Compliance for Digital Assets

2/1/2022

One year ago, my topic was “Cryptoassets and Advisors,” which gave an overall look at the investment space and how advisors might begin to think about allocating client funds to digital assets. This article expands on the regulatory requirements for advising clients on digital assets.

For those of you who hold fiduciary certifications or are registered as RIAs, it is becoming a fiduciary responsibility to understand digital assets and be able to determine if they are appropriate in client portfolios. Onramp Invest has produced a 55-page review of how cryptoassets might be incorporated into the CFP® Curriculum (report can be requested here: https://onrampinvest.com/cfp-professional-conduct-and-regulation/).

With that in mind, an understanding of the compliance requirements is also necessary.  The SEC issued two documents during 2021 addressing digital assets. An SEC Risk Alert dated 2/26/21 (https://www.sec.gov/files/digital-assets-risk-alert.pdf) identified 6 categories of risk on which they intend to focus:

• Portfolio Management, including due diligence, evaluation and management of specified risks associated with digital assets, and fiduciary duty.
• Books and Records, to include records of trading activity.
• Custody, which covers controls around safekeeping, business continuity plans, software, and security around software and digital platforms.
• Disclosures, including marketing materials and regulatory brochures and supplements, with a focus on the specific risks associated with digital assets.
• Pricing client portfolios, which looks at valuation methodologies as well as fee calculations.
• Registration issues, which considers AUM calculations and how digital assets are characterized in pooled vehicles and private funds.

Their 2021 Examination Priorities were released on 3/3/21, also selecting 6 areas of focus, but slightly differently. Keystone Compliance Consulting (info@keystonecomplianceconsulting.com) summarizes the requirements in this document as follows:

To date, there is very little clarity around how digital assets will evolve in the future. What we do know, is that the SEC Division of Examinations’ 2021 Examination Priorities calls out digital assets, specifically, as an area of focus. (https://www.sec.gov/files/2021-exam-priorities.pdf).

The guidance highlights six areas that can be expected to be reviewed in an SEC exam. Compliance professionals should take the following actions to address these areas.

1. Investment Suitability – Document investment suitability for each client, specific to digital assets. For example: Digital assets are/are not suitable for the client because (list reasons).

• Portfolio Management and Trading Practices – Establish policies and procedures specific to how digital assets will fit within portfolio construction and management. Establish when and how the assets will be traded.

• Safety of Client Funds and Assets – Discuss the custody of digital assets in your compliance policies and procedures. Consider what documents would be produced to evidence the custody of the assets.

• Pricing and Valuation – Review your current pricing and valuation policies and procedures. Be sure to incorporate specifics about digital assets.

• Effectiveness of Compliance Programs and Controls – Digital assets should be reflected in the inventory of risks. The policies and procedures established for digital assets should be reviewed, at a minimum annually, for efficacy and completeness as the digital asset space changes.

• Supervision of Employee Outside Business Activities – Review Outside Business Activity policies and procedures and make any amendments needed to include digital asset activities. Services related to digital assets offered by employees, outside of their employment arrangement, should be evaluated. Additionally, these arrangements should be assessed to determine if they qualify as securities activity.

The digital asset world continues to change quickly. In these early days the due diligence required to select legitimate investments and evaluate the requirements listed above is ongoing and can seem overwhelming. Newsletters I have found most informative and actionable to stay up to date on all topics relating to digital assets are from Fidelity Digital Assets (send an email to digitalassets@fmr.com and request research updates) and Galaxy Digital (sign up at https://www.galaxydigital.io/newsletter/). To stay current on SEC requirements, bookmark the SEC examinations page https://www.sec.gov/exams  and check the Priorities Memos and Risk Alerts on a regular basis.