Regulating Robots: Will the SEC Hold Algorithms to the Same Standards as RIAs?

June 02, 2021
Regulators are reviewing how gamification and other tech led sales techniques sit within their Regulation Best Interest framework after the recent Robinhood/GameStop events. Here, we discuss their considerations.

You are just a machine, an imitation of life.
Can a robot write a symphony?
Can a robot turn a canvas into a beautiful masterpiece?

One of the fallouts of the Robinhood/GameStop event earlier this year was that the online broker was criticized in some quarters for its use of gamification strategies. Robinhood’s major growth trajectory in signing up over 13 million users and growing to a $12 billion market valuation is why they are now in the regulator cross hairs. But the GameStop event was so impactful that it was always going to be addressed directly with all of the major players in the story.

To the uninitiated, gamification refers to a technique which creates for a product user similar experiences to those experienced when playing games, in order to motivate and engage users to use the product more. In the case of Robinhood, strategies included sending daily “nudge” notifications tempting people to trade or displaying confetti raining down after each trade in celebration of a job well done. These methods have the potential to incentivize increased customer activity on the trading platform, which in turn would generate more revenue to Robinhood.

It should be noted that Robinhood is far from the only online trading platform to use similar techniques and that trading platforms are not the only online activity to apply these techniques. The contemporary on-line public is conditioned to respond to regular prompts and dynamic interfaces with many of the online products and platforms with which they engage. For example, popular products like Fitbit, Apple Watches, and Peloton include gamified fitness, motivating users to exercise more and meet their goals.

To be fair, Robinhood has generally been lauded for democratizing the market and especially mobilizing younger investors to invest for the first time, but this comes with a level of responsibility yet to be defined by regulators. Regulators are increasingly worried about amateurs being disadvantaged in a highly professionalized marketplace where information asymmetry is heavily weighted towards professional firms rather than retail investors. Also, many retail investors believe their investment skills are much higher than is actually the case. There is a body of research on the topic which shows that these investors are often over-confident in their personal investment capabilities. For example, a study by the TIAA Institute showed that 62% of younger U.S. investors rated their own financial knowledge as “high” or “very high” when surveyed while at the same time, only 1 in 5 of these respondents could answer the three financial literacy questions posed to them correctly. It is this mix of youthful exuberance and overconfidence in investing ability that has regulators contemplating how to balance both investor participation and investor protection. 

Market developments are often steps ahead of new regulations, and regulators are just now trying to keep up with Robinhood and their fintech-heavy ilk. The question of how to, or even whether to regulate nascent technology and business models is one that the new SEC Chair, Gary Gensler is grappling with right now.

The Securities and Exchange Commission is already considering how gamification and other tech driven sales techniques sit within their Regulation Best Interest framework. Reg BI was finalized in 2019 and largely dictates the standard of conduct for broker-dealers when making investment recommendations to retail customers. It usually captures regulated real-life human investment advisors, rather than artificial intelligence algorithms and computer programs, but this is the question currently at the door of Gensler’s SEC and other regulators. 

Robinhood does not contemplate a fiduciary obligation in its business model, which would make their activity outside the scope of Reg BI. Regulation Best Interest (Reg BI) is not the only arrow in the SEC’s quiver and the Commission might choose to use enforcement, guidance, or specific rulemaking outside the Reg BI strictures to move against broker-dealers’ gamification practices.

There are diverging schools of thought about whether the gamification practices of online brokerage services even come under the preview of the SEC, but if not the SEC then who?

Another area of the market which poses similar problems in determining an appropriate ruleset is the use of robo-advisor algorithms designed to shape investor portfolios based on the specifications provided by the investor themselves. It is not clear under securities law whether an algorithm can be called investment recommendation or advice under the law, and it depends on other complex facts and circumstance. Most online brokerages are at pains to disclose that their online trading apps do not issue investment recommendations, but instead provide a platform for users to make unsolicited transactions. However, the nudges, curated news notifications, predictive modelling tools, and lists of stocks that are “hot and not” type communications appear to skirt the line between passive order taking and at least influencing the users trading activity.  

Gensler has already promised the House Committee, who questioned him on the GameStop event, that he will “prepare a request for public input for consideration on these issues,” and that the SEC needs to “ensure investors using apps with these types of features continue to be appropriately protected and consider how all of our rules apply in these situations, including Regulation Best Interest.”

How the SEC review ultimately pans out is anyone’s guess at this time and the spectrum of opinions is wide, but two questions that will long exercise everyone in the industry are:

  1. What will be the rules of the gamification?
  2. How do you regulate robots?  

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