SEC Division of Examinations Issues Risk Alert on Digital Asset Securities

Practical Law Legal Update w-029-9744 (Approx. 6 pages)

SEC Division of Examinations Issues Risk Alert on Digital Asset Securities

by Practical Law Corporate & Securities

Investment Advisers

Based on the risks identified during examinations of investment advisers managing digital asset securities, future examinations will focus on regulatory compliance associated with:

Portfolio management. The Division will review policies, procedures, and practices of investment advisers who invest client assets in digital asset securities, particularly focusing on:
- the classification of digital assets managed on behalf of clients;
- that the investment adviser has conducted due diligence, and understands the digital asset, wallets, any other device or software used to interact with a particular digital asset network or application, and the relevant liquidity and volatility of the digital asset;
- evaluation and mitigation of risks related to trading venues and trade execution or settlement facilities;
- management of risks and complexities associated with "forked" or "airdropped" digital assets; and
- fulfillment of fiduciary duties with respect to investment advice across all client types.
Books and records. The Division will review whether investment advisers are making and keeping accurate books and records. The Division notes that digital asset trading platforms vary in reliability regarding order execution, settlement methods, and post-trade recordation and notification, which should be taken into consideration when developing recordkeeping practices.
Custody. The Division will look at the risks and practices related to the custody of digital assets by investment advisers and examine for compliance with Rule 206(4)-2 under the Advisers Act (Custody Rule). Regardless of how digital assets are stored, the Division will review:
- occurrences of unauthorized transactions, including theft of digital assets;
- controls around safekeeping of digital assets, such as employee access to private keys and trading platform accounts;
- business continuity plans where key personnel have exclusive access to private keys;
- how the investment adviser evaluates harm due to the loss of private keys;
- the reliability of software used to interact with relevant digital asset networks;
- storage of digital assets on trading platform accounts and with third-party custodians; and
- security procedures related to software and hardware wallets.
Disclosures. The Division will review disclosures made to investors regarding the unique or heightened risks associated with digital assets. In particular, the Division will assess disclosure regarding specific risks, including:
- the complexities of the products and technology underlying such assets;
- technical, legal, market, and operational risks (including custody and cybersecurity);
- price volatility;
- illiquidity;
- valuation methodology;
- advisory fee calculations and the impact valuation practices have on such fees;
- related-party transactions; and
- conflicts of interest.
Pricing client portfolios. The Division notes valuation challenges investment advisers may face due to market fragmentation, illiquidity, volatility, and the potential for manipulation. Examinations will include a review of the valuation methodologies utilized to determine principal markets, fair value, valuation after significant events, and recognition of forked and airdropped digital assets.
Registration issues. Examinations will include a review of compliance matters related to appropriate registration, including, among other things, understanding how the investment adviser calculates its regulatory assets under management.

For more information on the regulation of investment advisers, see Practice Note, Investment Adviser Regulation: Overview.

Broker-Dealers

Future examinations of broker-dealers will focus on regulatory compliance associated with, among other things:

Safekeeping of funds and operations. The Division will examine broker-dealers to understand operational activities, including operations unique to the safety and custody of digital asset securities.
Registration requirements. Examinations will include compliance with registration requirements of broker-dealers and any affiliated entities. For more information broker-dealer registration requirements, see Practice Note, Broker-Dealer Registration: Overview.
Anti-money laundering. The Division notes it has observed:
- broker-dealer anti-money laundering (AML) programs have not consistently addressed or implemented routine searches, or not updated those searches, to check against the Specially Designated Nationals list maintained by OFAC at the US Department of Treasury; and
- inadequate AML procedures, controls, and documentation regarding digital asset securities.
Future examinations will continue to examine broker-dealer compliance with AML obligations, such as filing suspicious activity reports and performing customer due diligence. For more information on AML compliance program requirements, see Practice Note, Broker-Dealer Anti-Money Laundering Program: Overview.
Offerings. Examinations will include a review of the due diligence performed by broker-dealers and the disclosures made by broker-dealers to customers related to an offering of digital asset securities.
Disclosure of conflicts of interest. The Division will review the existence and disclosures of conflicts of interest, and the compliance policies and procedures to address them.
Outside business activities. The Division will continue to review FINRA-member broker-dealer compliance processes in connection with the evaluation, approval, and monitoring of outside business activities.

National Securities Exchanges

For national securities exchanges, the Division will:

Examine platforms facilitating trades in digital asset securities and review whether they meet the definition of an exchange, as defined under Section 3(a)(1) of the Exchange Act.
Review whether an alternative trading system (ATS) that trades in digital asset securities is operating in compliance with Regulation ATS.

Transfer Agents

The Division's examinations of registered transfer agents will include a review of whether transfer agents servicing digital asset securities are operating in compliance with SEC rules intended to facilitate prompt and accurate clearance and settlement of securities transactions.

For more Practical Law resources on blockchain and digital asset-related topics, see Blockchain Toolkit.

SEC Division of Examinations Issues Risk Alert on Digital Asset Securities | Practical Law