The Securities and Exchange Commission (SEC) is taking a proactive stance on integrating artificial intelligence (AI) in the financial sector. While comprehensive federal legislation on AI remains a distant possibility, the SEC has proposed new rules to address potential conflicts of interest arising from AI use by broker-dealers and investment advisers.
A divided stance on AI regulation
The SEC’s proposal, stemming from concerns under the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, aims to regulate the use of AI and other analytical technologies. However, the 3-2 vote on the proposed rules indicates a division among the SEC commissioners about the necessity of such regulations. Stakeholders have 60 days to comment once the proposal is published in the Federal Register.
Protecting investor interests
Announced on July 26, 2023, the primary objective of these rules is to safeguard investors. The SEC aims to ensure that broker-dealers and investment advisers do not exploit “predictive data analytics” (PDA) and related technologies to prioritize their interests over those of their investors. Concerns arise from the potential misuse of these technologies to manipulate investor behavior or optimize firm revenue at the investor’s expense.
The SEC’s primary concerns include
– The opaque nature of “black box” PDA technologies makes it difficult to understand their decision-making processes.
– The risk of relying on biased, corrupted, or mislabeled data.
– The potential for technology to amplify conflicts of interest with investors.
To address these issues, the SEC proposes rules that focus on eliminating or mitigating these conflicts rather than merely disclosing them.
Key provisions of the proposed rules
Defining ‘covered technology’:
The term refers to any technological or computational method influencing investment-related behaviors or outcomes. This broad definition encompasses various technologies, including AI, machine learning, and neural networks. The SEC has explicitly included technologies like AI, deep-learning algorithms, and natural language processing models under this umbrella.
Scope of application
The rules apply whenever a firm uses a “covered technology” to interact with an investor. This includes any engagement, communication, or exercise of discretion related to an investor’s account.
Conflict of interest clarification
The proposed definition of “conflict of interest” is expansive, encompassing any situation where technology might consider information favorable to the firm during an investor interaction.
Requirements for using ‘covered technology
Firms would need to evaluate the potential conflicts arising from using such technology, adopt and implement policies to prevent violations and maintain records related to these rules.
Implications and observations
The SEC’s proposal marks a significant departure from traditional securities laws, emphasizing eliminating potential conflicts rather than just their disclosure. The broad definitions of “covered technology” and “investor interaction” could encompass many tools and interactions, potentially affecting even basic technologies like spreadsheets and statistical tools.
The compliance requirements, especially eliminating or neutralizing conflicts, could pose significant challenges, especially for smaller firms. There’s also a potential risk that these regulations could stifle innovation and deter firms from adopting technologies that could benefit investors.
As the world grapples with the implications of AI and related technologies, the SEC’s proposal is a significant step in the ongoing debate about how best to regulate these powerful tools in the financial sector.
