The outgoing Commissioner for the Capital Market Dr. Moshe Barkat published today a significant draft circular that establishes instructions regarding custody management of financial assets, including crypto-currencies. The formulation of custody rules and asset management is an essential part of the activity of entities that manage crypto-currencies in their clients’ accounts.
“The purpose of the circular is to establish a standard of action in order to ensure the proper preservation of financial assets by financial service providers,” notes Barkat in the explanatory notes.
According to the draft, “customer assets that are not tangible financial assets that are physically kept – whether customer money in virtual currencies or in a legal process – will be kept in trust by the financial services provider. The reason for this provision is that any keeping of an asset, with the exception of an asset that is physically kept, involves carrying out Certain actions while preserving the assets. Therefore, it is required that those actions be carried out faithfully – in accordance with all the provisions of the law involved – for the customers. In this way, the interests of the customers will be adequately protected.”
Keeping assets in trust has meaning in case of bankruptcy of the governing body, since they are not considered part of the assets used to pay off its debts to creditors. In addition, they must be kept completely separate from the funds of the governing body, so that they can be claimed in case of financial difficulties the governing body encounters. As part of the custody instructions, “a financial services provider will not be allowed to perform any operation on the client’s assets, other than at the client’s written request and subject to the provisions of any law. This instruction is intended to ensure that the operations performed on the client’s assets are at his discretion and at the client’s request.”
Outsourcing for the safekeeping of clients’ assets
The circular allows the financial services provider to keep the clients’ assets through a third party (outsourcing) who will actually hold the clients’ assets. However, the obligations stipulated in the law, including the provisions of this circular, will apply to the service provider himself, even if the activity is carried out by another party. If the financial entity applies for outsourced custody services, the custody service provider should keep the clients’ funds in a separate account and in trust with him.
“When customer funds are kept with a third party, it is important that the funds be defined and presented to the outsourced service provider as customer funds that are managed in trust by the financial services provider,” notes Barkat.
Section 9 of the draft circular specifically deals with the custody of crypto-currencies and states: “The custody of virtual currencies exposes the custodian to operational risks at a higher level than that which exists in the custody of non-virtual assets. For example, virtual assets are more exposed to cyber attacks that have actually occurred and resulted in the loss of assets on a significant scale and other failures that characterize the activity in the digital space. There is also a fear of increased exposure to the event of embezzlement of the client’s assets or treatment that does not suit the client’s wishes, and this is partly in light of the fact that this is a field of activity with relatively young regulation and without sufficiently entrenched mechanisms to protect the client’s assets The customers. In addition, keeping virtual currencies involves additional characteristics that differ from keeping other financial assets.”
Due to the increased risk involved in keeping virtual currencies, additional instructions have been established for the custodian of this type of assets, and this goes beyond the general instructions, also regarding the transfer of coins, their technological protection and corporate governance for carrying out operations in them. In addition, rules were established for custody services for outsourced cryptocurrencies, and it was determined that these services can only be provided by entities that can properly safeguard virtual currencies subject to the supervision of the local regulator in the place where they operate.
Additional conditions have been set regarding the experience and ability of entities that can be chosen as outsourced custody service providers for crypto, as well as restrictions on the scope of the virtual assets that the service provider may keep in accordance with the experience it has gained. The circular also enumerates instructions regarding the body’s corporate governance in relation to the management of funds in custody, instructions to prevent cyber attacks, and other operational issues.
In fact, in a practical sense, the circular states that the entities operating in the field of crypto will not be able, at least in the coming years, to carry out custody independently, due to the experience requirements, when the solution is either custody in Israel with an institutional body or bank, or custody by a specialized body abroad.