By John Filar Atwood
Better Markets has written to the SEC to offer a defense of the agency’s predictive analytics proposals against critics who claim the proposals are unnecessary, flawed, and overbroad. The group said that the proposals are necessary to ensure the securities laws keep pace with innovations, especially the growing use of AI in the securities industry.
The rules proposed last July would require firms to identify and eliminate any conflicts of interest arising from the use of covered technologies, and to adopt appropriate policies, procedures, and recordkeeping measures. The foundation of the proposals is the increasing use of AI-based predictive analytics to direct individual investor behavior, and digital engagement practices like behavioral prompts and game-like features to engage retail investors when using a firm’s digital platforms for trading, advice, and financial education.
The proposals have generated some pushback from stakeholders, including a divided SEC Investor Advisory Committee which recommended in March that the Commission scale back the proposals by narrowing some proposed definitions and increasing the focus on disclosing conflicts of interest.
Better Markets sees three primary objections to the proposal: 1) the proposal is unnecessary because existing rules address conflicts of interest; 2) the proposal is flawed because it goes beyond requiring the disclosure of conflicts of interest; and 3) the proposal is overbroad because it covers even mundane uses of technology. The group believes these criticisms lack merit.
Unnecessary. According to Better Markets, the problem with the argument that the proposal is unnecessary because existing rules address conflicts of interest is that those rules only cover recommendations. Regulation Best Interest, for example, “requires broker-dealers in making recommendations to have a reasonable basis for believing that a series of recommended transactions.” Absent a recommendation, Reg. BI’s duties do not apply, the group noted. The proposed rules are needed, therefore, to eliminate the conflicts that arise when brokers use predictive analytics in a way that produces de facto recommendations and that induces investors to engage in a series of transactions that are not in their own interest, the group stated.
Better Markets also argued that AI-based practices in the securities industry and elsewhere use behavioral psychology to entice users into frequent usage. The group cited lawsuits in other industries claiming that hidden algorithms are manipulating users to keep them hooked on the app they are using. Accordingly, the SEC’s proposed rules are needed to prevent broker-dealers from using predictive data analytics, digital engagement practices, and gamification to similarly turn retail investors into investing addicts.
Flawed. To the claim that the proposals are flawed because they should require only that conflicts of interest from the use of predictive data analytics be disclosed, Better Markets said there are many reasons why a disclosure-based regime is ill-suited to protect retail investors. To begin with, the group said, retail investors tend not to read disclosures and have reduced time, resources, and capacity to understand and use any disclosures relative to their sophisticated counterparts. Incremental increases in disclosure will not necessarily lead to better decision making, the group stated.
The group cited academic studies that found how simple disclosure obligations may not be sufficient for machine learning algorithms, and that when it comes to conflicts that arise as a result of firms using technology in their interactions with investors, disclosure alone will not be an effective solution.
This is why Better Markets disagrees with the recommendation of the SEC’s Investor Advisory Committee to allow firms to disclose the existence of conflicts of interest with respect to their use of some technologies rather than eliminate those conflicts. The group agrees with another recent study that suggested this approach would leave investors exposed to predatory behavior on the part of firms who might draft or time their disclosures in a way that would cause investors to overlook or misunderstand them, particularly when the underlying product or service is complex.
Better Markets urged the SEC to retain the proposal’s requirement that firms eliminate or neutralize the conflicts of interest arising from their use of certain technology in their interactions with investors because disclosure alone is an insufficient tool to address them.
Overbroad. The group also urged the Commission not to be persuaded by claims that the proposal is overbroad because it applies to innumerable functions that are necessary to support day-to-day operations of broker-dealers and investment advisers. The group noted that the proposal clearly states that it applies only to “an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction.”
The proposal applies to technologies that have the potential to lead to conflicts of interest in investor interactions, according to Better Markets, and does not apply to a firm’s use of mundane technologies such as spreadsheets. The proposal’s concern is with the conflicts arising from the use of the specified technology, and there is nothing overly broad about requiring that firms use technological advancements in a way that does not prioritize their own interests over the interests of the investors, the group concluded.