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Why regulators are taking aim at robo advisors

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Riding a decade-long bull market, robo advisory firms have proved investors are willing to let complex and proprietary algorithms be at the heart of their investment advice. Assets under management at digital platforms are expected to top $1 trillion in the next few years.

With the added marketshare, though, comes greater scrutiny. After years of playing catch-up and giving digital upstarts room to develop, regulators are ratcheting up their examination of digital platforms. In recent disciplinary actions against two prominent robos in December, regulators showed they are not only prepared to test investment algorithms, but will also hand out penalties to firms that are out of compliance.

In 2017, the SEC released guidance targeting robos with recommendations on how to properly disclose services to investors. The guidance focused on placing protocols during the development of algorithms that drive investment decisions. The guidance illustrated how disclosures should include a description of any circumstances that might cause the robo adviser to override the algorithm and include any third party that could become a conflict of interest. Regulators would also flag any instance of owner of the algorithm directing clients into products from which it earns a fee, according to the update.

“For fintechs, robos aren’t very startup-y anymore,” says Tom Baker, a professor at the University of Pennsylvania Law School and co-author of a recent paper on the future of digital regulation. “We now have a pretty good idea of what they do and so the SEC has had time to think and understand how they operate. The SEC has come to the conclusion — they have to understand these algorithms.”

Industry experts, like Boris Khentov senior vice president of operations and legal counsel at Betterment, agrees. “It would be a mistake to not see years from now the governance is ultimately going to be applicable to any software that performs a regulated task,” Khentov said at a FINRA RegTech conference held in New York in January.

In the SEC guidance, the regulator effectively issued a compliance program around algorithms for the first time, which will eventually be expanded to any task that has an effect on investor outcomes, Khentov said. Out of 10 disclosures recommended regarding robo advisory business models, more than half are directed specifically at algorithms.

“It’s making sure the software actually functions as specified,” Khentov says. It’s a commonsense concept, but it was the first time it was explicitly spelled out, he says. “It’s not a business function anymore — it’s a compliance function. That’s where the regulators are turning because that’s where the action is.”

Specifically, regulators are looking to test the level of compliance systems in place during software development, and how designers determine the software is behaving as designed. “It’s no longer about due diligence or something that you prove by gathering a few documents,” he says. “Show me the controls that ensure it’s doing what it’s doing,” Khentov says.

The SEC fired the first rounds at robo advisors in December for making improper disclosures to clients. Wealthfront, one of the industry’s leading automated platforms with more than $11 billion in assets under management, was the first robo to settle an enforcement action with the regulator. Clients were told that proprietary tax-loss harvesting software protected them from certain transactions, but the system failed to do so.

“Tax-loss harvesting is an algorithm," Baker says. "That is not something done by a person with green eyeshades.”

In a separate order, the robo advisor Hedgeable, which had approximately $81 million in client assets under management on its now shuttered platform, was accused of making a series of misleading statements about its investment performance. On its website and social media platforms, the firm posted misleading performance comparisons with higher than average returns that made up only 4% of all client accounts, says the regulators.

Without admitting or denying the findings, Wealthfront agreed to pay a $250,000 penalty and Hedgeable agreed to pay an $80,000 penalty.

“We take our regulatory duties seriously at Wealthfront and are happy to have reached a settlement with the SEC,” said a Wealthfront spokeswoman in an email in December.

Hedgeable co-founder Mike Kane declined to comment on the SEC order at the time.

In 2017, FINRA performed 1,492 cycle exams, or routine exams that take place every one to four years, overseeing 3,726 securities firms. (The regulator does not break down the exams by firm type and does not disclose which firms received exams.)

“These are smart, smart people,” Baker says. “If these financial geniuses can make a mistake about the operation of their algorithms, that suggests the technology is not necessarily perfect.”

The algorithms synthesize millions of data points — from broad market data to client risk tolerances — and suggest suitable products. While portfolio construction and vanilla ETFs that track indices are relatively straightforward, a growing buffet of more sophisticated offerings that mimic actively managed funds could be a cause for concern, experts say.

“It’s more about the bells and whistles,” Baker says.

For example, Wealthfront faced serious industry backlash after the launch of its Risk Parity fund, an actively managed, asset-allocation strategy that used a proprietary fund. Wealthfront says in SEC filings that the fund is not suitable for all investors, but instead only for those who “intend to actively monitor and manage their investments in the fund.”

Wealthfront’s active product was a departure from traditional low-cost and passive funds, which was jarring to many customers. The product originally cost 50 basis points before the firm slashed the price in April. “Wasn’t that exactly how the wirehouse private wealth groups used to work, too?” wrote Robert Clark using the handle @rfcdealflow on Twitter. “This is a sales contest golf trip short of a regulatory violation.”

While the SEC charges highlight a growing concern, the $250,000 fine was minor. In fact, the fine may have had more to do with deterring future bad behavior than recouping client funds, says Ethan Silver, a partner at national law firm Lowenstein Sandler, which specializes in compliance and technology.

“It’s a warning shot,” Silver says. While the fine would be significant for most startups, an established firm wouldn't have a problem footing the bill, he says. “It’s easy for firms to launch and get into this business, but they have to make sure compliance programs remain strong or the SEC will hit them.”

In addition to an error disclosing its tax-loss harvesting, Wealthfront also did not properly disclose that it paid bloggers for client referrals, according to the SEC order. Enhancing disclosures and limiting the claims made in marketing literature on social media have quickly become top of mind for newly formed robo advisors, Silver says.

“We’re constantly telling clients to be more careful on social media whenever they're releasing new products,” Silver says, who works with around two dozen robo advisor clients. “You have to make sure you’re delivering on what you promised through marketing channels.”

As young firms utilize podcasts, social media and other online media as cheap sources of marketing, the SEC has been quick to scout the landscape. “These types of companies are looking at social media differently than traditional incumbents and the SEC is surveilling that more than they ever have,” Silver says.

The exam process is getting stricter, probably because regulators have more experience dealing with fintech firms, says Silver. In particular, the SEC has learned to tailor its checklists to fit digital advice firms. “They’ve gotten smarter about it,” Silver says. “Retail investors are the most typical client coming onboard these types of advisors. And with more and more robos popping up, the SEC is paying attention.”

Not surprisingly, digital startups are primarily focused on the technology that is driving revenue, says Vijay Raghavan, a senior analyst with Forrester. However, some may not be investing heavily enough in compliance programs. A prime example is the challenges Robinhood faced after its failed launch of a checking and savings account late in 2018, he says.

“Firms are not putting enough focus on building out strong compliance programs to understand how to operate in a highly-regulated industry,” Raghavan says. “If they want to remain viable and compete with incumbent firms like Vanguard and Schwab, they will need to get their regulatory basics right — otherwise, investors may lose faith and hesitate before sending their money to robo advisors.”

That might be changing. Compliance roles are some of the most sought after positions at fintech firms, according to research from Bloomberg. Fintechs are actively looking to fill open compliance positions, according to job posting data. Among them are Betterment, Robinhood and Wealthfront, which have openings in compliance-related roles.

However, compliance staff is generally far outnumbered by other departments, according to the research. For example, the digital lending provider SoFi has more than twice as many people who list roles in marketing than compliance, according to accounts listed on LinkedIn.

“It’s the shiny penny problem,” says SIFMA managing director Melissa MacGregor at the FINRA RegTech panel in January. “You think you don’t need as many people when you have this new technology. In reality you probably need more people, in the short term, and more expensive people.”

In the case of Betterment, the firm says it was highly proactive about its time as a robo startup and was eager to engage the SEC with comments and questions about the process, says Khentov. “It seemed like a strange thing to do,” Khentov says, about reaching out to regulators. “We were very small and trying to work quickly and reduce any surface area that would get in the way of shipping product.”

But, pretty early on the firm ran into questions that didn’t have readily available answers. “Ultimately, the people you wind up talking to on that end are the people who are fundamentally interested in the intellectual aspect of what you’re doing,” Khentov says, “and can potentially help you get through the more tactical process.”

Betterment hasn’t been without its skirmishes with regulators. The New York-based robo was handed a $400,000 fine by FINRA for failing to comply with customer protection rules in June. Known as “window dressing,” the firm arranged to make transactions differently on the days that it was required to calculate its reserve deposits, which reduced its customer reserve account obligations, the regulator says.

While digital firms are bracing for increased scrutiny and hiring more experienced compliance staff, regulators will continue to increase surveillance on new forms of online investing. In fact, regulators have much more work to do to adequately protect retail clients, according to Baker.

“Regulators need to get involved and ask for clear explanations of exactly what algorithms are doing and then test the algorithms to make sure they’re verifiable,” Baker says. “That’s not rocket science.”

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