Tuesday, September 14, 2021

SEC Investor Advisory Committee examines digital engagement practices

By Lene Powell, J.D.

The Investor Advisory Committee heard input about digital engagement practices, or features of investment platforms that shape the user experience. Some, including SEC Chair Gensler, are concerned that behavioral prompts and gamification are in some cases being used to maximize brokers’ profit at the expense of investors. Commissioner Peirce said trading platforms are expanding investor access and opportunity, and innovation should be encouraged rather than discouraged. An official at Betterment, a "robo-advisor," said that digital design features are not inherently good or bad, and the important question is what are they prompting the investor to do and why.

Commissioner statements. Chair Gensler noted that the SEC has put out a request for information about digital engagement. In his view, certain investment platform features raise questions about investor protection. Digital engagement practices (DEPs) can encourage investors to trade more often, invest in different products, or change their investment strategy. Predictive analytics and other DEPs often are designed, in part, to increase platform revenues, data collection, and customer engagement, said Gensler.

Gensler is interested in the following questions:
  • How are investors protected in light of the potential conflicts of interest that may exist when DEPs optimize for platform revenues, data collection, or investor behavior?
  • How might that affect whether DEPs are making a recommendation or providing investment advice, which has implications in our securities laws?
  • How do these new business models ensure for fairness of access and pricing, particularly given underlying data used in the analytic models could reflect historical biases that may be proxies for protected characteristics, like race and gender?
Commissioner Hester Peirce focused on the potential for technology advances to create investor opportunities. In her view, while investors want protection from fraud and easy access to robust disclosures, they also want to be able to interact with their financial firms using the latest technologies, to have access to the full range of investment options, and to take charge of their financial future by spending their hard-earned money as they see fit.

Peirce spoke of the regulatory mindset as saying no instead of yes and stop instead of go, and seeing danger instead of possibility. In her view, regulators have a "Not so fast, sonny, you might put your eye out!" mindset.

"As you discuss digital platforms and other topics in the future, help us to remember that a regulator who always says no or takes too long to say yes is not serving investors well," said Peirce.

Likewise, Commissioner Elad Roisman said he hopes the Commission does not lose sight of the benefits that technological innovation provides investors and the markets. He observed that a wide variety of service models have formed to reach and meet the interests and needs of different types of investors.

"We should be encouraging continued innovation to increase engagement, particularly among investors that historically have been less likely to directly participate in securities markets," said Roisman.

Manipulative tactics and Reg BI. Steve Hall, legal director and securities specialist, Better Markets, focused on two main points. First, some dominant online trading platforms appear to be driven by a powerful profit motive rather than serving the needs of investors. Platforms use a variety of platform features to bombard investors with manipulative signals, enticing or even pressuring them into trading as much as possible.

These tactics can cause investors to take trading risks that are not thoughtful and can be ruinous, said Hall. He observed that the Securities Division of Massachusetts filed an enforcement action against Robinhood last December, finding the company's gamification tactics so toxic that the agency sought not only to impose penalties but to ban the company from the state entirely.

According to Hall, platforms engage in these manipulative tactics in order to maximize trading volume. Platforms maximize their revenues by selling trading information to market makers in exchange for huge payments. For example, said Hall, Robinhood reportedly made over 80 percent of its revenue from payment for order flow (PFOF) in 2020, amounting to nearly $700 million. Hall views PFOF as one example of a conflict of interest between platforms and users. Other conflicts of interest include steering clients explicitly or subliminally to products or services that are more lucrative for the broker, such as proprietary products, products that involve third party payments, and margin services.

Hall’s second concern is that in his view, at least some platforms are either directly or indirectly making recommendations to their users within the meaning of Regulation Best Interest. According to Hall, Reg BI can and should be brought to bear, as it would at least help ensure that online trading platforms that engage in recommending securities transactions and trading strategies, always act in investors best interest, make important disclosures, and mitigate conflicts of interest.

Behavioral prompts and the illusion of control. Punam Anand Keller, PhD, Charles Henry Jones Third Century Professor of Management, said that behavioral prompts differ from advice. They evoke an "implementer" rather than deliberative mindset.

"They don't prompt reflection, they don't prompt the option to make a decision. It's almost like, I'm going to overcome your hesitation," said Keller.

Keller said these behavioral prompts can operate to give the illusion of control. For many novice investors, trading platforms can seem on the investor’s side, offering community and free, easy, 24/7 trading. But gamification techniques can cause quite addictive behavior, said Keller. She advocates that prompts should instead evoke a deliberative mindset, by creating decision points, building in delays, and nudges like envisioning the effect of the decision in the future.

Betterment: A robo-advisor’s perspective. Dan Egan, director of behavioral finance and investing at Betterment, noted that Betterment was the first independent robo-advisor, and that Betterment is not a broker in its relationship with clients, but a registered investment adviser. As such, Betterment is held to a fiduciary standard and is required to act in clients’ best interest. Betterment earns revenue from client fees, not from PFOF or investing clients in certain funds.

With this orientation, Betterment works to improve the service and offerings to try and help clients be more successful and managing their money without having to spend a lot of time on it, said Egan. Betterment uses various techniques to present information efficiently so it can be easily grasped.

For example, in showing clients how their investments have done that day, the platform codes upward movement as green and downward movement as red. For longer-term investments, color is used to bring attention to things the client can control, such as whether they are saving enough for a child’s college education, or have set up a beneficiary for an IRA.

In other words, design choices are not inherently good or bad, but rather the intent behind them.

"It's not that we should not use color," said Egan. "That is that we should use color to help people make better decisions that are good to improve their future outcomes."

Egan said he is wary of the idea of regulating specific design elements, because it is very important to encourage pro-consumer innovation, design, and experimentation. Instead, regulators should think about how to align incentives with customer success.

"Let's think about how we encourage firms to win when their clients win and potentially lose a little bit when their clients lose. But also, that they always have to do the right thing for their clients, so that there isn't a conflict of interest at the bottom, at the foundation of the relationship that can percolate up in very small and unintended ways inside of the design," said Egan.