Jay Clayton, chairman of the Securities and Exchange Commission (SEC or Commission), made clear back in December 2017 that his Commission was concerned with the proliferation of crypto-assets. The SEC defines crypto-assets as “crypto-currency (e.g., Bitcoin), initial coin offering (ICO), distributed ledger technology, blockchain and/or any related products and pooled investment vehicles.” Clayton cautioned both retail investors and professional market participants to perform their diligence, including evaluating the securities law implications of transactions, on any investment involving crypto-assets. This interest has recently manifested in an increased focus by the SEC’s examination arm, the Office of Compliance Inspections and Examinations (OCIE), on investment advisers’ and broker-dealers’ activities in crypto-assets.

Earlier this year, the SEC turned its attention to hedge funds focused on investing in cryptocurrencies and initial coin offerings. The Commission’s interest at that time was in two things: valuation and protection of client assets. On valuation, OCIE wanted to know more about the methods these funds used to assign values to crypto-assets in their portfolios. There are also risks unique to crypto-funds when it comes to asset protection. Because digital tokens are often held in “virtual wallets,” they are particularly susceptible to theft by hacking. Certain crypto-funds even received subpoenas from the SEC’s Enforcement Division that demanded information on valuation and protection, as well as conflicts of interest, where fund managers had relationships with, or personal stakes in, ICOs in which their funds were investing.

The SEC recently expanded the scope of its examination to broker-dealers that handle transactions in cryptocurrencies. OCIE examiners have been asking questions about how these service providers are generating fees from their trading and financing activities tied to ICOs. They are also asking questions about the investment advisers for whom broker-dealers are executing some of these trades, and sending examination requests directly to investment advisers, demanding detailed information on their transactions in crypto-assets. This focus on crypto-assets has now spread to the Financial Industry Regulatory Authority, the National Futures Association (NFA) and the Commodity Futures Trading Commission. For example, last month NFA announced that it is going to start requiring additional disclosures from firms engaged in cryptocurrency derivatives trading.

While the SEC under Clayton has made clear that its primary focus is on protecting retail investors, its concerns about fraud in crypto-asset investing have expanded beyond ETFs and mutual funds. Hedge fund managers who invest directly in cryptocurrencies or ICOs, as well as private equity managers who oversee funds invested in companies tied to the crypto-market, should expect a new section in their next OCIE request regarding their involvement with these products. There is no reason to think the Commission’s interest in these assets is going to decrease until there are additional regulations in place to protect investors. Until then, investment advisers and broker-dealers should start bolstering their compliance programs to address the Commission’s concerns regarding crypto-assets.