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 SEC “Safeguarding Proposal” looks dangerous

ISDA is in the process of responding to a request for comments on the SEC’s proposed “Safeguarding Rule for Investment Advisers (the “Safeguarding Rule”). The regulator seeks to amend the 60 years old Rule 206(4)-2 of the Advisers Act 1940, redesignating it as a new rule 223-1 under the same Act (the “Custody Rule”). Aimed squarely at crypto assets and their (often lack of) custodial arrangements, the new rule would have broad consequences across all asset classes. In summary, the Safeguarding Rule extends the protection offered to a client’s funds and securities by the Custody Rule to all assets over which an investment adviser has discretionary authority. If adopted, the Safeguarding Rule would be phased-in, compliance within one year for advisers with more than $1 bn. in regulatory assets under management and 18 months for advisers with less than $1 billion. Adoption seems likely, the Commissioners passed the Proposal 4 to 1, and the SEC does not have a record for backtracking. If adopted, the Safeguarding Rule will increase costs for SEC-registered investment advisers and custodians. Even if not adopted in its current form, the proposal contains interpretations of the existing Custody Rule that expose advisors to the risk of non-compliance.

Expansion of “Client Assets”

The existing Custody Rule is confined in its application to “client funds or securities”. The proposed Safeguarding Rule (the Proposal) amends the definition of client assets to include “funds, securities or other positions held in the client’s account”. This open-ended, and intentionally evergreen, definition will comprise the following asset classes: cryptocurrencies and other digital assets, precious metals, physical commodities, real estate, cash deposits, artwork, contracts held for investment purposes and collateral posted in connection with swaps. The definition will also include “other positions” which are not explicitly recorded as “assets” such as written options, short sales and balance sheet liabilities. At least some of these assets i.e. physical commodities are at best inimical to traditional custody arrangements.

Expansion of “Custody”

The Proposal widens the definition of “custody” to explicitly include an Adviser’s discretionary authority to trade client assets i.e. “authority to decide which assets to purchase and sell for the client.” The consequence is that any Adviser who has discretionary authority over client assets will be subject to the new safeguarding rule in respect of those assets. There is a limited exception if the discretionary authority is limited to transactions in assets that only settle on a delivery versus payment (DVP) basis. The effect is that discretionary authority would explicitly become custody. The Proposal states that this may already be the case, that any “authorized trading” for transactions other than those that settle on a DVP basis falls within the current definition of custody. While the SEC staff had suggested this interpretation in 2017, it was never officially adopted by the Commission and remained uncertain. The inclusion of this interpretation in a new proposal will surprise industry observers, and may force a re-evaluation of existing practices, irrespective of the Proposal’s final form.

Additional Qualifications for Custodians

The Proposal maintains the definition of “qualified custodian” (QC), including registered broker-dealers, regulated banks and savings associations, registered futures commission merchants, and certain foreign financial institutions (FFI). However, it imposes additional requirements on banks, savings associations, and FFIs to qualify as “qualified custodians.” Banks and savings associations are required to hold client assets in an account that protects them from the bank’s creditors in case of insolvency or failure. FFIs must meet seven new requirements to be considered “qualified custodians”:

  • Can have a judgment enforced against it by the Adviser and the SEC.
  • Is subject to oversight by a foreign government or financial regulatory authorities.
  • Is required to segregate customer assets.
  • Is subject to AML regulations similar to those under the Bank Secrecy Act.
  • Has the requisite financial strength to provide due care for client assets.
  • Is required to implement practices, procedures and internal controls designed to ensure the exercise of due care with respect to the safe-keeping of client assets.
  • Is not operated for the purpose of evading the Safeguarding Rule.

Additional Possession or Control requirement

Under the Safeguarding Rule, a QC would be required to have “possession or control” over all client assets, except for certain exceptions. “Possession or control” would mean that the custodian holds assets in a way that requires its participation in any change in ownership, its involvement would enable the transaction to take place, and its involvement is a prerequisite for the change in ownership to occur. This requirement aims to prevent unauthorized transfers and loss of client assets, as custodians would only report on holdings that they have in their possession or control. Reporting of assets for which the custodian does not accept custodial liability, also known as “accommodation reporting,” would not meet the possession or control standard.

This requirement appears to target crypto and digital assets, for which it can be challenging for custodians to demonstrate possession or control. The Proposal acknowledges that many digital assets are traded on platforms that settle trades directly, such as crypto exchanges, where investors are required to pre-fund trades by transferring currency and digital assets before executing a trade. The proposal explicitly states that these assets fall under the purview of the Safeguarding Rule and will not meet the possession or control requirement. Additionally, the Proposal suggests that pre-funded transactions on crypto exchanges do not comply with the current Custody Rule since most exchanges are not “qualified custodians,” and trading on these exchanges means client assets are not held with a qualified custodian. This requirement will also apply to other assets that may not have been considered by the Commission, such as loans or specific derivatives where third parties are responsible for transferring ownership of assets or collecting payments.

 Written Agreement

Advisers must enter into a written agreement with QCs to ensure clients receive standard custodial protections during the period for which the Adviser has custody over a client’s assets. The agreement includes provisions such as the requirement for the QC to provide records to the SEC or an independent public accountant upon request and the obligation to specify an Adviser’s level of authority. Moreover, Advisers must obtain reasonable assurances in writing from the QC that it complies with certain requirements. These requirements include exercising due care, indemnifying the client against losses resulting from the custodian’s negligence, and not subjecting client assets to any right, charge, security interest, lien, or claim in favour of the custodian or its related persons or creditors. These proposed requirements represent a departure from current practices, such as the indemnification standard that subjects custodians to a simple negligence standard rather than a gross negligence standard.

Surprise Examination Modification

The proposed amendments modify the Custody Rule’s surprise examination requirement for advisers who have custody over a client’s assets, subject to certain exceptions. The current rule mandates that advisers must enter into a written agreement with an independent public accountant to undergo an annual surprise examination, with additional requirements that the accountant performs the examination as agreed and submits relevant filings when required. The proposed amendments also require that the advisers reasonably believe that the written agreement has been implemented.

The proposal retains the exception to the surprise examination requirement for limited partnerships and pooled investment vehicles subject to annual audit, while expanding it further to all entities that can have their financial statements audited according to the Safeguarding Rule. The Safeguarding Rule audit provision is similar to that under the Custody Rule, but non-US advisers who don’t prepare their financial statements according to US GAAP must meet certain requirements to rely on the exception.

Enhanced Reporting and Record-keeping

The proposal would amend Form ADV to align advisers’ reporting obligations with the new requirements and improve the accuracy of custody-related data available to the SEC, its staff, and the public. The proposed amendments would also modify Rule 204-2 under the Advisers Act, requiring advisers to keep additional and more detailed records of trade and transaction activity, and position information for client accounts over which advisers have custody.

Potential Problems

In seeking to regulate a relatively small crypto “asset” market, the Proposal over-reaches to include virtually everything over which an advisor may have authority. This includes: OTC swaps, cleared swaps, futures, options, SFTs and commodity transactions. At least in respect of OTC and cleared swaps, these markets cannot be said to be under-regulated. The possession or control rule would act to fundamentally alter the bilateral nature of OTC swap contracts, introducing a third party that requires participation in any change in beneficial ownership of assets. QC’s would have to become a party to each ISDA MA and trade confirmation over which a registered advisor has discretionary authority. In the case of VM, current regulations recognise that the counterparty has a legal title right to the previous day’s mark to market exposure, the proposed involvement of a QC third party is in direct contravention of this principle. The requirement to segregate assets, thereby making them unavailable for rehypothecation, will have significant implications for the prime broker business model.


In summary, the proposed Safeguarding Rule includes some beneficial changes in regard to client protection, but it is also highly complex and will result in inadvertent violations as a consequence. The transition period provided for compliance may not be sufficient, especially for medium- and larger-sized advisers who need to overhaul their custodial arrangements and agreements. In the context of derivatives transactions and associated collateral exchange, the Proposal takes no account of existing regulations and for those relationships affected would mark a radical change from the status quo.

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