In its latest risk alert released on February 26, 2021, the Division of Examinations (formerly known as the Office of Compliance Inspections and Examinations) offers its observations regarding digital asset securities after examining investment advisers, broker-dealers and transfer agents.
One of the broad themes noted for investment management firms and advisers is the need to adequately document how prepared you are for specific risks and complexities surrounding digital assets, and how that has informed your decisions in managing digital asset securities for your clients.
The following summarizes the six compliance issues, at the bare minimum, to review closely related to portfolio management, books and records, custody, disclosures, valuation and registration.
>> Read the full alert from the Division of Examinations
1. Portfolio Management
Regarding portfolio management, investment advisers must understand and document the following:
- Classification of digital assets managed on behalf of clients
- Due diligence performed on the digital asset issuer and related service providers
- Risk assessment and mitigation efforts related to trade execution, settlement facilities and custody providers, such as security breaches, fraud, insolvency, market manipulation, the quality of market surveillance, and KYC/AML policies and procedures
- Management of risks and complexities associated with forks and airdrops, such as client account allocation and conflicts of interest
- Fulfillment of fiduciary duty to your advisory clients
The sufficiency of trade records can vary across digital asset trading platforms; however, the recordkeeping requirements of Rule 204-2 still require investment advisers to maintain appropriate records for digital asset activities. You must consider any limitations that might be presented and make necessary adjustments to your procedures to ensure you capture all required trade data.
To date, custody has presented some of the biggest roadblocks for advisers managing digital assets. However, some of the most significant advancements within the digital asset ecosystem in the past year have been made with regard to custody solutions. You have considerably more options, enabling you to choose a custodian with the capabilities to balance both usability and security. The alert advises that regardless of how digital assets are stored, the staff will review:
- Occurrences of unauthorized transactions and theft
- Safekeeping controls, such as access to private keys and trading accounts
- Business continuity plans
- Risk management around loss of private keys
- Reliability of software used to interact with digital asset networks
- Storage of digital assets, including trading accounts and third party custodians
- Security procedures and controls related to software and hardware wallets
Disclosures is one area that offers advisers managing digital assets ample opportunity to excel. You are required to provide clients and prospective clients with a written disclosure document that details the unique risks associated with digital assets, including technical, legal, market, and operational risks as well as price volatility, illiquidity, valuation methodology, related party transactions and conflicts of interest. The staff will also review any disclosures made within marketing materials, fund documents, social media and any other public forum for accuracy, consistency and compliance with regulations.
Despite an active market for digital assets, valuation challenges continue to plague investment advisers. In an examination, the staff will review the valuation methodologies used, including those used to determine principal markets, fair value, valuation after significant events, and recognition of forked and airdropped digital assets.
6. Registration Issues
Investment advisers must be able to demonstrate an understanding of registration requirements as well as that of any pooled investment vehicles they manage. An examination will review compliance matters related to registration, including the calculation of regulatory assets under management, the characterization of digital assets in the pooled investment vehicles (is it a security, commodity, currency or something else?), and the status of its clients.
Digital assets are in high demand and reaching the mainstream. Although there isn’t complete regulatory clarity, it is imperative that investment advisers managing digital asset portfolios understand, interpret and apply the regulations as best as possible. The risk alert is one additional tool that can enhance your knowledge about the minimum required compliance standards and the areas where regulators will focus when it comes to your compliance posture.
Contact Jamie Gasiorowski at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.