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?



Detective Del Spooner, I, Robot 2004

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?  

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2021. All rights reserved. IS-07357-2021-05-27

This browser is not fully supported by our public website and may not display or function as expected for this reason. Please note, the Infuse Portal and BBH client applications fully support the IE 11 browser.

Important Information for Non-U.S. Residents

You are required to read the following important information, which, in conjunction with the Terms and Conditions, governs your use of this website. Your use of this website and its contents constitute your acceptance of this information and those Terms and Conditions. If you do not agree with this information and the Terms and Conditions, you should immediately cease use of this website. The contents of this website have not been prepared for the benefit of investors outside of the United States. This website is not intended as a solicitation of the purchase or sale of any security or other financial instrument or any investment management services for any investor who resides in a jurisdiction other than the United States1. As a general matter, Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) is not licensed or registered to solicit prospective investors and offer investment advisory services in jurisdictions outside of the United States. The information on this website is not intended to be distributed to, directed at or used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Persons in respect of whom such prohibitions apply must not access the website.  Under certain circumstances, BBH may provide services to investors located outside of the United States in accordance with applicable law. The conditions under which such services may be provided will be analyzed on a case-by-case basis by BBH. BBH will only accept investors from such jurisdictions or countries where it has made a determination that such an arrangement or relationship is permissible under the laws of that jurisdiction or country. The existence of this website is not intended to be a substitute for the type of analysis described above and is not intended as a solicitation of or recommendation to any prospective investor, including those located outside of the United States. Certain BBH products or services may not be available in certain jurisdictions. By choosing to access this website from any location other than the United States, you accept full responsibility for compliance with all local laws. The website contains content that has been obtained from sources that BBH believes to be reliable as of the date presented; however, BBH cannot guarantee the accuracy of such content, assure its completeness, or warrant that such information will not be changed. The content contained herein is current as of the date of issuance and is subject to change without notice. The website’s content does not constitute investment advice and should not be used as the basis for any investment decision. There is no guarantee that any investment objectives, expectations, targets described in this website or the  performance or profitability of any investment will be achieved. You understand that investing in securities and other financial instruments involves risks that may affect the value of the securities and may result in losses, including the potential loss of the principal invested, and you assume and are able to bear all such risks.  In no event shall BBH or any other affiliated party be liable for any direct, incidental, special, consequential, indirect, lost profits, loss of business or data, or punitive damages arising out of your use of this website. By clicking accept, you confirm that you accept  to the above Important Information along with Terms and Conditions.

 
1BBH sponsors UCITS Funds registered in Luxembourg, in certain jurisdictions. For information on those funds, please see bbhluxembourgfunds.com


captcha image

Type in the word seen on the picture

I am a current investor in another jurisdiction