• Philipp Maume

Regulating Robo-Advisory

Robo-advisors, online-based advisory services that use algorithms to create investment recommendations with no human input, promise to deliver financial advice at a fraction of the cost associated with traditional financial advisors. This makes them particularly interesting for small investors that have so far been of low interest for the financial advisor industry. I discuss many of the important legal issues connected with robo-advisors in my recent paper, forthcoming in the Texas International Law Journal.

Robo-advisors operate based on the traditional frameworks for human financial advisors. This is problematic because in robo-advisory there is no interaction between humans. Robo-advisors do not build up personal relationships and they do not make decisions applying subjective elements such as intuition or experience. Instead, robo-advisory is about algorithm-based investment strategies that rely on a high level of diversification. The logical consequence is that the regulatory framework for human advisors might be unsuitable for robo-advisors.

Some regulators (for example in the US or in Germany) have been reluctant in their approach to robo-advisory. A common position taken is that financial regulation is ‘technology neutral’ (which means that regulation applies to a particular service, irrespective of whether delivered online or in a traditional setting) and that a ‘level playing field’ needs to be guaranteed (which describes an idea of fairness and equal treatment between incumbent financial advisers and robo-advisers).

It is the author’s view that regulators are under an obligation to fill the gaps and inconsistencies in the current legal framework. Given that there is not yet a robust framework created specifically for robo-advisors, national regulators need to pay particular attention to the IOSCO Objectives and Principles of Securities Regulation. The IOSCO Objectives and Principles present three key goals: to protect investors, to ensure that markets are fair, efficient and transparent, and to reduce systemic risk. The mission statements of various national regulators reiterate these objectives in similar wording.

In IOSCO’s correct understanding, the ‘level playing field’ does not require the application of the same rules to all market participants. Instead, it is supposed to enable all market participants (and in particular, newcomers) fair access to the market. An application of the ‘same rule’ principle could even be particularly unfair in a historical context. The current capital and reporting requirements for financial service providers are an amalgamation of regulatory responses to market failures. They can be a significant entry barrier for a robo-advisory start-up. The irony is that misconduct in the past can bar new competitors from entering the market today.

Applying the same set of rules to human advisors and robo-advisors could also be detrimental to market efficiency. Applying rules that were initially designed for the interaction between humans to an increasingly digitized world might be pointless or even harmful.

Another potential issue is investor protection. Obviously, the level of investor protection applied to robo-advisors should be the same as for human advisors. However, there is no logical justification why robo-advisors need to be better than human advisors (and we need to keep in mind how bad the track record of human advisors is!). Accordingly, a certain level of fallibility would be acceptable for robo-advisors, too. Investor protection should not be misconceived as a comprehensive safeguard for investors. If a failed investment is based on flawed advice, the investor must be given recourse against the advisor. Regulators also need to be able to react, through fines or other forms of punishment. All these mechanisms are present in current financial advisor regulation and can be applied to robo-advisors accordingly.

It is true that if robo-advisory reached a certain market share, their similar decision-making processes could trigger major shifts in the market. But even though a robo-advisor’s algorithm might react instantaneously to market developments, any transaction that goes beyond the client’s original approval (in particular, regarding the mix of different investment forms) typically requires a new client approval. Thus, instantaneous or even very fast decisions by robo-advisor clients are possible, but overall unlikely. Many robo-advisors apply passive strategies, which means that they tend to advise clients to buy and keep investments based on the long-term outlook and performance and to a lesser extent on market movements.

The alleged uniformity of the advice (basically all robo-advisors recommend exchange traded funds) also appears to be a theoretical issue. There are a wide range of ETFs (more than 4,700 at the end of 2017), based on stock market indexes, foreign currency, sectors and industries, commodities and derivatives. Thus, the robo-advisors’ focus on ETFs does not mean that their recommendations are similar or even uniform.

Naturally, regulators need to keep an eye on robo-advisors’ recommendation patterns. If there are indicators that robo-advisors facilitate the creation of investment bubbles, regulators and policymakers will need to take action. It might be necessary to hold robo-advisors to a higher standard, or to introduce new mechanisms. However, robo-advisors have not yet reached such a market share at the time of writing this blog. Thus, it would be worthwhile to focus on the possibilities of robo-advisory instead of alleged risks.

Philipp Maume, Munich

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