Cryptocurrencies in Your Compliance Program
Investing in cryptocurrencies represents a relatively new alternative investment opportunity to diversify an investment portfolio to many investors. To registered investment advisers, it represents opportunities to offer clients solutions to include cryptocurrency as an investment option. Precisely because investing in cryptocurrency represents an alternative to traditional asset classes advisers must consider offering such products from the business, operations and compliance perspective.
From the business and operations perspective, advisers need to understand the unique characteristics of this asset class and how cryptocurrencies are traded. Like any other investments, prior to investing, it is critical for investment advisers to do their homework first, and conduct product due diligence on the cryptocurrency from an operational perspective by examining a host of supervisory and regulatory issues, including, but not limited to valuation, liquidity, trade execution, recordkeeping, custodial functions, and client know your customer onboarding processes and disclosures. Additionally, in the private fund space, having adequate governing fund document disclosures is of paramount importance.
From the compliance perspective, advisers must consider their fiduciary and regulatory obligations. In designing the firm’s policies and procedures, advisers need to identify conflicts and other compliance factors that create risk exposure for the firm and its clients, and then develop or enhance policies and procedures that address those risks. These topics include portfolio management and consistency of portfolios with client objectives, disclosures, safekeeping of client assets, recordkeeping, valuation, marketing, and privacy, among others. In other words, advisers must consider almost every aspect of compliance program requirements when considering cryptocurrency as an additional portfolio asset option.
The SEC’s Division of Examinations issued a Risk Alert in February 2021 entitled “The Division of Examinations’ Continued Focus on Digital Asset Securities,” which offers guidance related to the offer, sale and trading of digital assets. It is from this guidance that we can identify several areas of focus for a compliance program. The areas of focus generally fall into one of several buckets: policies and procedures pertaining to portfolio management, disclosure to clients, custody, recordkeeping and pricing.
- Portfolio Management Policies and Procedures: Advisers should consider how cryptocurrency managed on behalf of clients are classified; what due diligence should be conducted on the investment vehicles offered and/or service providers supporting the digital asset products; and the portfolio management risks associate with digital assets.
- Disclosures: Regulators expect that investment advisers will provide adequate disclosure to clients about the unique and heightened risks involved with cryptocurrency investing. These can include investment risks and information security risks associated with crypto investing, disclosures of fees, as well as compliance with evolving domestic and international regulations. Related compliance issues include marketing (and the adequacy of marketing disclosures) for such digital assets. In addition, regulatory filings for advisers trading in cryptocurrency will need to be updated accordingly to reflect such changes in services, disclosures, risks, and conflicts.
- Books and Records: Recordkeeping is at the heart of a compliance program and maintaining accurate records pertaining to offering cryptocurrency products and client investments in such products are paramount to documenting an adviser’s actions. Because trading platforms and exchanges for cryptocurrency can differ widely in their trade execution, settlement and reconciliation processes, and reporting capabilities, it is important from a compliance perspective to structure cryptocurrency investing in a manner reasonably designed to capture such trading records and to provide assurances to clients and regulators that best execution was sought and that client holdings are secure and verifiable.
- Custody: Recordkeeping is closely linked with custody rule requirements for the safeguarding of digital wallets and accounts from theft or loss. Advisers should have strong controls around the safekeeping of digital assets, including private keys and other employee access to trading platform accounts. Custody considerations also arise with respect to the storage of assets on trading platform accounts and third-party custodians, and the software used to interact with such platforms. Cryptocurrency trading can be structured by advisers to avoid the adviser being deemed to have custody through the use of a single omnibus account and strong digital key management practices employed by a trusted, third-party custodian. Many custodians offering cryptocurrency safekeeping are state registered trust companies and have implemented strong controls over safekeeping.
- Pricing: Additional compliance issues related to portfolio management include pricing and valuation of digital assets, including the valuation methodologies used and the impact of fee calculations. In addition, consider controls for monitoring the flow of information to ensure that trades are not placed based on material, non-public information (which is applicable not only to transactions in public securities, but also private investments, such Bitcoin and its current status as a non-security) and tax lot tracking for capital gains purposes.
Keep in mind, however, that one of the most challenging aspects of offering cryptocurrency investing to clients is what we don’t know yet. Regulations and regulatory guidance are evolving. While the Digital Assets Risk Alert and statements made by the SEC’s Chairman and other Commissioners on investing in cryptocurrency and other digital assets provide insight into what the regulators are thinking, there are a number of open items that still need to be addressed. Additionally, key participants in this asset class, including investment advisers, broker-dealers, mutual funds, regulators, investors and the growing crypto ecosystem of service providers, will all have a seat at the table and play a key role in moving these developments forward. It is incumbent upon, advisers offering investment opportunities to clients to stay apprised of regulatory developments and revised their compliance controls to address the evolving standards and requirements.
For more information or to speak with a regulatory expert, please email [email protected].
 Division of Examinations Risk Alert, The Division of Examinations’ Continued Focus on Digital Asset Securities, February 26, 2021