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hi my name is richard levine i'm the chair of the fintech regulation practice at nelson mullins i'm joined by my colleague brad ruskin who's the chair of our bank regulatory practice we are happy to have you join us today for our presentation on custody of digital assets if you could go okay today we're going to talk about a couple of different areas we're going to discuss distributed ledger technology or what's known as blockchain technology to help you understand what is driving both the development of the industry and the regulations we're going to walk through the differences between blockchain technology digital currencies digital assets and wallets we're also going to be introducing you to the views of the contour of the currency with respect to regulation of custody of digital assets by focusing on two pieces of guidance a letter from october uh from 2020 and then a second letter from 2021 we will also talk about the fcc's view of the occ's letter from 2020 and then we will talk about regulation at one of the states which has taken the most active role in regulation of digital assets the state of new york with their bid license so in the united states regulators focus on trying to understand what are digital assets digital assets can be either a commodity it could be a currency they can be a security now the problem is many of the laws that are used to regulate currencies securities and commodities were written in the 1930s 40s and 70s this was a time when the laws were written people wore leather football helmets to play football so we're now refereeing a football game with rules that are far out of date for the scope of regulations unfortunately the laws were not designed to address digital assets or digital currencies so the regulators the contour of the currency the securities exchange commission the cftc and states like new york have been working diligently over the last 10 years to establish a regimen for regulating each of these types of assets in the presentation we're going to use the term digital asset to cover the broad category of assets which may be using distributed ledger or blockchain blockchain technology these can include currencies coins tokens or what are known as digital asset securities with respect to digital asset securities the federal securities laws do not define when a digital asset is in security this is something that the fcc has crafted most recently next slide please so when we talk about blockchain technology the first thing we're looking at is how these transactions are recorded and what i'm going to do is turn it over to my my colleague brad rustin to walk through more detail on blockchain technology thanks so much rick and when we talk about blockchain we're really talking about is how do we create an authoritative record of transactions how do we create a series a system of what's called nodes or operators people all working together who are then agreeing on a common set of transactions and what becomes an official record if you think about traditionally that was done at a centralized point of contact you had for instance in your bank a core provider that hosts your official record of transactions for the bank really what we're talking about when we start talking about blockchain or distributed ledger technology is a way of shifting that so that different operators different nodes all working together to maintain the quote official record of transactions associated with that particular ledger we use an example that was created by the federal reserve that i really like if you think about it we've got a series of people who are all working we'll call them nodes or operators and each of them is keeping a record of transactions in an ideal world everybody agrees we all compare notes if you will and we say yes absolutely we all agree these are the transactions associated with this particular product this particular contract this particular bitcoin whatever the case may be and there's consensus or agreement amongst all the operators then you say okay what happens when something changes when something changes one of the operators or one of the nodes if you will will say i have a new transaction to add and suddenly the entire network that we're talking about here notices that something doesn't match in the example the chicago fed uses we're using this fancy barcode that codes to chicago fed0 suddenly one of the nodes says i'm submitting a transaction they say the new set of sequences is chicago fed 100. the the the entire set of nodes notices the error and then there's got to be some way to reconcile or fix the ledger so that all of us come back into consensus and that's really the secret to blockchain or distributed ledger technology is this concept of validating or fixing those discrepancies and it can happen any sort of way some distributed ledger technology is in fact not distributed there's an official central authority that approves changes other times there are ways of voting meaning all the various nodes vote on what the official record is and then they all have to adopt what's elected or voted in as the record many of you who are potentially considering banking or working with bitcoin uh in particular bitcoin's somewhat unique in that it uses the concept of miners these are folks who are hosting computer systems have massive computing power and every time we add a transaction to the chain for a particular bitcoin it creates a new cryptographic uh giant math problem that has to be solved and the solution to that that math problem if you will is a key that the owner of that particular bitcoin uh uh is in possession of and when somebody wants to transfer a particular bitcoin they say here is my private key i assert that the solution to the math equation is this and then the minors all go out and they run this massive mathematical sequence and say yes that is a solution to the equation and here's my work and the benefit why you want to be a minor is you get rewarded with bitcoin for doing that for validating those transactions and showing your work to the entire world the neat thing that this creates then is every block of bitcoin is a history of that coin it can go back forever you can't change the transaction record and it's indelible all you can do is add to it the other thing the neat thing about this network and why so many folks are interested in very secure which is in order for you to commit fraud on a distributed ledger technology is you'd have to corrupt multiple nodes or operators and so it becomes really difficult because you'd have to go out onto the entire network and get all the different nodes to agree on your fraudulent transaction and that's part of the inherent stability or the inherent fraud protection associated with it and so because that you can see why things like bitcoin cryptocurrency or dl-tech and distributed ledger technology has become so popular because of those inherent strengths and the anti-fraud protections associated with it rick back to you now anytime that we're dealing with assets in the united states and we have multiple regulators involved it does create a level of confusion for the institutions that are regulated so banks having to be uh managed by the s by the occ by the fed or by state banking regulators dealers and securities having to answer questions from the securities exchange commission and firms that are dealing in commodities or quantity futures or commodity swaps or derivatives having to deal with the cftc now the securities exchange commission has been at the forefront in this space for a number of years and in order to address whether a digital asset is subject to their jurisdiction they have crafted this new definition of what they refer to as a digital asset security and what they're looking at is whether the asset that is issued and transferred using distributed ledger blockchain technology is acting in a manner that makes it look like an investment contract meaning that was it used to raise capital does it have the characteristics of a debt instrument an equity instrument or some type of security based swap if it does the fcc will say that is a digital asset security subject to their jurisdiction if it is a digital asset that looks more like currency they will leave that to the jurisdiction of the department of the treasury's financial crimes enforcement network or to state regulators who are dealing with the regulation of money service businesses and payment processors if the digital asset has the characteristics of a commodity and that it is traded in a manner that looks like a commodity swap a commodity future or commodity option the fcc will leave that to the cftc the problem is this leaves a a plethora of regulators who at various times assert jurisdiction over firms in the space and it requires firms operating the space to operate with a great degree of caution because every time they are involved with the product they need to determine are we acting for example as a custodian of a digital asset that is a security are we acting as a custodian of a digital asset that is not a security or a currency are we acting as a custodian of something that could be deemed a commodity or commodity swap or future or an option so as firms work in this space they have to proceed with a great degree of caution and so we'll start with a little discussion of digital currencies and uh frankly rick gets to talk about all the cutting edge stuff with securities and what have you i'm going to start a little bit more historically and talk briefly about banks that are providing services to digital currencies you know when we think about digital currencies it's probably a very limited world that it truly classifies as currency but when we talk about a digital currency it's a it's a coin or a a digital asset or a cryptographic token that's really not speculative there's no securities aspect associated with it's not being used to raise capital you know any of those issues that that rick just mentioned instead it's truly being used as a means of exchange it has a value that's set by the market people take fiat government currency they convert it into digital uh assets in this case crypto currencies and it becomes a means of exchange it can be used by goods or services by other currencies you know unlike fiat currency issued by government that's backed by the full faith and credit of a government you know whether that's the us government or another digital currencies are either backed by what the market says it's worth think bitcoin every day the price of bitcoin goes up and down based on the perceived value of it or it can be what's called a tether coin meaning it's somehow tied to some asset or fiat currency you can have coins that are tied to gold you have coins that are tethered to the us dollar what have you but you know when we talk about think about this very narrowly which is a true cryptocurrency is something that is a means of transferring value for goods or services it's not speculative it's not an investment contract you know and really as we as bankers think about this we can see just how quickly this market has grown if you look at the federal reserve update from then to 2019 the number of crypto currencies has skyrocketed in his in essence in the last four years from 2015 to 2019. uh as of today the total market capitalization of cryptos is over 1.11 trillion dollars because there are so many that are currently living out there you know we talk about digital currencies fincen has taken a very very narrow approach to it we talk about treasury's approach what they've done is in essence treated as a means of transferring money it's not a currency it's not a foreign exchange that is also a type of regulated money services business instead it's treated as money transmission the movement of money between people or between locations and as you think about banking people playing in this space remember that generally fincen has taken the position that anyone who converts fiat government issued money into digital currency is a money transmitter has to be registered with fencing subject to bsa aml and ofac obligations anybody who converts digital currency to digital currency or allows for transfers of digital currency between people or locations is a money transmitter subject to registration within sim subject to bsa aml and ofac if you provide a digital a currency atm meaning you're changing out either money for crypto currencies or cryptocurrencies for fiat money also a money transmitter recently you've seen guidance coming out from fencing the folks who act as what are called mixers or currency anonymizers people specifically focused on helping owners of digital currencies anonymize the ownership of it also subject to fencing also a money transmitter anytime you're dealing with digital currencies unless it is simply someone who is mining cryptocurrency or paying in cryptocurrency for goods or services generally they're going to be classified as a money transmitter uh by fencing one really interesting thing to remember as bankers if you are going to bank uh folks in the digital currency space the exemptions from money uh for merchant payment processing and the other exceptions to money transmission registration do not apply to digital currency so there is a very commonly used exception called merchant payment processing where an intermediary processes payments to p to to businesses that are owed money for goods or services they're generally not classified as money transmitters those exceptions have not been extended to digital currency payment processors so something really to remember there because of that exchange of value concept it's interesting brad when you mention the anonymizer function oftentimes people will say that cryptocurrencies are anonymous and generally that's not true they provide a degree of pseudonymity the same way a bank account number is a digital representation of the name of the account holder and in fact people have gotten in trouble in this space where they thought that they in fact were anonymous only to find out later that no was a pseudonym the best example is ross ulbrick who ran a crypto platform called silk road the federal agents who arrested him found his computer they associated the pseudonym with his identity and he is now serving multiple consecutive sentences in a federal correctional facility unfortunately two federal agents who were involved in apprehending mr ulbrick also did not realize that when the government seized his bitcoins they then tried to misappropriate some of the bitcoins and they did not realize that the blockchain created a record of that misappropriation those federal agents are also now serving time in a credit uh federal correctional facility but as brad pointed out fincen is concerned about platforms that are designed in fact to create a higher level of anonymity from pseudonymity in this space so when we talk about cryptocurrencies you'll also hear people talk about wallets now wallets are basically a electronic mechanism for the storage of digital assets on the web on servers hard drives mobile devices even on paper pronouns you can have the key which then allows you to release the funds from the digital wallet when a digital wallet is created it's basically connected to a cryptographic public key with a string of numbers and letters and each key has a matching private key known only to the user you may read stories about people losing their key and losing millions or tens of millions of dollars of bitcoin that can happen if you do not use uh cryptographic wallets that have mechanisms for storage and preservation and retrieval so there is a risk depending on how the digital asset wallet is designed now when we talk about wallets though a wallet in effect is a custodian a custodian of a digital asset and if the digital asset is a security the securities exchange commission will say is that custodian properly qualified to hold a digital asset security and there have been questions that have come up with operators of platforms for both cryptocurrencies and digital asset securities attempting to ask the question is a state charter trust company a suitable custodial location for what's known as the customer protec
ion rule 15c 3-3 is it a proper control location for an investment advisor these are issues that the fcc and finra the frontline regulator have been working for the last year to resolve and provide guidance to the industry yeah that's a really good point rick that you know when we talk about this there are a lot of gray areas that we really need to be aware of such as what is the difference between providing a repository for these keys versus actually custodying these assets and i guess you know subject your input it sounds like there's still a lot of development as to where these various lines will be drawn by the various organizations as to those issues you know we talk about digital currency the other thing to remember as bankers is just like with any money services business fencing places the obligation on the banking services providers the banks the federal savings banks the credit unions etc to diligence the folks whose accounts they are hosting not to provide or facilitate access to the federal reserve system payment systems settlement systems for individuals that are operating unlicensed money services businesses and in the past fencing as well as the prudential banking regulators have pursued claims against banks including through the department of justice for facilitating illegal money transfers illegal money services business operation people who were not properly registered with fincen in kind of a bellwether event in february of 2020 the occ for the first time took action against a bank that was facilitating cryptocurrency related transactions for unregistered msbs money services businesses and so you see it referenced there but that's really the first step and this is the warning to financial institutions who are considering their relationships with digital currency providers that by facilitating those transactions you may bring liability into your bank for facilitating unregistered msbs and their access into the payment systems in essence settlement or facilitating their business operation violation of treasury rules you know generally everything we see with msbs remain an obligation of the banks as you consider your relationships with each with digital asset providers or digital currency providers which is make sure you're doing your customer due diligence and really make sure that if you're going to play in this space you understand the legal and compliance obligations associated with digital asset providers custodial services associated with that or cryptocurrency or digital currency transactions in particular where we always see people getting caught in enforcement orders is really making sure you understand not only your bsa aml obligations for your institution but also the bsa aml obligations that are applicable to the underlying provider of different services meaning if you're working with an exchange if you're working with a custodian even if you're working with a digital wallet that hosts these private keys making sure you understand both their obligations uh and yours and then yes rick is going to point out a little bit later understanding for those that are potentially classified as securities what your obligations are as an institution for banking folks working in a a security space and what those sec obligations are and are they complying with state laws as well don't forget you know we always have the federal obligations of treasury and sec but also state securities regulations as well as state currency or or you know in some cases as rick's going to point out a little bit later on states that are specifically regulated in the digital currency space and then mainly making sure as with everything you can properly manage the assets making sure you can properly manage the relationship and you fully understand it so that you can demonstrate your knowledge and awareness of the risks associated with it so as we look at the regulation of digital currencies and digital assets in july of 2020 the contrary currency published an interpretive letter recognizing that national banks may provide custody services for cryptocurrencies including providing storage for these cryptographic keys associated with the assets and this was a watershed moment uh brian brooks the contrary of the currency of the acting control of the currency previously was the general council of coinbase one of the leading cryptocurrency trading platforms which recently is filed to go public this opened the door to banks providing services similar to escrow services for the keys and for digital assets including uh storage of digital certificates web-based document storage retrieval and collaboration with respect to documents the letter does provide for custody of cryptocurrencies will require banks to provide you know custody for the keys and they re they reiterated that national banks have to have the authority to provide custody for this type of digital assets uh the occ also made it very clear that it believes it has the power to authorize national banks to provide these types of services this has been an issue of dispute several years ago the control of the currency proposed a fintech charter for banks which has resulted in litigation between the contrary of the currency and state banking regulators who claim that the banking laws do not preempt state law in this area and that this is beyond the scope of the contrary of the currency's authority so we do anticipate under a new democratic administration in both the white house and both houses of congress that this will be an area of focus and that the new contra of the currency will be scrutinized for any actions they take authorizing the custody of digital assets going forward really great point there rick particularly as we move into the new administration because there's potentially a change in tone at the top both in this and many of the fintech initiatives that the prior occ fdic uh have been pushing particularly as they work towards fintech models and increasing the role of the national banks or the state banks in those types of fintech models you know the big thing is what the occ has done with this 2020 letter is really broadened what it considers the prudential powers or or the banking powers of the national bank and they've really broadened it out so it could be exchanges it could be transaction settlement trade executions uh everything down to record keeping valuation and tax services that they are believe are commensurate with existing rights to provide custodial services then truly acting as a custodian for the digital assets or a custodian for the cryptographic keys all of these occ has broadly interpreted to fall within the powers of the national bank to provide these including acting in a fiduciary contra context and providing these as a trustee or in other fiduciary context where the bank is actually you know acting on behalf of other third parties in the same way it does within its existing trust department subject to the rules and regulations associated with trusting those assets so in addition to the 2020 letter the occ has flagged issues that enables the banks to hold custody now this creates a question uh whether under the investment company act a bank holding cryptocurrencies is a suitable control location or an investment company uh whether it's a suitable control location for an investment advisor to a registered investment company or to investment company entities that are exempt from registration under the investment company act and then the last point it also raises the question of whether these types of institutions banks are suitable control locations for digital asset securities under rule 15 c33 the customer protection rule so following the 2020 letter the occ published a set of guidance oh sorry excuse me the fcc published a set of guidance in response making it very clear that they reserve the authority to themselves to determine for purposes of investment advisors investment companies and broker dealers whether a certain bank was a suitable control location for purposes of the investment advisors act the investment company act or for purposes of the securities exchange act which applies to broker dealers and they then published at the end of 2020 a statement and request for comments regarding the custody of digital assets for broker dealers most importantly this statement does propose a five-year period that will allow broker dealers to operate in certain very specified circumstances and not be subject to enforcement actions if they are holding digital asset securities in a specified control location then following that sec letter we get in january of this year january 2021 occ published another interpretive letter the 2020 2021 letter that in essence responded to what the sec was saying and reconfirming the authority of national banks and federal savings associations or federal savings banks to actually participate in the node verification networks just like we talked about earlier where we have those different operators and nodes who are each you know coming in and verifying those transactions a national bank or federal savings bank could provide those types of services and it's really even further broadening not only traditional concepts of banking and custodial relationships transaction clearing and payment but actually taking one step further and saying you can participate in the node verification networks and serve as a node that is verifying uh transactions and as you know the quote here uh about by comptroller brooks noted it's really designed to be broad that is national banks are given broad power to transact business associated with blockchains digital assets and digital currencies you know in essence banks are in a very good position to provide those services because they've done it traditionally with other payment systems and other uh custodial relationships dealing with securities and commodities really what the the takeaway from this is the existing occ subject any changes in the administration is really taking a very broad very expansive a view of what a bank or a federal savings bank could do in terms of providing services to the digital asset world you know kind of on that same note then when we look at the press release that came out with the 2021 letter yeah reemphasizing in occ the need for uh technology development in the blockchain system and you know we see even more an endorsement of these types of payment networks as we talked about because of the nature of distributed ledger technology they can help eliminate fraud uh they can be used in very creative ways that simply you know single source payment systems do not work well with meaning you know where you're trying to create a network of different individuals all able to post transactions and prioritize them and reach resolution on them and generally the occ has been expressing confidence that banks know how to manage these risks now you know caveat with that as we all know with our relationship management obligations you need to make sure you do in fact have the the resources to manage this if your institution is thinking about working in this space but truly you know the position of occ has been that digital assets cryptocurrencies digital currency commodities are all similar to existing assets that are custodied by banks or managed by banks and therefore banks are in a very good position to provide uh these types of services you know as we think about kind of what the offshoot the the the effect of that 2021 uh letter is going to be is you know more and more we think national banks are going to help uh provide payment services in this space uh we've talked a little bit about the creation of stable coins and other types of coins that are used or you know either through tethers or through other mechanisms to create less volatility and fluctuation in the cooling marketplace you know as we noted here we've already seen some major international banks uh starting to uh play in the space issuing stable coins and creating a system where the banks are providing the services that right now are created through this very fragmented state by state regulatory regime where different uh you know exchanges or hosts or issuers are operating under different national laws different state laws uh you know and truly it's creating this very broad view similar to how the occ has approached fintech charters and others you know that going back to the national bank act is these are very very broad rights given to national banks to provide uh security to the banking system and generally a very broad interpretation of what those rights would be rick back to you in addition in addition to the regulation of digital assets by the sec the cftc the contour of the currency you also have state regulators the most prominent action taken by a state regulator was by the new york department of financial services in june of 2015 where they adopted regulations for virtual currency businesses in their state it's common commonly known as the bit license and the the licensing requirements are fairly stringent uh one of the problems that you run into is that if you are doing business in new york in a manner that falls within the licensing regime i you have you are going to have to have a place compliance policies comply with capital requirements set by new york department of financial services meet prescribed customer protection asset cuts to these standards keep certain books and records and be subject to ny dfs examinations have an anti-money laundering program and establish and maintain customer complaint processes many states are also looking at adopting or have adopted their own version of regulations of virtual currencies for example louisiana adopted their law or currency of virtual currencies or for custody of virtual currencies in august of 2020. however new york is the most aggressive state with respect to next slide please it doesn't grant reciprocity so if you are conducting business in the state of new york you may have to get a new york bid license even though you normally would be licensed in your own state and then would believe you would have reciprocity in every other context new york new york to date has not recognized reciprocity with other states for purposes of the bit license this slide walks through what is what brings you within the scope of the bid licensing regime i would encourage you to take a look at it we can spend a little more time after the call with you there are exemptions from the bid licensing and reciprocity a number of those are identified here but again if we leave you the most important point new york is not recognizing any type of reciprocity as now with other states so if you hear people getting chartered in south dakota nevada wyoming recently the problem is that those institutions will more than likely have to either become licensed or fall within the scope of the bit license exemptions in the state of new york yeah and that's a great point you make there rick is very similar to what we see in the msb space which is simply having a license in one state oftentimes regulators particularly state regulators are going to take the position to providing the services to residents of their state itself puts you within the regulatory regime of those various states and so more and more those businesses are looking to banks to partner with so that they can offer uh you know whether it's msb services or in this case digital asset cryptocurrencies or commodities uh through bank partnerships and so particularly if you're going to be banking these folks you really need to understand those various risks associated with the the state regimes as well as the uh federal regimes so that you really can understand what these obligations are particularly as you noted some of the more aggressive states such as new york is articulate a very clear position that trust companies limited purpose trust companies others offering any sort of uh digital assets uh custodial services or trust services would have to comply with that particular state's law rick your thoughts so as we look at custody of digital assets hopefully you realize from this presentation that it is right with complex issues you have state and federal regulators all fo
used on what is a proper custodial location and much of that will depend on the assets that are being held at that custodial location and the applicable legal regime are you acting as a custodian for an investment advisor that may be setting up a commodity pool to invest in crypto or a investment company or an exempt fund that is holding digital assets are securities are you working with a broker dealer that may be holding digital assets that are securities each of these will require banks to and custodians to determine what are the appropriate legal regimens and how do those in effect square pegs fit into the round hole so as you go forward in the space we would encourage you to proceed with caution caution should be your watch word because both federal and state regulators can take action against an entity that is violating the law with respect to a proper custodial location depending on the type of asset and also making sure that any firms you choose to do business with or associate with are properly registered because we would hate for your firm to get dragged into an investigation or enforcement action by virtue of working with an entity that is also not properly licensed for the business that they are conducting yeah that's a really great point rick is you know as institutions begin to play more and more in the space really knowledge is the power to offer this in a responsible way which is understanding the the myriad of potential pitfalls or traps that exist you know whether those be the treasury traps or the sec traps so that your institution your financial institution really has a feel for what it is you're either banking or providing and understanding exactly what is the black and white rules where the gray areas as you mentioned here even going so far as you know concerns about fdic insurance and what does it apply to i mean it this is constantly developing monitoring is key as well as really understanding this world in order to for your financial institution to play in the space thank you for taking the time to speak to join us on this webinar today if you have any questions about the topics that were covered during this presentation or any other issues with respect to fintech and digital assets please do not hesitate to reach me or my colleague brad ruxton at the telephone numbers and emails that are listed at the end of this presentation thank you very much thanks so much everybody
