SEC Risk Alert explains the focus of examinations for firms dealing in digital assets

THE SEC YESTERDAY PUBLISHED A RISK ALERT DESIGNED TO HELP FIRMS DEALING IN DIGITAL ASSET SECURITIES UNDERSTAND THE COMMISSION’S FOCUS IN ITS EXAMINATIONS.

The risk alert covers Investment Advisors, Broker-Dealers, National Exchanges and Transfer Agents and highlights key themes that the SEC’s examiners have identified. Firms should review the risk alert and ensure their compliance program meets these supervisory expectations.

This blog provides a summary of the key risk factors that SEC examiners will focus:

Investment Advisors

• Portfolio management

  • Classification of assets: security / non-security

  • Due diligence on assets: does the advisor understand the digital asset, wallets, blockchain; liquidity and volatility of the asset

  • Risks associated with trading venues, execution and settlement

  • Blockchain-specific risks: forks, 51% attacks, air-dropped assets

  • Fulfillment of fiduciary duty

• Books and records

  • “Digital asset trading platforms vary in reliability and consistency with regard to order execution, settlement methods, and post-trade recordation and notification, which an adviser should consider when designing its recordkeeping practices.”

• Custody

  • Unauthorized transactions, including theft of digital assets.

  • Controls around safekeeping of digital assets, esp. private key management.

  • Security of third-party custodians and wallets.

• Disclosures

  • How advisors explain to investors the unique risks associates with digital assets and risks heightened by the digital nature of these assets.

• Pricing client portfolios

  • Focus on valuation methodologies (considering market fragmentation, illiquidity, volatility and the potential for manipulation) and advisory fee calculations.

• Registration issues

  • Focus on how the investment adviser calculates its regulatory assets under management, and characterizes the digital assets in the pooled vehicles it manages and the status of clients.

Broker-Dealers

• Safekeeping of funds and operations

  • Focus on how the broker-dealer’s operation ensure the safety of funds, with a particular emphasis on aspects unique to the custody of digital assets.

• Registration requirements

  • Ensuring the registration of affiliated entities which effect transactions in digital asset securities.

• Anti-Money Laundering (AML)

  • Particular focus on the unique AML challenges arising from the pseudonymous nature of blockchains and how broker-dealers are ensuring effective customer due diligence, implementing OFAC sanctions lists and filing suspicious activity reports.

• Offerings

  • Review of due diligence performed by broker-dealers in respect of underwriting and private placement activity.

• Conflicts of interest

  • Focus on the management of conflicts of interest where broker-dealers act in multiple capacities, including across multiple platforms.

• Outside Business Activities

  • Ensuring that broker-dealers exercise effective control over their staff’s outside business interests.

National Securities Exchanges

• Ensuring that blockchain based trading platform register as exchanges or alternative trading systems (ATSs) and operate in compliance with the Exchange Act or Regulation ATS as appropriate.

Transfer Agents

• Compliance with Transfer Agent rules, including the requirement to register with the Commission.

As ever, regulatory guidance like this SEC Risk Alert should only be one consideration when designing an effective compliance program; it is important that firms consider whether their business model presents additional or idiosyncratic risks and implement effective controls for such risks.

Braithwate has extensive experience designing pragmatic compliance programs - contact us to discuss how we can help your digital asset business grow in a sustainable and compliant manner.