On January 26, Reuters reported SEC probes into registered investment advisers and their compliance with the custody rule for digital assets. Investment advisers should be ready to respond to any SEC inquiry and take the opportunity to review their own processes and disclosures such as, among other things:

1. Due diligence processes for selecting custodians;

2. Disclosure of counterparty, bankruptcy remoteness and other digital asset risks; and

3. Any arrangements likely to result in scrutiny, such as the use of platforms not ordinarily accessible by U.S. persons.

Gavin Fearey, a member of Winstead’s Investment Management and Private Fund industry group, commented: 

“Investment advisers with digital asset exposure have every incentive to examine their own due diligence and compliance processes, and their disclosures, to see whether they are ready to withstand the scrutiny of regulators following market shocks and counterparty failures like FTX and Celsius.  If there was ever any doubt, it is no longer difficult to justify allocating sufficient resources and paying close attention to counterparty risk, bankruptcy remoteness, internal controls, compliance and other preparations, all of which are proving essential.”

Mr. Fearey was principal contributor, with colleagues from the Wall Street Blockchain Alliance (“WSBA”), in a recent letter to the SEC’s Division of Investment Management discussing these very issues. The WSBA letter has a detailed appendix containing many questions that investment advisers can consider when evaluating potential digital asset custodians (available here and cited by CoinTelegraph).

A first step for investment advisers, or anyone else evaluating digital asset custodians, is to make sure they ask questions like those in the appendix of the WSBA’s letter. Gavin elaborated:

“Whilst more regulatory guidance is sure to follow recent events, a risk alert from the SEC’s Division of Examination also guides investment advisers on the custody rule and other topics to focus on in the specific context of digital asset securities [available here and discussed by Winstead here]. From there, the next step is to engage with lawyers, compliance consultants and other subject matter experts in digital assets to build out existing infrastructure and disclosures on digital assets and digital asset service providers.”