On March 12, 2019, the Securities and Exchange Commission’s (“SEC”) Division of Investment Management published a letter addressed to the Investment Adviser Association seeking input from interested parties regarding custody issues related to:
- Investment adviser and custodial trading practices that are not processed or settled on a delivery-versus-payment ("Non-DVP") basis
- Digital assets
Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended (the “Custody Rule”), which serves as a key investor protection control by discouraging the misuse or misappropriation of assets in the “custody” of advisers, states that it is fraudulent, deceptive, or manipulative for an investment adviser to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule.
The Failure to Address Non-DVP Trading Practices
The SEC outlined in the 2003 amended rule release that the Custody Rule does not apply to “authorized trading” taking place on a “delivery versus payment” arrangement.
However, difficulty has arisen because the 2003 amended Custody Rule does not directly address proper practices related to the authorized trading of securities that do not settle on a delivery-versus-payment basis, leading the Division of Investment Management to consider issues regarding Non-DVP trading and other custody issues that have arisen and are not specifically addressed in the Custody Rule.
Questions Surround the Custody of Digital Assets
The recent development and subsequent surge of digital asset trading and investment has created an entirely new set of custody concerns impossible to address in 2003.
As a result, the Division of Investment Management has engaged a number of interested parties to discuss how unique aspects of digital assets affect compliance with the Custody Rule, including:
- The use of DLT (distributed ledger technology) to record ownership
- The use of public and private cryptographic key pairings to transfer digital assets
- The “immutability” of blockchains
- The inability to restore or recover digital assets once lost
- The generally anonymous nature of DLT transactions
- The challenges posed to auditors in examining DLT and digital assets
A list of questions on this topic has been presented in the letter in hopes that information gathered from interested parties will further inform policy surrounding the Custody Rule’s application to the rapidly developing practice of digital asset trading.
Participation and Vigilance Are Strongly Encouraged
First, participation in the shaping of policy is strongly encouraged.
The request for input on custody issues related to both non-DVP trading and digital assets provides firms the opportunity to make their opinions known through the feedback channels made available—see the closing paragraphs of the published letter, available here.
Such efforts could influence regulatory bodies to clarify in a timely manner the many gray areas of policy that lead to missteps and potential enforcement.
Second, many questions and difficulties regarding crypto currencies and digital assets arise as this highly volatile market develops.
It is critical that any firm that is presently trading or moving toward trading on the digital asset market remain current with the frequent regulatory developments, legal precedents, risk alerts, examination priorities, and other communications from the regulatory bodies involved.
Contact Us for Assistance
The consultants at Core Compliance & Legal Services, Inc., possess extensive experience in the investment advisory industry, have a thorough understanding of the complexities surrounding custody, and stay abreast of the latest developments in the digital assets market.
For assistance with any and all of your firm’s related compliance needs, contact us here.