Pre- and Post-Trade Compliance in Digital Assets

‍

Compliance Does not Equal Compliance

There are many facets of compliance, especially within an investment management context, including licensing, regulation, KYC/AML, etc. However, in this article, we want to shed particular light on investment compliance, specifically pre- and post-trade compliance, i.e. the adherence to investment management principles and the boundaries of a particular investment strategy. As the landscape of digital assets increasingly merges with mainstream investment practices - driven by the influx of institutional investors - the particularities of investment compliance within the domain will gain even further importance. After all, appropriate pre- and post-trade investment compliance is an essential part of any best practice investment management process, irrespective of the asset class. It serves as a critical pillar that essentially ensures investment activities are in line with the stated investment policy as well as any overarching company and regulatory requirements. In this article, we will dive into the background of investment compliance, its roots in traditional finance, and how it translates into the realm of digital assets.

Investment Compliance in Traditional Finance

At its core, investment compliance in traditional finance (TradFi) plays a key role in ensuring that investment activities remain strictly within the bounds of predefined policies and regulatory frameworks. Essentially, every investment strategy has (or should have) an investment policy that describes the approach and defines its boundaries. Such boundaries could include the inclusion or exclusion of certain assets, limitations on maximum exposures to certain sectors, or definitions of minimum cash levels required. In addition, there might be operational rules and checks (such as maximum trade sizes, four-eyes principles) or company-wide restrictions that apply to any strategy within the company. Finally, regulatory rules will have to be taken into account as well. Investment compliance, therefore, aims to translate investment policies or fund strategies into actionable, operational guidelines, usually expressed as pre-trade and post-trade compliance rules, which can be expressed as soft or hard rules.

Implementing Investment Compliance: Pre- and Post-Trade Rules

Investment compliance aims to translate investment policies or fund strategies into actionable, operational guidelines, usually expressed as pre-trade and post-trade compliance rules, which can be soft or hard rules. Pre-trade rules, as the name implies, are checked before any trade or transaction is executed and trigger a warning or outright stop in case any of the rules would be breached by the execution of the trade. Soft rules are rather warnings that inform the user of a potential breach but still allow the transaction to go ahead if the user wishes to do so. Hard rules do not allow the transaction to go ahead (e.g., because it involves an asset that has been explicitly excluded in the investment policy). Post-trade compliance rules run on a regular basis to check the current positions and ensure continued adherence to established guidelines. This dual-layered framework plays a crucial role in maintaining consistent alignment with both investment strategy and regulatory obligations, thereby mitigating risks of policy breaches and operational discrepancies.

Investment Compliance in Digital Assets

Transitioning to digital assets, the fundamental idea of investment compliance applies in the same way, yet the distinct characteristics of these assets call for tailored considerations. For example, compliance measures may need to integrate digital asset-specific metrics derived from on-chain data or adapt to the trading constraints inherent to pre-funded digital asset transactions. They also need to be able to consider the changing nature of the same asset given its current use, such as a spot token position vs. that token being staked through which it suddenly has a yield attached to it, a new protocol exposure, and potential liquidity constraints. In addition, they may need to not only consider constraints on an asset level (i.e., tokens) but also on the infrastructure level (e.g., max exposure to a particular blockchain or protocol). Incorporating these particularities within best practice investment compliance frameworks not only requires an understanding of digital assets themselves but also sets new requirements on a technical level to ensure an investment management system can handle those rules in a consistent and reliable way.

The Alloy Approach to Investment Compliance

What we’ve observed from our own experience as well as numerous client discussions is that robust pre- and post-trade compliance functionalities for digital assets are scarce. As a full front-to-back investment platform, having investment compliance functionality is a necessary component. We have, therefore, built best-practice functionality to define bespoke pre- and post-trade compliance rules based on digital asset-specific features. In addition, users can view rule breaches across various dimensions in one comprehensive dashboard.

Conclusion

The integration of digital assets into broader investment strategies introduces new complexities to the field of investment compliance. While the fundamental principles remain true for both traditional assets and digital assets, the distinctive nature of digital assets necessitates a customized approach and new technical capabilities for portfolio management and execution systems. Pre- and post-trade compliance rules need to be able to capture the changing nature of tokens as well as be able to capture infrastructure-related aspects as well (such as blockchain and protocol exposures). Finally, with the maturing of the market as well as changing regulatory landscape, digital asset investment compliance needs to be particularly adaptable to ensure these developments are captured correctly.