By John M. Jascob, J.D., LL.M.
The use of predictive data analytics and other digital engagement practices is rapidly transforming the way brokers and advisers engage with investors, but these electronic “behavioral nudges” raise important issues about the nature of investment advice and fairness in the financial markets, according to SEC Chairman Gary Gensler. While the industry’s use of artificial intelligence and machine learning to create individually tailored behavioral prompts can be powerful and profitable tools, Gensler questioned whether these tools are optimizing the digital experience for the benefit of investors or simply prioritizing platforms’ revenue and performance. Gensler delivered his remarks virtually to an audience of state securities regulators and industry professionals at the 2022 NASAA Public Policy Symposium in Washington. D.C.
Gensler drew a comparison with the way grocery stores tap into behavioral psychology to activate shoppers’ impulses to purchase items they may not need by locating fruits and vegetables in the outer aisles but placing gummy bears and other candy and snack foods near the cash register. Gensler cited research showing that impulsive purchases account for 62 percent of supermarket sales. Although grocery stores serve the public, many consumers recognize that stores also have a profit incentive and thus may tempt us with products that serve their interests rather than ours while employing the latest technology and research to do so.
The expectation changes, however, when consumers seek advice from their investment professionals. The world of finance is different, Gensler observed, because investment professionals are dealing with other people’s money. Accordingly, brokers and advisers have legal duties to comply with standards on care, loyalty, best interest, and best execution. “You can’t dangle gummy bears over an investor’s shopping cart, so to speak—even if the latest technologies might make it all the more easy, subtle, and profitable to do so,” Gensler said.
Gensler noted, however, that robo-advisers, brokerage apps, and wealth management apps are increasingly using digital engagement practices to narrowly target each investor with specific marketing, pricing, and nudges. Returning to his grocery store analogy, Gensler compared this to a store being able to rearrange its inventory, shelving, and pricing for each shopper every time they visited that store, down to the placement of impulse items by the register. Although this scenario might not be fully realized yet, it raises questions about what constitutes investment advice or recommendations in the new digital world of finance. For example, does a behavioral nudge like a flashing “options trading” button when opening a brokerage account constitute a recommendation? Moreover, Gensler asked, when do behavioral nudges take on attributes similar enough to advice or recommendations such that related investor protections are needed?
The securities industry's use of digital engagement practices also presents related issues of bias and fair access and prices in the financial markets, Gensler said. The SEC chairman suggested that the underlying data used in the analytic models could be based upon data that reflects historical biases, along with underlying features that may be proxies for characteristics like race and gender. As investment platforms rely on increasingly sophisticated data analytics, Gensler said that it will be appropriate to safeguard against fortifying such biases algorithmically. He added that the new forms of predictive data analytics raise issues for financial stability through herding, interconnectedness, and possible greater concentration in the capital markets. Accordingly, Gensler has asked the SEC staff to examine how to improve efficiency and competition throughout the financial markets.
Following the SEC chairman’s remarks. NASAA President and Maryland Securities Director Melanie Senter Lubin asked Gensler what can be done to prevent firms’ use of digital engagement practices from leading to overly aggressive and risky trading. Gensler responded that the answer lies truly in firms placing the interests of investors first. Gensler also said that regulators should be technologically neutral but not technologically naive. Noting the dramatic growth in robo-advisers, Gensler said that machine learning and artificial intelligence are rapidly changing the landscape. Accordingly, regulators need to be asking what is behind the algorithms. Does optimization steer outcomes for the benefit of investors or merely toward increases in firm revenue?