SEC staff also emphasized that advisors should focus on risks related to trading venues, trade execution and settlement facilities. “Advisors should evaluate and mitigate these trade-related risks, including but not limited to risks in connection with security breaches, fraud, insolvency, market manipulation, the quality of market surveillance, Know Your Customer rules" and money laundering procedures, the attorneys said.
“Last but not least, the staff recommends that investment advisors consider whether their fiduciary obligations have been met with respect to investment advice on digital assets,” the attorneys said.
On the pricing front, the SEC also warned that digital assets may present valuation challenges for investment advisors as a result of market fragmentation, illiquidity, volatility and the potential for manipulation. “Because of these challenges and the fact that evaluation methodologies differ among advisors, the staff expects that advisors will apply a variety of pricing methods when managing digital assets on behalf of clients,” the attorneys said.
Expect SEC examiners to focus on advisors’ disclosures related to advisory fee calculations and the impact that valuation has on advisory fees, the attorneys warned. Examiners focus will also be on advisors’ valuation methodologies, including methodologies disclosed and utilized to determine principal markets for and fair value of digital assets. SEC examiners will also focus on how advisors value digital assets following significant events, the attorneys said.
While advisors can use a variety of media and publications to meet their legal obligations to make legal disclosures to clients “regardless of the medium, the staff indicates in the risk alert that it expects investment advisors to disclose the unique risks associated with digital assets and to focus on the circumstances in which those risks may be heightened,” the Eversheds attorneys said.
SEC staff noted they will focus examinations on disclosure of conflicts of interest and related party transactions, as well as whether advisors have disclosed the complexities and underlying technology of the digital asset.
“The staff will also focus on disclosures related to technical, legal, market and operational risks associated with digital assets, including but not limited to cybersecurity and custody risks. Last, the SEC will focus on disclosures regarding price volatility, illiquidity and valuation methodologies in connection with digital assets,” the attorneys said.