SEC seeks to ease advisors' custody burdens with discretionary trading

Key insight: The SEC wants to prevent RIAs from falling under onerous custody requirements when they exercise their discretionary authority to trade client assets while also providing a self-custody option for client assets.

Supporting data: Discretionary trading dominates the wealth management industry, accounting for $117.57 trillion of the $128.96 trillion in total assets managed by advisors.

Expert quote: "This is a net positive for both the regulated financial services industry, the investors they serve and the qualified custodians like Prometheum Capital that make it possible to hold crypto assets with the same protections investors already expect from their brokerage accounts." — Aaron Kaplan, founder and CEO of Prometheum Inc.

A new SEC proposal is meant to relieve RIAs from certain possibly onerous custody requirements when they've been entrusted to trade securities on clients' behalf.

Among other things, the rule would:

• Specify that advisors don't come under custody requirements when they use their discretionary authority to trade client assets, as long as they meet certain conditions;
• Allow advisors to act as self-custodians of cryptocurrencies and other digital assets when they can't find an outside broker-dealer to enlist for that purpose; and
• Prevent advisors from being subject to surprise examinations from outside accounting firms when they've been authorized to use client assets for payments on mortgages and other recurring bills

The Securities and Exchange Commission on Thursday released a 760-page proposal aimed at revising various aspects of its custody rule requiring registered advisors to hold clients' stocks, bonds and other assets at brokerages or banks for safekeeping. SEC Commissioner Paul Atkins noted in a statement on the proposed changes that it's been decades since custody rules last underwent revision.

"Therefore, this proposal seeks to ensure that they are fit for purpose and better address current industry practices and feedback," he said.

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Discretionary trading wouldn't trigger heavy custody requirements

For many RIAs, the biggest change relates to discretionary trading — or the authority many advisors are granted by clients to make trades without having to obtain approval for each individual one. The SEC stirred anxieties about discretionary trading in 2023 when it put forward a now-abandoned proposal that would have subjected advisors to new requirements when they placed trades on client assets custodied at outside broker-dealers.

The rule would have required RIAs to enter into written agreements with custodians specifying that records on investor assets be attainable on request and that clients' assets would be protected against creditors should the custodian go bankrupt. Many in the industry complained the requirement would necessitate redrafting thousands of contracts. RIAs with discretionary trading authority could have also been subjected to surprise exams by outside accountants.

The SEC's new rule is intended to provide relief from all of that, provided RIAs meet three conditions. Advisors with discretionary authority would not come under custody requirements as long as they have authority to trade or move assets into clients' accounts and not into their own or to those of a person related to their firm. Advisors could move assets into accounts that are not the clients only if specifically directed to.

The SEC has said that RIAs exercise discretionary authority over the vast majority of assets in their industry. In 2023, it reported that about $117.57 trillion of the $128.96 trillion in assets advisors had been managing as of the previous June were in discretionary accounts.  

Richard Chen, the founder of Brightstar Law Group in New York, said he thinks the new rules for discretionary trading and other proposals put forward by the SEC will be "a net positive, although advisors still need to be aware of the conditions around any relief."

READ MORE: Vanguard's Altruist purchase could break open RIA custody market

Advisors wouldn't have to worry about surprise exams

A separate provision of the SEC's new proposal would similarly prevent advisors from custody requirements if they've been instructed by a standing letter of authorization to use client assets to make mortgage payments or pay other recurring bills. An SEC staff letter from 2017 provides informal guidance stating advisors with standing letters of authorization aren't subject to surprise examinations by outside accounting firms'

The SEC's new proposal would codify that exemption, provided that clients specify in writing whom they want their payments going to and don't give their advisors any authority to alter the recipient or other payment terms. 

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Allowing advisors to self-custody crypto

Concerns about discretionary trading aside, the main goal behind the SEC's ill-fated custody proposal in 2023 had been to extend custody requirements to cryptocurrency, real estate, derivatives and other alternative assets. The SEC's newly proposed rule takes up the question of how crypto and digital assets should be held for safekeeping.

The new rule would take a swerve by allowing advisors be their own custodian for crypto provided they meet certain conditions. They'd first have to confirm that there are no existing outside custodians that are either able or willing to safeguard the assets. 

They then would have to adopt protection and cybersecurity systems intended to prevent theft or tampering with crypto assets and have those safeguards tested at least once a year. They would also have to obtain annual reports from outside accountants attesting to the soundness of their internal controls and send account statements to clients once a quarter.

The founder of Prometheum, whose Prometheum Capital subsidiary was the first entity approved as a special-purpose broker-dealer for digital assets, said he doesn't view the SEC's proposal as a threat. Prometheum CEO Aaron Kaplan said he thinks very few advisors will end up taking the self-custody option.

He noted advisors can't cite costs as a reason for not turning to an outside custodian to hold digital assets.

"The moment a qualified custodian becomes available, the asset has to move there," Kaplan said. "This is a net positive for both the regulated financial services industry, the investors they serve and the qualified custodians like Prometheum Capital that make it possible to hold crypto assets with the same protections investors already expect from their brokerage accounts."

Separately, the SEC's new rule would allow advisors to use so-called state trust companies — financial institutions regulated at the state level — as custodians of crypto assets. Before engaging them for that purpose, advisors would have to review their internal audited statements and controls.

The public will have 60 days to comment on the proposal following its publication in the Federal Register. Industry groups are already expressing support for its general tendencies while saying they need to examine the specifics more closely.

The Investment Adviser Association, which represents more than 600 RIAs and related firms, released a statement Friday deeming the proposal "an important and welcome step toward a more modern, workable custody framework."

Introductory bullet points created by AI with editorial review.