The SEC’s Office of Compliance Inspections and Examinations recently published a risk alert related to investment advisers managing Digital Assets for their clients, either directly or indirectly through pooled investment vehicles. The risk alert makes it clear that digital assets create a number of unique compliance challenges that firms should consider.
Based upon risks identified in recent examinations, future examinations will focus on regulatory compliance associated with:
- Portfolio Management – A review of policies, procedures and practices with a focus on: (i) whether digital assets are appropriately classified as securities; (ii) due diligence on the adviser’s knowledge of the particular digital assets, wallets, and other software or devices; (iii) evaluation and mitigation of risks related to trading ventures, trade execution or settlement facilities; (iv) management of risks and complexities with “forked” or “airdropped” digital assets; and (v) fulfillment of fiduciary duty with respect to investment advice.
- Books and Records. The SEC will review the adviser’s books and records related to digital assets. The SEC noted that “digital asset trading platforms vary in reliability and consistency with regard to order execution, settlement methods, and post-trade recordation and notification, which an adviser should consider when designing its recordkeeping practices.
- Custody. Examine compliance with custody rule. The SEC noted that it will review, among other things, “occurrences of unauthorized transactions, controls around safekeeping of digital assets; business continuity plans where key personnel have exclusive access to private keys, reliability of software, and security procedures related to software and hardware wallets.”
- Disclosures. The Staff will review the disclosures made to investors with a particular focus on the unique risks associated with digital assets, such as the technical, legal, market and operational risks (including custody and cyber security), price volatility, illiquidity, valuation methodology, related-party transactions, and conflicts of interests.
- Pricing client portfolios. The Staff will review the valuation methodologies used for digital assets, particularly in markets with illiquidity, volatility and the potential for manipulation.
If your firm advises clients with respect to digital assets – a detailed review of the risk alert is a good idea. It can be found here: https://www.sec.gov/files/digital-assets-risk-alert.pdf