Advisors and broker-dealers know to avoid conflicts of interest in their investment advice to clients. But what if they're turning to artificial intelligence or robo advisors for the recommendations?
Securities and Exchange Commission regulators are worried that advanced technologies like machine learning, AI and sophisticated algorithms may be spitting out advice that goes against investors' best interests — sometimes without advisors and brokers even realizing that's happening. On Wednesday, the commission voted 3-2 to advance
"We are concerned that given the complex nature of many of these technologies, a firm's data or software might intentionally or unintentionally cause the firm to place its own interests ahead of investors' interests," said William Birdthistle, director of the SEC's division of investment management, in Wednesday's online meeting.
The SEC's new proposal comes largely in response to the surging popularity of online brokerages offering commission-free trading.
Some have hailed this trend as showing that investment vehicles once reserved for large institutions are now open to the broader public. But Birdthistle said regulators think those opportunities come with large risks. That's especially true when online brokerages are using algorithms and other systems that they might not even understand to broadcast recommendations to large numbers of investors whose individual needs they might also not know.
"Insufficient oversight of and controls related to conflicts of interest could cause firms to implement technologies that make decisions that favor the firm's interests at the expense of investors interests, and rapidly to implement those decisions in interactions with investors, potentially on a large scale," Birdthistle said.
Read more:
The SEC isn't the only regulator looking into whether online brokers and advisors are taking care to look out for investors. Massachusetts Secretary of the Commonwealth William Galvin
On Wednesday, Robinhood Chief Brokerage Officer Steve Quirk said new technologies have opened markets to tens of millions of U.S. investors.
"The SEC's proposal would turn back the clock, bringing U.S. financial markets to the old, manual days when retail investors were forced to interact with their broker or advisor by phone or at a branch office," Quirk said in an email statement. "This isn't in anybody's best interest, least of all the new generation of retail investors."
The SEC's proposed rule would take brokers and advisors through a three-step procedure with any technology they use to "optimize" or "predict, guide, forecast, or direct" investment decisions. The firms would first have to scan these systems for conflicts and then decide if these conflicts are of the sort that place their own interests ahead of clients'. If that's the case, they'd have to find ways to eliminate or neutralize those conflicts.
One of the two "no" votes on Wednesday, Commissioner Hester Peirce, said the proposed rule would be redundant because most financial advisors are already under an obligation to avoid conflicts of interest. Investment advisors have a fiduciary obligation to put their clients' interests first and to eliminate most conflicts. And broker-dealers fall under the SEC's regulation best interest, which places an emphasis on disclosing unavoidable conflicts.
Peirce said in the meeting that the proposal "joins a growing list of commission rulemakings that are simply unnecessary."
Read more:
Peirce said advisors and brokers are already required to eliminate most conflicts of interest and inform investors of any that can't be avoided.
"It reflects the commission's loss of faith in one of the pillars of our regulatory infrastructure: the power of disclosure and the corresponding belief that informed investors are able to think for themselves," she said.
Adam Kanter, a partner in Mayer Brown's investment management group in the firm's Washington D.C. office, said in an interview that it's not unprecedented for the SEC to issue rules to regulate a specific activity that might fall under a more general existing obligation. Kanter said most people's reaction to the SEC's latest proposal might be to think that it's all about AI.
Really, though, it's coming in response to many new means of electronic trading that have opened up to retail investors in recent years. The real concern is when technology — no matter of what type — is used to "elicit a response from a customer or client that creates a problem, or a potential one, from the SEC perspective."
"Everybody knew this was coming," Kanter said. "It's a natural evolution of what the SEC has been talking about for a while."
Steffen Hemmerich, the head of Mayer Brown's broker-dealer regulatory and compliance practice in the firm's New York office, said in an interview the SEC's proposal had to be drawn up in a way that it could accommodate future innovations in trading technology. To do that, he said, its language had to be made somewhat vague.
"The downside to that is that it creates uncertainty," Hemmerich said.
Concerns that the proposed rule would prove onerous to the wealth management industry were shared by the Investment Adviser Association, an industry group representing more than 600 fiduciary advisory firms. Gail Bernstein, general counsel for the IAA, contended the SEC has not furnished data showing why such a new regulation is needed.
"It also doesn't seem to seriously consider operational difficulties or accurately describe the likely costs advisers will bear, particularly smaller advisers," she said in an email statement. "These operational difficulties and costs will be on top of the many other new requirements coming at advisers at an unprecedented speed and scale."
The SEC's proposed rule estimates the cost of rooting out any conflicts that arise from working with a firm that uses relatively simple technology (like spreadsheets for investment advice) at $5,575 a year, plus an upfront cost of $11,150. The annual cost of collaborating with firms that rely on complex systems (like AI or machine learning) was pegged at $78,050, plus an upfront cost of $156,100.
Jessica Wachter, chief economist and the director of the SEC's division of economic and risk analysis, acknowledged that the cost could prove a burden to small firms that need to rely on complex technology to compete with large rivals.
"But there is that point that if the technology is not complex, we don't expect the burdens to be substantial," Wachter said. She also said firms might turn to third-party companies for help with meeting their obligations to monitor AI and algorithm-driven advisory systems for conflicts.
The public will have 60 days to comment on the SEC's proposed rule following its publication in the Federal Register. Birdthistle said regulators have yet to set a schedule for compliance should the rule eventually be adopted. He said he wants to hear thoughts from brokers, advisors and others in the industry on what a reasonable deadline might be.
Separately on Wednesday, the commissioners voted unanimously to advance a proposal that would allow advisors who plan to offer recommendations exclusively through a website to become registered with the SEC. Generally speaking, advisory firms are now allowed to sign up with the SEC only if they have $25 million or more in assets under management. Smaller outfits must register themselves with state regulators.
One exception to that rule now allows SEC registration for advisors who plan to offer advice mainly through a website and who have fewer than 15 non-internet clients. The proposed change would stipulate that advisors who plan to make use of that exception would have to do all their work throughout their websites and could have no offline clients.
