The segregation of digital assets is often touted by many but seldom done in practice.
by Edmund Yong
[Back to Part 1]
One of the unmistakable hallmarks of the laws that govern trustees is in the segregation of assets. Since the trustee or custodian acts in a fiduciary capacity for its client, it is only right for the assets of the client to be always kept distinct from the trustee’s own assets, as well as those belonging to the trustee’s other clients.
This could entail keeping the client’s assets in “separate accounts and marked in the books of the trustee as such to distinguish them from any other account in the registers or books kept by the trustee,” so that at no time shall these assets form part of (be ‘mixed’, ‘pooled’ or ‘commingled’) with the general assets of trustee. Furthermore, all transfers made by the trustee for the client shall be properly designated so that they can be readily identified at any time (Section 16 of Trust Companies Act 1949).
You can see almost identical provisions in the Securities Commission’s (SC) Guidelines for Capital Market Service Providers (SC-GL/5-2018 Paras 6.02 and 6.03).
How is segregation of assets currently done?
It is one thing to segregate fiat currencies but quite another for digital assets. When we checked with the Terms & Conditions of the three licensed digital asset exchanges (DAX) in Malaysia, we found that all of them clearly state their practices for fiat (see below).
- Tokenize Customer Agreement – Clause 11.2: “The trust account into which you make a deposit will be a segregated account used exclusively for the purpose of holding and processing Customers’ funds.” 
- Sinegy Terms of Service – Clause 22: “In order to complete a buy order via the Services, you must first deposit Funds to your Account using a Bank Account registered to you.” And Clause 3: “The Company uses custodian banking providers in order to receive Your funds and to make payments.” 
Again, this is for fiat only. None of them however, state how digital assets are being segregated, or whether it is even done at all; though if conventional norms go by, the answer is presumably no. Since Bitcoin and Ether are highly commoditized, the standard practice is for the DAX to just commingle them in an omnibus trading account and/or hot wallet.
Segregation is easier said than done in practice. User accounts are usually kept separate by way of their public keys or addresses. If a DAX decides to segregate assets based on public addresses, it will have to incur a lot of cost and time for transfers from one address to another. It is neither cheap nor convenient and could be downright uncompetitive. And do note that Bitcoin and Ether run on different record-keeping models (the former keeps track of ‘unspent transaction output’ or UTXO, while the latter uses a simpler account balance approach like a debit card), so there will be slightly different procedures involved as well.
Consider these two global market leaders:
Coinbase uses shared blockchain addresses but segregates the digital assets of users by keeping separate accounting entries off-chain. This is without doubt an approach that most DAXes will be familiar with.
- Coinbase User Agreement – Clause 5.18(D) In order to more securely hold customer Digital Currency, the Coinbase Group may use shared blockchain addresses, controlled by a member of the Coinbase Group, to hold Digital Currencies held on behalf of customers and/or held on behalf of Coinbase Europe. Customers’ Digital Currency is segregated from the Coinbase Group’s (including Coinbase Europe’s) own Digital Currency or funds by way of separate ledger accounting entries for customer and Coinbase Group accounts.
Notwithstanding the foregoing, the Coinbase Group shall not have any obligation to use different blockchain addresses to store Digital Currencies owned by you and Digital Currencies owned by other customers or by the Coinbase Group. 
Gemini is the standard-bearer here. When a user opens an account with Gemini, he or she enters into a User Agreement and a Custody Agreement simultaneously. A separate blockchain address is created for the user to segregate assets with clear designation and identification of ownership.
- Gemini Custody Agreement – Custody Account: You agree and understand that we will establish a Custody Account in your name. Your Custody Account will have one or more associated unique Blockchain Addresses in which your Assets will be (i) segregated from any and all other assets held by us and (ii) directly verifiable via the applicable blockchain. We will provide you with all Blockchain Addresses associated with your Custody Account.
The ownership of your Assets will be clearly recorded in our books as belonging to you. Our records will at all times provide for the separate identification of your Assets. We will not loan, hypothecate, pledge, or otherwise encumber any Assets in your Custody Account, absent General Instructions from you. 
Did you create a valid trust relationship?
The topic is not complete without touching this crucial question, though we can only deal with it a reductive way due to article constraints. It is common to see poorly drafted Terms & Conditions with contradictions as to whether a trustor-trustee, bailor-bailee or debtor-creditor relationship is intended. In the landmark case of Quoine Pte Ltd v B2C2 (2020) SGCA(I) 2, the Singapore Court of Appeal overturned a lower court ruling to find that there was no intention to create a trust as there was no segregation of digital assets and the DAX operator Quione’s T&Cs did not state any measures to deposit client’s assets with a trust or custodial bank.
To illustrate the above, here are the actual terms from a licenced DAX in Malaysia which we have anonymised. Some questions arise: If this is a trust, wouldn’t the legal title be held by the trustee (in this case the DAX) rather than the client? And if the title always remains with the client, then the client has ‘full control’ – which means this is not a custodial relationship for the purposes of SC Guidelines (see our previous article Part 1)?
- Unnamed – Clause 10.1: “All Digital Assets held in your Digital Wallet are custodial assets held by (the DAX)”
- Unnamed – Clause 10.2: “Title to your Digital Assets shall at all times remain with you and shall not transfer to (the DAX)”
Upshot is, if you plan to operate as a DAC, the last thing you want is to find that the structure you create is not a trust at all. Often, you’d only find out when legal troubles have started and it’s too late.
[Read Part 3]
 https://www.luno.com/en/legal/terms (accessed on March 1, 2021)
 https://tokenize.exchange/customersa (accessed on March 1, 2021)
 https://marketplace.sinegy.com/terms-of-service#terms_rules (accessed on March 1, 2021)
 https://www.coinbase.com/legal/user_agreement (accessed on March 1, 2021)
 https://www.gemini.com/legal/custody-agreement#section-custody-account (accessed on March 1, 2021)