SEC Seeks Input on Advisors' Custody of Digital Assets
Issues have been raised about the regulatory status of advisors' custodial trading practices involving certain assets.
The Securities and Exchange Commission’s Division of Investment Management is soliciting input on custody of digital assets by registered investment advisors.
For custody purposes, are digital assets “funds,” “securities” or neither? notes Nicolas Morgan, partner at Paul Hastings in Los Angeles.
As the IM Division notes in a notice published Tuesday, in February 2017, IM issued Guidance Update 2017-01, which discussed the custody rule under the Investment Advisers Act of 1940.
Following that guidance, investment advisors and other market participants raised issues regarding the regulatory status of investment advisor and custodial trading practices that are not processed or settled on a delivery versus payment, or non-DVP, basis.
IM staff said Tuesday that it welcomes engagement from advisors, other market participants and the public on these issues, as well as on questions regarding the application of the Custody Rule to digital assets, and whether revisions to the Custody Rule could be helpful in addressing the issues cited in the notice.
To further inform IM’s consideration of how characteristics of digital assets impact the application of the Custody Rule, the staff said that it would like further input on such questions as the challenges investment advisors face in complying with the Custody Rule with respect to digital assets.
The Custody Rule, as IM explains, is “a key investor protection” under the Advisers Act.
When investment advisors have “custody,” or access to client funds or securities, there is an increased risk of misappropriation or misuse of these assets.
The notice also points out that amendments to the Custody Rule are on the commission’s long-term unified agenda.
To inform future steps “and in light of growth in the variety and complexity of the types of securities and other assets commonly utilized” by RIAs that settle on a non-DVP basis, the staff, through the Division’s Analytics Office, has launched an initiative to gather information on non-DVP practices, IM states.
Morgan told ThinkAdvisor on Wednesday that the initiative “appears to be part of a thoughtful, deliberate approach by all divisions within the SEC on this topic: ask questions and learn about the space before storming ahead.”
IM staff said that it seeks input from all interested parties on the following questions, and plans to use what it learns in any future regulatory recommendations to the commission:
- What types of instruments trade on a non-DVP basis? How do these instruments trade?
- Describe the risks of misappropriation or loss associated with various types of non-DVP trading. What controls do investment advisors have in place to address the risks of misappropriation related to such trading? What types of independent checks, other than a surprise examination, do investment advisors use currently to test these controls?
- Are there particular types of securities transactions settled on a non-DVP basis that present greater or lesser risk of misappropriation or loss?
- What role do custodians play in the settlement process of non-DVP trading? What role do they play in mitigating risks of misappropriation or loss arising from such trading?
- For advisers who currently obtain surprise exams, what is the marginal cost of adding accounts that trade on a non-DVP basis to the list of client accounts provided to the accountant performing the surprise examination of a sample of client accounts?
- What challenges do investment advisors have in obtaining surprise exams regarding non-DVP traded securities? How do advisers to unaudited private funds that are subject to surprise examinations address these challenges?
- Are there types of external checks that could be more effective and less costly than surprise examinations with respect to non-DVP traded securities?
- To what extent do non-DVP assets appear on client account statements from qualified custodians? To what extent does an investment adviser have any influence over, or input into whether and how such assets appear on account statements? Are there any assets that trade on a non-DVP basis that would not appear on a qualified custodian’s account statements?
- To what extent could evolving technologies, such as blockchain/distributed ledger technology (“DLT”), provide enhanced or diminished client protection in the context of non-DVP trading?