The proposed Enhanced Safeguarding Rule introduces significant changes to how "custody" is defined and interpreted for Registered Investment Advisers (RIAs). Under the current rule, custody already includes any scenario where an adviser has control or authority over client assets, whether physical possession or the ability to direct asset movement. However, the proposed rule expands this definition in several critical ways:
Inclusion of Discretionary Authority: The proposed rule broadens the definition of custody to include scenarios where an adviser has discretionary authority to make decisions regarding client assets, even if they do not physically control those assets. This could include situations where the adviser has the power to direct trades, transfer assets between accounts, or even decide on how assets are allocated without needing direct client authorization for each action.
Under the proposed rule, if an advisory firm has discretionary authority to trade client accounts within a Delivery Versus Payment (DVP) arrangement, it generally would not be considered custody. As long as a qualified custodian is safeguarding the assets and the firm does not have the ability to change beneficial ownership outside of the DVP arrangement, a surprise audit would  not be required.
Some examples of Non-DVP (Not an exhaustive list)
Certain Derivatives or Complex Instruments: Some trades involving derivatives or complex financial instruments might involve delayed or conditional settlement, which wouldn’t qualify as DVP.
Options: Certain options contracts, especially written options, might require the adviser to hold collateral or securities that are not immediately exchanged for payment at the time of execution.
Futures Contracts: These typically involve margin deposits and may not settle on a simultaneous DVP basis. The final cash settlement could occur separately from the contract's execution.
Swaps: Many swap contracts (e.g., interest rate swaps, credit default swaps) involve periodic payments or exchanges of cash flows over time, rather than a one-time, simultaneous exchange of securities and funds.
Â
Forwards: Forward contracts often involve a delay between the trade execution and the actual settlement (e.g., foreign exchange forwards or commodity forwards), with assets potentially not being exchanged simultaneously.
Â
Collateralized Debt Obligations (CDOs) or Other Securitized Products: These complex financial instruments may involve a series of cash flows and settlements over time, which are not typically handled via a standard DVP mechanism.
Private Placements: Securities or investments in privately offered funds or assets that do not have regular or simultaneous settlement processes (e.g., private equity or real estate investments) could also be outside DVP.
Third-Party Arrangements: The rule also considers arrangements where third parties are involved. For example, if an adviser delegates certain functions to a third party but retains some form of authority over how those functions are executed, the adviser may still be deemed to have custody under the proposed rule. This expansion is particularly relevant for advisers who use external managers or sub-advisers but maintain oversight or final decision-making authority.
An advisory firm that uses an external portfolio manager for specific client accounts but retains the authority to approve or reject final trade decisions.
An adviser who delegates account administration to a third-party service provider but has the ability to direct fund transfers or reallocations of assets between accounts.
An adviser that employs a sub-adviser to manage a portion of client assets but maintains the right to override specific trades or investment strategies.
An advisory firm that uses a third-party platform to execute trades but retains control over the timing and size of trades.
Digital and Crypto Assets: Another significant expansion under the proposed rule is the explicit inclusion of digital assets, such as cryptocurrencies. The rule acknowledges the unique challenges and risks associated with safeguarding these assets and requires advisers to implement specific controls to protect them. This broadens the scope of custody to include not just traditional financial assets but also digital and crypto assets that have become increasingly common in client portfolios.
Â
Enhanced Recordkeeping and Reporting: The proposed rule requires more detailed recordkeeping and reporting practices related to custodial arrangements. Advisers must maintain comprehensive records of all actions taken concerning client assets under their custody, including those involving third-party custodians or digital asset platforms.
Â
Authority Over Client Contracts: The rule also expands custody to include situations where an adviser has the authority to amend or modify client contracts, particularly regarding asset management or custodial arrangements. This could apply to advisers who have the power to negotiate or change terms on behalf of clients without needing additional client consent.
Â
Actionable Steps if the rule is finalized as proposed:
Â
Review Custody Arrangements: Evaluate and document how client assets are custodied, ensuring they meet the new requirements, especially in light of expanded discretionary authority.
Update Policies: Modify existing custody policies to cover all asset types, including those managed through third-party arrangements or digital platforms.
Implement Strong Controls: Establish and enforce internal controls for the safeguarding of client assets, particularly in scenarios involving discretionary authority or third-party oversight.
Engage with Custodians: Work closely with custodians to ensure they comply with the SEC’s enhanced safeguarding standards, especially regarding digital and crypto assets.
Educate Clients: Inform clients about how their assets are protected under the new rule, including the implications of expanded custody definitions.
Concerns:
The broadened definition of custody may significantly impact operational practices, particularly for firms that engage in specific discretionary management or utilize third-party service providers. Firms may need to enhance their compliance infrastructure, adopt new technologies, and implement stricter oversight to meet the new requirements. The inclusion of digital assets in the custody definition also raises concerns about the adequacy of existing safeguards and the need for specialized expertise in managing and securing these assets.
If you would like specific compliance education, training, and services to help with your compliance program or project, please contact Coulter Strategic Services.Â
Check out Coulter Strategic Services' growing collection of training resources, including IARCE. Visit today and stay tuned for new training resources.
All information provided is for educational purposes and shall not be construed as specific advice. The information does not reflect the view of any regulatory body, State or Federal Agency or Association. All efforts have been made to report true and accurate information. However, the information could become materially inaccurate without warning. Not all information from third-party sources can be thoroughly vetted. Coulter Strategic Services and its staff do NOT provide legal opinions or legal recommendations. Nothing in this material should be considered as legal advice or opinion.Â
Comments