Introduction

Advancements in technology means that the provision of investment services and transactions is no longer limited to face-to-face consultations with a staff member of a financial institution, but has been extended to online platforms including mobile applications. A recent trend is the provision of investment advice generated by artificial intelligence, which is known as “robo-advice”.

In light of the transformation of modes of providing investment advice, the Securities and Futures Commission (the “SFC”) issued the Consultation Paper (the “Consultation Paper”) on the Proposed Guidelines on Online Distribution and Advisory Platforms (the “Proposed Guidelines”) in May 2017.

This newsletter discusses the proposed regulatory framework governing robo-advisors and its upcoming challenges.

What is robo-advice

A core component of robo-advice is algorithm, which consists of a computer-generated and predetermined set of rules for delivering specific execution outcomes. Advice on investment portfolio can be programmed based on personal circumstances inputted by the investors. For instance, advice can be tailored to achieve certain investment goals, such as planning for education of children and saving for retirement. For robo-advice in a more advanced form, the use of artificial intelligence algorithm enables the robo-advisors to change their responses when exposed to new situations and gain new experiences which were not contemplated by the programmer.

Approaches to utilise robo-advice in the market vary. On the one hand, it can be utilized as a tool to assist an ordinary human financial advisor in providing investment advice, thereby leveraging the capability of human advisor. On the other hand, it can go as far as providing fully-automated investment advice through online platform without any human intervention.

The Proposed Guidelines

In May 2017, the SFC issued the Consultation Paper and proposed to introduce a set of specific guidelines applicable to all SFC-licensed or registered persons when conducting regulated activities online in providing order execution, distribution and advisory services, including the provision of robo-advice. The following discussion focuses on the major guidelines in relation to the provision of robo-advice.

Governance and control

On top of introduction of general principles for operation of online platforms offering investment services, the SFC proposed specific guidelines on the provision of robo-advice. When robo-advisors are soliciting potential investors, they must ensure sufficient and accurate information in relation to the services of such robo-advisors are provided (such as risks, limitations of the services and degree of human intervention), to enable the potential investors to make an informed decision. After the robo-advisors are engaged by investors, they should obtain sufficient information from the investors in order to provide suitable and customized advices.

In addition, the design and operation of algorithms, being the core component of the robo-advice system, are addressed in the Proposed Guidelines. Licensees are required to manage and supervise the design, development, deployment, operations and testing of the algorithms used by the robo-advisors. In particular, objective criteria should be used to generate suitable investment advice. It is explicitly stated that the algorithms should not be programmed to direct investors towards particular investment products for which the licensees receive higher commissions or other benefits.

Suitability requirement

Further, the Proposed Guidelines endorsed the applicability of the suitability requirement from paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the SFC to robo-advisors, with the following obligations:

• The advice and recommendation must be based on thorough analysis and take into account availability of similar, less costly products;
• The risk/return profile of the recommended investment product must match with the investor’s personal circumstances (for instance, by assessing his risk tolerance and risk profile and conducting due diligence to ascertain the risk return profile of an investment product); and
• The risk profiling mechanism should be (i) properly designed so as to take into account both quantitative and qualitative factors (including credit risk, liquidity risk and use of leverage); and (ii) periodically reviewed and updated.

Regulatory challenges

Regulator’s capability in monitoring robo-advisors

In an ideal situation, the automation features of robo-advice should render it accurate and objective. It should also be less prone to human and clerical errors in the sales process. However, robo-advisors are ultimately designed by human, who may be tempted to utilize robo-advisors as tools for their personal benefits instead of acting in the best interest of investors. For instance, the algorithms may be designed in a way that investors are steered to invest in products which offer higher commissions to the licensees. Accordingly, conflict of interests arises between the licensees and investors, and eventually to the detriment of investors.

The Proposed Guidelines do offer guidance in this respect, by requiring robo-advice to be given based on objective criteria and explicitly prohibiting the programming of algorithms for personal interests of the licensees. However, there are doubts as to whether the regulators are well-equipped to understand the overwhelming algorithms behind the robo-advice platforms. The concern is aggravated with the advent of artificial intelligence algorithms. Its ability to learn enables robo-advisors to respond to new situations without being explicitly programmed. Therefore, apart from implementing procedures to regularly assess the algorithms, the regulators have to create scenarios to robustly test the robo-advisors.

Regulation of alternative approaches to investment advice

Pursuant to Part V of the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong), provisions of investment advice in relation to securities and future contracts are “regulated activities”, thereby requiring a licence granted by the SFC.

As discussed, robo-advisors may have different levels of participation in the provision of investment advice, including fully-automated robo-advisors that directly interact with the investors through an online platform and robo-advisors with human intervention. For partially-automated robo-advisors, investors may interact with the robo-advisor through a call center. In this context, it is possible that only the robo-advisors, but not human representatives, are fully aware of the nature of the investment products. Uncertainties arise as to whether such call center representatives and/or the call center operators are required to be licenced under the SFO (as these staff do not provide investment advice themselves, but are merely relaying investment advice from the robo-advisor), which are not addressed in the Proposed Guidelines.

Distinction between specific investment advice and general guidance

Under the current regulatory regime, only provisions of specific investment advice such as recommending investment on certain securities are regulated activities. The licensing requirement does not cover activities involving a mere provision of general factual market information where no specific recommendation or advice is given[1]. John Griffiths Jones, Chairman of the Financial Conduct Authority in the United Kingdom, commented that “the distinction between advice and guidance, once reasonably clear, has become much greyer with the advent of platforms and the potential of robo advice”[2].

An example of such grey area is the suggestion of certain kinds of products for investors with different investment objectives by filtering tools, with a disclaimer stating it is not a specific investment advice. Nonetheless, even when detailed disclaimers are set out, in an online context, investors have minimal opportunity to seek clarification and the robo-advisors cannot examine the investors’ perception and understanding of such information. In addition, it is customary for Internet browsers to click through the disclaimers without reading them thoroughly.

Conclusion

One of the major objectives of the SFC is to offer protection to the investing public. While the introduction of robo-advisors may bring about a major shakeup of the asset management industry alongside the Exchange Trade Funds to allow retail investors to access a wider range of investment products at a lower fee than otherwise possible, this poses new regulatory challenges.  It remains to be seen how the SFC would regulate new and existing licensees on the provision of robo-advisor services.

For enquiries, please contact our Litigation & Dispute Resolution Department:

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.