Blog: Switzerland: Enabling bankruptcy-remote custody of crypto assets – International Financial Law Review

As the interest of institutional
and retail investors in crypto assets such as bitcoin or ether is gaining
further momentum, the regulation of virtual asset service providers providing
custody services for crypto assets (custodial wallet providers) has become a
priority issue for regulators and legislators around the world. While some
jurisdictions have put in place bespoke regulatory frameworks for custodial
wallet providers, other jurisdictions still struggle to determine the right measures
for a risk-based yet innovation-enabling regulation of custodial wallet
providers.

The Swiss Financial Market
Supervisory Authority FINMA, the Swiss watchdog for the financial industry at
large, pursues a technology-neutral ‘same risks, same rules’ approach and
applies its existing regulatory framework based on the activities pursued by a custodial
wallet provider. The Swiss legislator is supportive of this approach and is
ready to amend existing rules in order to ensure a robust legal framework for
crypto assets and other fintech developments.

Customer protection: a growing international concern

A growing concern for national
and international regulators and legislators is the protection of holders of crypto
assets in the insolvency of a custodial wallet provider. As custodial wallet
providers often do not require a banking or securities firm license in order to
offer custody services for crypto assets, customers of custodial wallet
providers lack the protection conferred by regulatory capital requirements, bank
depositor protection schemes and other rules ensuring the preferential
treatment of customers in the insolvency proceedings of a bank or securities
firm.

Policymakers therefore
increasingly call for adequate customer protection measures in the crypto
space, including e.g. by requiring custodial wallet providers to publish
unambiguous risk disclosures to promote transparency for customers or by
ensuring that customer assets are held in a bankruptcy-remote manner protected
from claims of other creditors of the custodial wallet provider.

Against this background,
Switzerland is set to introduce an amendment of its insolvency laws which will enable
the segregation of ‘crypto-based’ customer assets in the event of a bankruptcy
of a custodial wallet provider. The amendment is part of a larger revision of
Swiss law aimed at further enhancing the legal and regulatory environment for
DLT-based projects in Switzerland. While some of the revisions have already
been enacted in the beginning of the year, the segregation rules are expected
to enter into force as of August 1 2021.

Segregation rules: applicability

The new segregation rules do not
distinguish between different categories of crypto-based assets and apply in
our view with regard to all types of tokens irrespective of their qualification
as a payment token, asset token, utility token or a hybrid form of these tokens.
However, in order to qualify as a ‘crypto-based’ asset, access to the tokens
must be conveyed through a cryptographic protocol.

Furthermore, the custodial wallet
provider must hold on behalf of its customers all cryptographic keys that are necessary
to access and dispose of the relevant tokens on the distributed ledger. If the customer
independently holds some or all of the cryptographic keys that are necessary to
access the tokens (for example as part of a multi-signature address), the tokens
in question will usually not form part of the custodial wallet provider’s
bankruptcy estate, in which case the segregation rules are redundant. However,
the customer will still be entitled to claim the cryptographic keys that are held
by the (bankrupt) custodial wallet provider.

Individual vs omnibus custody

Custodial wallet providers either
hold their customers’ tokens in individual addresses on a distributed ledger or
operate under an omnibus structure, meaning that customers’ tokens are held collectively
in one or several omnibus addresses on the distributed ledger.

In order for the segregation
rules to apply, the custodial wallet provider must be able to allocate the
tokens held on-chain to each of its customers individually or at least be able
to determine the proportional entitlement of each of its customers to the
tokens held in an omnibus address. It is sufficient if the customer-by-customer
allocation is established at the internal books and records level of the
custodial wallet provider rather than on-chain.

Irrespective of the custody
structure used, the custodial wallet provider is required to keep the tokens available
for its customers at any time and may not carry out proprietary or own-account
transactions with customer assets. The custodial wallet provider is accordingly
precluded from engaging in lending and similar commercial activities with the
assets of its customers in order to ensure the customer privilege stemming from
the segregation rules.

Committed to responsible innovation

With the implementation of the new
segregation rules for custodial wallet providers, Switzerland proves once again
that it is committed to be at the forefront of responsible innovation in the
DLT space.

The new rules are expected to
further strengthen Switzerland’s position as a leading hub for DLT projects as
they will enable Swiss-based custodial wallet providers to offer their
customers a bankruptcy-remote custody of crypto assets, albeit at the cost of refraining
from certain commercial activities.

Eric Stupp

Partner, Bär & Karrer

Gadi Winter

Associate, Bär & Karrer

© 2021 Euromoney Institutional Investor PLC. For help please see our FAQs.

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