Compliance Considerations for RIAs and BDs Trading Digital Asset Securities

WHAT HAPPENED?

Digital assets continue to be a hot topic among regulators as these securities gain momentum in the marketplace. While more comprehensive regulations around these trades are implemented, examiners from the U.S. Securities and Exchange Commission are emphasizing the risks these products pose to firms and investors. In a recent Risk Alert, the Division of Examinations outlines compliance vulnerabilities for registered investment advisers and broker-dealers trading digital assets:

KEY TAKEAWAYS

For investment advisers:

  • Thoughtfully manage portfolios containing digital assets. Best practices in this area include:
    • Reviewing policies and procedures with a focus on how your firm classifies securities as digital assets.
    • Conducting due diligence before executing trades.
    • Determining and mitigating the possible weaknesses of trading technology for these investments.
    • Understanding and evaluating the risks of forked and airdropped investments.
    • Satisfying your fiduciary duty to clients, like deciding whether digital asset investments are in the best interests of investors.
  • Maintain accurate and comprehensive books and records and consider possible inconsistencies that could arise on digital asset trading platforms when designing recordkeeping practices.
  • Remain cognizant of the Custody Rule when trading digital assets. During an exam, Division staff may review your practices around safekeeping, mitigating unauthorized transactions, business continuity plans, software reliability, and data storage with respect to these securities.
  • Make proper disclosures to investors. Exam staff will look at risk disclosures on any advertisements or documentation that could be seen by current or prospective investors. These notices should always include comprehensive information about the risks and complexities associated with digital assets.
  • Establish and follow fair valuation methods for client portfolios containing digital assets. Examiners may review these methods and related disclosures, as well as the impact of valuation practices on fees.
  • Make sure these securities are properly registered. Examiners may evaluate how your firm calculates its assets under management, how it characterizes digital assets, and other related issues.

For broker-dealers:

  • Maintain operations to prioritize safety and custody of digital assets.
  • Meet all registration requirements associated with digital assets, especially among affiliates that may need to register as broker-dealers in order to effect transactions in these securities.
  • Fully integrate any digital assets into your firm’s anti-money laundering program. These securities present unique risks related to money laundering, especially when utilizing distributed ledger technology in trading practices. Your AML program should include controls, procedures, and documentation to identify and address illegal activities associated with these trades.
  • Conduct proper due diligence and make all required disclosures related to digital asset offerings.
  • Disclose any conflicts of interest if your firm provides other products or services, like acting as a trading platform, for example.
  • Monitor potential outside business activities. If your firm’s employees are independently offering digital asset-related services, this activity should be approved, supervised, and recorded by your firm, as appropriate.

WHAT DOES THIS MEAN FOR ME?

If you are an investment adviser or broker-dealer managing or effecting trades in digital assets, your firm may be subject to additional scrutiny by the SEC. In the recently issued 2021 Examination Priorities, the Division listed “FinTech and Innovation Including Digital Assets” as one of their areas of focus this year.

This guidance provided by the Division should be fully integrated into your compliance policies and procedures as soon as possible if you have not already done so. Maintaining comprehensive policies and procedures around digital assets will not only protect your firm from possible regulatory violations, but, most importantly, will help protect your clients and customers from potential harm, loss, and fraud.

As regulators adapt to the changing digital landscape, new rules and regulations are expected to be released. Fairview will keep you up to date with the newest guidance from the SEC, as it become available. In the meantime, reach out to Fairview directly if you have questions about how digital assets fit into your compliance program.

About the Author:

Fairview®
Founded in 2005 with the goal of developing streamlined solutions for investment advisers, Fairview® is now servicing investment advisers, foundations, and funds with nearly $300 billion in collective assets.