Artificial Intelligence or Artificial Concerns? The SEC's Tech Trepidation
Recently, the Securities and Exchange Commission (“SEC”) has embarked on an aggressive rulemaking agenda, partly addressing the challenges posed by rapidly evolving technologies in the financial services sector. This historically aggressive stance is marked by a heightened focus on emerging areas like Artificial Intelligence (“AI”) and predictive data analytics (“PDA”) used extensively by broker-dealers and investment advisers. However, this approach has sparked debate over the SEC's seemingly unfounded concerns regarding new technological domains.
While adopting AI and similar technologies promises enhanced efficiency and potentially better investment opportunities, the SEC's caution stems more from perceiving unknown risks rather than concrete evidence of harm. This is particularly noticeable when contrasted with its more accepting stance towards long-standing industry practices, such as the dominance of a few large custodians in the financial market. This inconsistency raises questions about the SEC's approach: Is the regulatory body overly cautious, potentially stifling innovation in its quest to mitigate risks that are not yet fully understood? The answer appears to be yes.
As the financial industry and fintech continue to evolve at a breakneck pace, driven by technological advancements, the SEC finds itself at a crossroads. Balancing the need for innovation and the imperative to protect investors presents a complex challenge, especially with how the commission approaches innovation. Some suggest that the commission should wait and see if new technology creates investor harm before regulating it. In contrast, others distrust any new technology that could destabilize financial markets—in late 2023, the SEC proposed new rules regarding the use of PDA by broker-dealers and investment advisers (“PDA Rule”). This proposal was a response to the growing adoption and use of newer technologies in the financial sector, which, while bringing potential benefits, also raises concerns about conflicts of interest that could harm investors.
Key Points from the SEC Proposal
The SEC's proposed rule would require broker-dealers and investment advisers to identify, determine, eliminate, or neutralize conflicts of interest and adopt policies and procedures to ensure compliance. There are also recordkeeping requirements. The commission's primary concern is the potential for conflicts of interest to harm investors, which is why Chairman Gensler and the staff argue that the rapid expansion of these technologies necessitates new rules now versus waiting to see what specific harm, if any, occurs to investors.
The SEC discusses the importance of broker-dealers and investment advisers evaluating and identifying conflicts of interest when using predictive data analytics and similar technologies. It outlines their need to test these technologies before implementation and periodically thereafter. The staff also provides standards on how firms should eliminate or neutralize conflicts of interest and the minimum requirements for policies and procedures to prevent conflicts of interest.
The key drivers of the rule's proposal include the following six areas.
1. Accelerated Use of Technology: Firms have increasingly adopted technologies like PDA. These technologies can enhance operational efficiency and investment opportunity identification, but they also present potential conflicts of interest that could harm investors more broadly than before.
2. Applications in Finance: One widely used application of machine learning in finance is algorithmic trading. Machine-learning models analyze large datasets to identify patterns and signals that guide investment-related behaviors.
3. Digital Engagement Practices (“DEPs”): Firms have expanded their technology usage to include DEPs such as behavioral prompts, differential marketing, and game-like features (i.e., gamification). These are designed to engage retail investors on digital platforms like trading apps or websites.
4. AI, Machine Learning, and Natural Language Processing (“NLP”) in Online Platforms: Investment firms increasingly use AI, machine learning, NLP, and chatbot technologies for online platforms. These platforms provide personalized investment recommendations to customers.
5. COVID-19 Pandemic Impact: The pandemic accelerated the adoption of PDA-like technologies, with many expecting AI to become a mainstream technology across various functions.
With the increasing adoption of AI tools by broker-dealers and investment advisers, Chairman Gary Gensler is concerned with using AI tools from only a few vendors. For him, relying on just a few AI providers in finance is like getting all your news from one gossip columnist – it's not just risky, it's a drama waiting to happen. This contrasts with the commission's acceptance of consolidation and oligopoly in many other parts of financial services, including investment companies, fund administration, and custody. For example, this position is intriguing when compared to the SEC's acceptance of the dominance of a few large custodians like Charles Schwab and Fidelity in the marketplace. This juxtaposition raises questions about consistency in regulatory approaches toward concentration and dependency risks in different areas of the financial services industry.
Contrasting Stances: Concern Over AI Tools vs. Acceptance of Custodian Dominance
The SEC's PDA rule proposal indicates wariness over the reliance on a few leading AI tool providers. The concern stems from the potential for conflicts of interest and the homogenization of strategies and risks, as these tools could lead to a convergence in investment behaviors driven by similar underlying algorithms. This reliance on a handful of providers may also lead to systemic risks, where a fault in one system could have widespread repercussions.
On the other hand, the SEC has historically been more accepting of the dominance of a few large custodians in the financial marketplace. Firms like Charles Schwab and Fidelity manage a significant portion of investor assets, which could pose similar systemic risks in theory. Their dominance affords them considerable influence over market practices and investment trends. However, the SEC's regulatory approach here has been more accommodating, possibly viewing these entities as stabilizing forces in the market. For the commission, a few big custodians running the show versus a few AI tools calling the shots is like trusting Grandpa with the remote control but not the teenager with the smartphone.
The difference in the SEC's approach might stem from the perceived nature of risks associated with each scenario, as relatively new and rapidly evolving AI tools present a novel set of challenges and unknowns, especially regarding automated decision-making and data privacy. In contrast, the risks associated with custodian dominance are more familiar and possibly viewed as more manageable within the existing regulatory frameworks. Further, the concern over AI tools might be driven by the potential for these tools to make widespread, uniform investment decisions that could harm investors, especially during market stresses. In contrast, the dominance of large custodians has been seen more as an issue of market efficiency and less direct investor harm. While caution in the face of rapid technological advancement is prudent, the SEC's approach, especially in contrast to its leniency towards custodian oligopolies, sometimes feels like using a sledgehammer to crack a nut.
The SEC's stance also reflects the evolution of its regulatory philosophy in response to technological advancements. The rapid development and adoption of AI in financial services necessitates a more cautious approach to ensure the regulatory framework keeps pace with technological innovation. But protecting investors from AI risks is like trying to childproof a house – no matter how many corners you pad, the kids will find something you missed.
Conclusion: Anything But Neutral
The SEC's tightrope walk between fostering innovation and safeguarding investor interests in an AI-driven financial world is akin to a high-stakes chess game, where every move could redefine the market's future. But the SEC is navigating the new AI landscape in finance like it is trying to play 3D chess in a 2D world – they're still figuring out where all the pieces go.
The true test for the SEC and similar regulatory bodies lies in their ability to adapt and evolve with the technological landscape. The fintech sector, buzzing with AI innovations, watches eagerly, albeit a bit nervously, as the rules of the game are constantly rewritten by the SEC. As we stand at this crossroads, the financial industry's journey into the future will be less about AI and more about how well our regulatory frameworks can keep up without stifling the innovation they seek to harness.