On February 26, 2021, the Division of Examinations (Division) of the US Securities and Exchange Commission (SEC) published a Risk Alert that provides guidance on the Division’s observations related to Digital Asset Securities and areas on which the Division will focus in future examinations.
The Risk Alert reminds investment managers, broker-dealers, national securities exchanges, and transfer agents that although there are risks and features unique to digital assets that are securities (Digital Asset Securities) and the distributed ledger technology used by the digital assets themselves, existing rules apply. Market participants should ensure compliance practices are enhanced to meet the challenges presented by these products.
The Division included many of these focus areas in its 2021 Exam Priorities.
Summary of the Risk Alert
The Risk Alert puts market participants on notice of specific issues the Division observed in relation to Digital Asset Securities. The publication identifies issues familiar to market participants such as registration, disclosure, anti-money laundering, pricing, safekeeping, reporting, and record keeping, and describes how the Division sees these themes are presenting in the digital asset realm.
- Portfolio Management
The notice does not provide guidance or otherwise define when a digital asset must be considered a security but indicates that an adviser needs procedures to classify how digital assets are treated in client portfolios. The SEC guidance linked to the Risk Alert provides a specific framework portfolio managers can use to determine whether a digital asset may be considered an investment contract and therefore treated as a security under federal law. In addition to understanding the classification of the digital asset, the Investment Adviser is expected to understand the risks related to the underlying technology used to create, hold, or transfer the asset, and trading venues, including execution and settlement mechanisms. Procedures should identify and manage liquidity and volatility risks associated with the digital assets in the portfolio, and the impact of a “fork” on the ledger or an “airdropping” event. Lastly, in line with its fiduciary responsibility, the Investment Adviser should ensure that, given the risks associated with Digital Asset Securities, whether such investments are suitable for a particular client.
- Books and Records
Investment Advisers should enhance record-keeping processes and procedures to consider specifics of the particular digital asset’s trading platform, which may differ from traditional trading venues.
The Division will review compliance with SEC’s custody rule where it applies and consider controls in place to protect digital assets. Investment Advisers should ensure appropriate controls are including access to platforms or private keys and security on wallets, instances of unauthorized access or theft and procedures followed in such cases, and protocols governing software used to connect to digital asset networks. Additionally, Division staff will consider the handling of storage on third party custodian or trading venues.
Investment Advisers should detail the specific risks identified as it understands the digital asset and the underlying technology that supports it, and include the method used to value the security. Like all disclosure requirements, in addition to valuation and technology, disclosures should include relevant legal, market and operational risks.
- Pricing of Client Portfolios
Investment Advisers should clearly articulate the method used to value Digital Asset Securities including the impact of forking or airdropping events, and how valuation affects the adviser’s fees.
- Registration Issues
In addition to documenting how the Investment Adviser classifies digital assets in pooled vehicles it manages, the adviser should also clarify how it determines client status, any exemptions from registration, and how it calculates assets under management.
- Safekeeping of Funds and Operations
Broker-dealers should ensure that operational processes, procedures, and controls consider safekeeping of Digital Asset Securities. The broker-dealer’s exam management team should be prepared to clearly explain the operational activities related to Digital Asset Securities with Division staff, and enhancements or accommodations made to control for the specific risks germane to these assets.
- Registration Requirements
Broker-dealers should ensure that any affiliates established to process client transactions in Digital Asset Securities are registered as broker-dealers, where required pursuant to the Securities Exchange Act of 1934.
- Anti-Money Laundering
Anti-money laundering (AML) obligations remain a priority for the Division. Broker-dealers must update both AML and Sanctions Programs to adapt to new products, markets, and business operations, including application of the program elements to the handling and offering of Digital Asset Securities. Specifically, broker-dealers should consider how sanctions screening applies to transactions effected through distributed ledger technology.
Broker-dealers should clearly document due diligence and disclosures related to underwriting of Digital Asset Securities.
- Disclosure of Conflicts of Interest
Broker-dealers should identify any conflicts of interest in disclosures and design policies and procedures to manage any such conflicts, specifically if the broker-dealer may be operating in more than one capacity when handling Digital Asset Securities.
- Outside Business Activities
Financial Industry Regulatory Authority (FINRA)-regulated broker-dealers should ensure that processes and procedures are appropriately requiring disclosure, approval, and monitoring of outside business activities or private securities transactions related to digital assets.
In addition to the Division, FINRA has included outside business activities and investments related to digital assets as a 2021 exam priority.
National Securities Exchanges
- Exchange Registration
Operators of any facility that is used to trade Digital Asset Securities should ensure they analyze whether such a trading venue meets the requirements for registration as a national securities exchange.
- Compliance with Regulation ATS
If an alternative trading system (ATS) permits trading of Digital Asset Securities, the ATS should ensure subscriber information is kept confidential and information reported on the Form ATS or ATS-R is accurate and filed timely.
Registered transfer agents servicing Digital Asset Securities should ensure they are processing trades in compliance with transfer agent rules, specifically in cases that involve using distributed ledgers in the trade process.
Market participants should proactively assess their exposure to Digital Asset Securities, both in current operations and any planned strategic changes, and conduct an analysis of the areas of focus the Division has indicated will be scrutinized. The market participant should document the assessment, including rationale for decisions and any action plans for issues identified or areas in need of further scrutiny. Action plans should have appropriate timelines and responsible owners, and senior management should be apprised on progress. The assessment and any corresponding action plans should form the basis of the conversation with Division staff on the topic of the participant’s compliance program with respect to Digital Asset Securities.
How Guidehouse Can Help
Guidehouse can help market participants assess their compliance programs to identify and enhance operations, policies, procedures, controls, and technology as needed. Guidehouse has been at the forefront working with market participants as new products and technologies become increasingly widespread. Its areas of relevant expertise include the following:
- Anti-money laundering
- Strategic planning
- Risk management
- Vendor sourcing and governance
- Executive training
Guidehouse is well-equipped to make an individualized assessment of your unique circumstances and offers innovative advice and solutions for responding to heightened regulatory requirements.