The SEC Division of Examinations (the "Division") (formerly known as the Office of Compliance Inspections and Examinations or OCIE) outlined areas of focus concerning digital asset securities for future examinations. The Division highlighted conduct involving digital assets, with different points of emphasis as to different types of regulated entities.
With regard to investment advisers managing digital assets, the Division stated that its examinations will assess regulatory compliance associated with:
- portfolio management, including whether an adviser (i) classifies digital assets as securities, (ii) conducts appropriate due diligence on digital assets including regarding the technology aspects of any product, (iii) evaluates and mitigates risks associated with trading venues and trade execution and settlement facilities, (iv) manages risks relating to "forked" and "airdropped" digital assets and (v) generally complies with its fiduciary obligations;
- books and records, including whether an adviser has considered the reliability and consistency of order execution, settlement methods and post-trade recordation and notification in digital asset trading platforms when designing its recordkeeping procedures;
- custody, including compliance with IAA Rule 206(4)-2 ("Custody of funds or securities of clients by investment advisers") as it relates to (i) the occurrence of unauthorized transactions, (ii) controls regarding the safekeeping of assets, (iii) business continuity plans that provide exclusive private key access to certain personnel, (iv) the adviser's evaluation of harm resulting from the loss of private keys, (v) the reliability of the software that is used to engage with relevant digital asset networks, (vi) digital asset storage on trading platform accounts and with third-party custodians and (vii) software and hardware wallets security procedures;
- disclosures in all types of media intended for investors regarding (i) the complexity of the underlying products and technologies of digital asset securities, (ii) technical, legal, market and operational risks, (iii) price volatility, (iv) illiquidity, (v) valuation methodology, (vi) related-party transactions and (vii) conflicts of interest;
- pricing client portfolios, including valuation methodologies, valuation following significant events and acknowledgment of digital assets that are forked or airdropped, and the effect of valuation on performance fees; and
- registration issues relating, for example, to the completion of Form ADV, including (i) the method of calculation for regulatory assets under management, (ii) the characterization of digital assets in pooled vehicles, (iii) the status of clients and (iv) how private funds determine investment company registration exemption eligibility.
Regarding broker-dealers, the Division reported that examinations will assess regulatory compliance relating to (i) the safekeeping of funds and operations and (ii) compliance of affiliated entities with registration requirements. Further, the Division stated that its examinations will review (i) due diligence in relation to offerings, (ii) broker-dealers' compliance with AML obligations, (iii) the disclosure of conflicts of interest and related policies and procedures and (iv) processes concerning the evaluation, approval and monitoring of outside business activities. The Division also stated that it has observed broker-dealer AML programs that are insufficient.
National Securities Exchanges and Transfer Agents
In relation to the markets for digital assets, the Division explained that it will examine whether (i) platforms facilitating digital asset securities transactions meet the definition of an "exchange" or an "alternative trading system" ("ATS"), and (ii) whether any such ATS has accurate Form ATS and Form ATS-R disclosures and processes to safeguard confidential subscriber trading information.
Additionally, the Division stated that its examinations concerning transfer agents will contain a review of whether agents are in compliance with Section 17A of the Exchange Act.
Commentary Steven Lofchie
As to broker-dealers, it is notable that the SEC just issued a concept release on custody of digital assets by broker-dealers that reflected the SEC's discomfort with broker-dealers custodying digital assets at all. See SEC Requests Comment on Broker-Dealer Custody of "Digital Asset Securities." This statement raises the question of what broker-dealer custodial arrangements of digital assets are permissible.
Commentary Conor Almquist
One point of focus in the risk alert relates to adviser due diligence on digital assets. What level of understanding will advisers be required to have as to particular digital assets? Given the level of technical complexity presented by various digital assets, this could prove to be an extremely challenging question.
Technological complexities of digital assets also may present substantial challenges when designing recordkeeping programs. Advisers should ensure that these unique products are given sufficient scrutiny in order to satisfy recordkeeping requirements.
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