FINRA Vows Keen Oversight of Digital Advice Tools

Register now

Investment advice from software will get a hard look from FINRA.

Acknowledging the explosive growth of robo advisors, FINRA on Tuesday released guidance on digital investment advice for broker-dealers considering the use of such tools.

FINRA says broker-dealers need a "firm reminder," about areas of concern with digital advice, particularly the use of algorithm-based investments and relying solely on automated questionnaires.

The 17-page report does not create any new legal requirements or change any existing broker-dealer regulatory obligations. But FINRA noted that firms employing digital advice will need to "govern and supervise the algorithms they use in digital advice tools" and "should also establish governance and supervision structures and processes for the portfolios digital investment tools may present to users."

FINRA CEO Richard Ketchum tells Financial Planning the report was prompted by broker-dealers’ increased use of robo advice.

Online advice firms are expected to gather over $655 billion in assets by 2019, up from $192.4 billion in 2014, according to research firm Tiburon Strategic Advisors. The promise of digital assets has prompted moves from a variety of firms: Merrill Lynch announced it was developing a robo advice platform, while LPL is in the pilot phase of developing its own digital advice offering. 

In response, earlier this year FINRA had begun reaching out to broker-dealers who offer robo advice, asking how they determine client risk tolerance, among other factors.

Read more: Offering Robo Advice? Prepare for FINRA Scrutiny

"[This is] a good time to reemphasize that, whether it is FINRA rules or just how you treat customers, there are the same issues there whether it's a human being or an algorithm," Ketchum says.

The regulator sees industry change being brought by digital advice and the impending DoL fiduciary rule, Ketchum adds. "Firms that continue to do commission business may do it through fewer products. Firms will experiment with digital advice direct to the client and through their existing advisors.

"The same requirements are in place — the same expectations that you understand your customer, both from the standpoint of what their risk appetites are, and also that you have asked enough questions to really understand their financial situation and that they can accept risk and the risk of loss."


"It's a warning shot," says Alois Pirker, research director for Aite Group's Wealth Management practice. "Obviously as digital advice grows, FINRA needed to step up and make sure it happens in a compliant manner. The paper suggests clearly, you're not getting out of the obligations you have because its digital delivery."

FINRA says they are not promoting or discouraging the development or use of digital tools.  "It’s a business decision,” a FINRA official says. "If a firm goes there, we hope that it would consider the effective practices, and that BDs consider their rule obligations. Actual governance structures could vary based on the firm, but the overall principles would apply."

"The paper will help guide us in our review of the infrastructure that firms have around the use of digital investment advice tools," the official adds. "Exams will continue to help inform us."

Because the robo movement is tiny relative to the industry, it’s been largely flying under the regulatory radar, says industry consultant Tim Welsh of Nexus Strategy. "But now it looks like there will be some compliance teeth that will give both wealth management firms and the robos pause with these new guidelines."

Lack of suitability is a common issue in any arbitration or legal claim against a rep or firm, Welsh notes. "Having a basic online form of six questions that generates an asset allocation recommendation may invite regulators to require more layers of data gathering that can expose the robo to liability if, and when, something goes wrong."

The number of risk profile questions asked by robos in 2015 to obtain asset allocations ranged from Hedgeable's high of 16 to Betterment's and AssetBuilder's low of four questions, according to a recent study by Cerulli Associates.

Welsh says FINRA’s guidance on assessing an algorithm wouldn't be a burden on smaller broker-dealers, primarily because most are still not using the tools. 

(Among its guidance: assessing whether the algorithm's model remains appropriate as market and other conditions evolve).

But any firm that does employ robo advice will need to understand the software that determines client allocations, says Joel Bruckenstein, a Financial Planning columnist and co-creator of the Technology Tools for Today conference.

"Most firms are following a reasonable vetting process at the corporate level," Bruckenstein says. "Whether the individual rep using the tool really has a firm grasp of these issues is another matter. A more relevant question may be: 'What training or testing do firms require before a financial professional may use the tool?' I suspect that the answer will vary widely from firm to firm."

Bruckenstein found one FINRA critique of current risk profiling done by digital advice platforms noteworthy — how many are assessing whether a client should be saving or paying off debt versus investing.

"It seems to me that many firms are not doing all of these things," he says. "To my knowledge, most client-facing robos don’t do this."


In its report, FINRA also advised investors to learn about potential conflicts of interest inherent in digital advice tools, contrary to claims from many robo providers that they are transparent and fiduciaries.

That caught the attention of Washington-based banking and securities attorney Melanie Fein, who has argued that robo advisors may be unregistered investment companies, in violation of both the Investment Company Act of 1940 and SEC regulations.

Read more: How Robos Fall Short of Fiduciary Law

The new report not only lends further support to her argument, Fein says, "[it] constitutes a significant warning to investors."

"Because of the complex algorithms used, wide disparities in advice given and conflicts of interest, the report recommends that investment professionals should carefully consider the various features of digital investment tools before using them with their clients," she adds. "It goes without saying that it may be hazardous for individual investors to use these tools on their own without education and training."

In its report, FINRA does note that registered representatives “cannot rely on the [digital advice] tool for the requisite knowledge about the … customer necessary to make a suitable recommendation.”

"This seems to recognize that digital advice tools, in their current state of evolution, are just that — tools — that should be an aid in the decision-making process, and that human involvement in providing advice about certain portfolio decisions, such as asset allocation, is still necessary," says Ron A. Rhoades, attorney, fiduciary advocate and chair of the financial planning program at Western Kentucky University.

"Hopefully FINRA’s report will inform various robo advisors that the use of digital technology has not evolved, as of this point in time, sufficiently to incorporate all of the factors that must be taken into account before recommendations can be undertaken as to the proper use of a client’s funds," Rhoades adds.

Read more:

For reprint and licensing requests for this article, click here.
Compliance Law and regulation Financial planning FINRA