SEC Proposes Changes to Current Custody Rule
In February 2023, the SEC proposed expansive changes concerning Safeguarding Advisory Client Assets (Safeguarding Proposed Rule), which would amend rules around the custody of client funds or securities. Under Rule 206(4)-2, investment advisers must safeguard client funds and securities in their possession or where they have the authority to obtain control of them. The proposed rules would make broad and significant changes to the current custody rule, enhancing the role of custodians and increasing compliance burdens on advisory firms.
The custody rule was last amended in 2009, the same year cryptocurrency emerged. Jumping back to today, the release of the Safeguarding Proposed Rule arrives just months after the massive collapse of FTX, one of the largest cryptocurrency exchanges in the world. FTX went bankrupt in November 2022, costing investors over $8 billion.
Cryptocurrency and SEC: What Comes Next?
While the fall of FTX is a singular event, it points to a broader concern around cryptocurreny as an asset class and one that the SEC made a note to highlight in the proposal. Cryptocurrency gained popularity due to its unique features—as a digital currency which uses cryptography to secure transactions, it does not rely on a central authority (like banks/governments). While this decentralized and unrestricted model piques the interest of some investors, others argue that a lack of necessary regulations leaves buyers vulnerable to elevated risk, volatility, and financial crime.
With the Safeguarding Proposed Rule, the SEC wants to expand client “funds and securities” to include “other positions held in the client’s account,” which would now include cryptocurrency (and other physical assets like artwork and real estate).
The proposal would also require firms to keep updated and detailed records of client communications and account activity. Specifically, this rule would require companies to create or retain records to document the following information: required client notices, client account identifying information, custodian identifying information, the basis of the adviser’s custody of client assets, all account statements, and any standing letters of authorization.
The Compliance Burden
The increasing interest in cryptocurrencies among regulators and institutional investors raises challenges for compliance. One significant challenge is the need to turn around regulatory changes related to crypto investments quickly. As the regulatory landscape for cryptocurrencies continues to evolve, investment firms must stay up to date with the latest rules and regulations and adjust their compliance processes accordingly. This process can be time-consuming and expensive, particularly for firms with large portfolios.
Moreover, BlackRock selected Coinbase to provide Aladdin clients access to crypto trading and custody via Coinbase Prime, and we can only assume more firms will follow suit. Compliance may need to code and test crypto rules in their Order Management Systems (OMS) shortly, ensuring that their OMS can handle crypto trades, generate crypto-specific reports, and build crypto-restricted lists, among other tasks. Failure to adequately test and implement these features could result in compliance breaches or other errors that could harm clients and damage the firm's reputation.
Tips to Prepare Your OMS for Crypto Trading
Firms that are well-prepared for crypto trading will be better equipped to meet clients' demands for exposure to these assets, which can potentially lead to increased business. While we continue to monitor the Proposed Rule, we can work with you to develop an efficient and adaptable compliance system. Here are some recommendations to consider:
- Collaborate with custodians and technology providers to ensure your OMS is equipped to handle crypto trades and generate crypto-specific reports. Verify that the OMS is integrated with reliable crypto exchanges that comply with applicable laws and regulations.
- Stay informed about regulatory changes in the cryptocurrency space and be prepared to adjust your compliance processes accordingly. Utilize a real-time monitoring system to track changes and communicate updates to relevant stakeholders.
- Develop a comprehensive compliance program that includes regular employee training, monitoring, and testing of compliance controls, and documented procedures for handling crypto trades and investments.
- Implement thorough due diligence processes for crypto investments, including conducting comprehensive risk assessments and implementing enhanced monitoring and reporting requirements for high-risk transactions.
