creditors of the custodian wallet provider (whether before or after insolvency, and whether the arrangement is a trust structure or equivalent) – for example, a requirement for separate identification of assets of each client in the books of the custodian wallet provider, and, where assets are held with/recorded in a third party system, a minimum requirement for separate identification of the custodian wallet provider’s own assets from any client assets.
- Secondary objective of providing clarity to market participants by ensuring consistency with and not unnecessarily disrupting existing regimes for securities custody.
- Clarity on the meaning of the term “custodian” – there should be a minimum level of activities or services the custodian wallet provider has to offer to be allowed to use this designation, as well as registration or licensing requirements and adherence with the relevant rules.
- Clarity as to segregation (in the books of the custodian and any delegate) best practice, in a way, to the extent possible, that achieves ring-fencing on insolvency. Ideally, this would also minimise the risk of any client assets being mistakenly regarded as assets belonging to the custodian wallet provider and/or other clients as a practical matter.
- Recommended disclosure around business operations and how client assets are held and recorded by the custodian wallet provider, including any use of omnibus wallet structures and title transfer arrangements. Transparency is key to allowing clients to make informed choices, particularly if the business model of the custodian wallet provider could ever involve the rehypothecation of client assets or similar arrangements that would impact the insolvency analysis.
- International cooperation and consistency, with the aim of having a broadly accepted market standard for what good custodial wallet services look like and how they are treated, as can be seen in the custody market for traditional financial instruments today.
“Our new report on cryptoasset custody in collaboration with Komainu has some positive findings for market participants who offer or use carefully-structured custodial wallet services,” says Laura Nixon, knowledge director – Fintech, at Clifford Chance. “However, the lack of consistent regulatory frameworks for cryptoasset custody globally presents a significant challenge for firms offering these services internationally. We hope that our policy recommendations will contribute to enhanced international consistency and legal certainty.”
Madeleine Yates, special regulatory advisor at Clifford Chance, adds, “This analysis of custody of cryptoassets throws into sharp relief the importance of understanding what is meant by the term “custody” and “segregation” amidst the operational constraints of cryptoasset services offerings.”