How are robo-advisors regulated
Robo-Advisor - regulatory hurdles when using artificial intelligence in financial services
In the investment advisory and asset management business, personal advice from financial service providers has so far been in the foreground. In the course of omnipresent digitization, this area is also experiencing the dawn of a new era. Banks, securities dealers, asset managers, investment advisors and also software developers, often start-ups, are increasingly offering their customers services controlled by artificial intelligence. The so-called “Robo-Advisor”, which automatically determines investment recommendations based on algorithms and, if necessary, also makes and executes investment decisions for the customer, opens up exciting new business models with not insignificant scaling potential. Such applications are currently sprouting up, especially in the area of virtual assets. However, the use of such software in a highly regulated area such as the financial market brings with it many questions, some of which are still unanswered, from a regulatory perspective. Depending on the orientation of the offer and the business model, providers of such services require approval from the Swiss Financial Market Supervisory Authority (“FINMA”) or affiliation with a supervisory organization (“AO”) or a self-regulatory organization (“SRO”). This article presents the main features of the relevant financial market regulation and the questions that are open today.
Why robo-advisors are used and what they can do
Robo-advisors are digital platforms or mobile applications that usually provide various financial services through an algorithm. Robo-advisors can use preprogrammed questionnaires to create customer and risk profiles and, on the basis of the data collected, use algorithms to diversify and optimize sample portfolios, determine investment proposals or optimized buy / sell times, and monitor the portfolio based on the personal risk profile. In the investment advisory and asset management business, they are primarily used as supporting digital investment advisory instruments and thus enable a significant reduction in transaction and advisory costs. In practice, however, fully automated and partially autonomous models (i.e. without human involvement) that have been developed by start-ups are emerging. Typically, the customer receives access to a digital platform, which he uses actively and independently, but the service is provided fully automatically. Most robo-advisors allow the pre-configuration to be defined, e.g. a certain pre-selection of investment products or categories, the definition of threshold values for buy / sell transactions, automated portfolio rebalancing and / or make possible investment decisions as part of the pre-configuration. The business models of the robo-advisor providers differ in terms of both automation and standardization.
Legal classification and regulatory challenges
From a legal point of view, the primary question is whether a company that wants to offer robo-advisor services carries out a regulated activity with the planned offer and requires prior approval from FINMA or affiliation with a supervisory organization ("AO") or a self-regulatory organization ("SRO") is required. Both of these entail various organizational and personnel requirements as well as an extensive approval or admission process (depending on the situation). It is particularly important to differentiate whether the robo-advisor is used for asset management or investment advice. The question is relevant because asset managers and, if applicable, investment advisors who invest in financial instruments in the name and on behalf of their clients will be recruited for the exercise of their activities with the entry into force of the Financial Institutions Act (“FinIA”) and the Financial Services Act (“FinSA”) Require authorization from FINMA (see our magazine article “Authorizations and licenses according to FINIG - an overview”). However, asset managers (including investment advisors who invest in financial instruments) are not supervised directly by FINMA, but rather by an AO to which they must be affiliated. Investment advice, on the other hand, does not require a license. Under the new FinIA / FinSA legislation, investment advisors, so-called client advisors, only need an entry in an adviser register and connection to an ombudsman, unless they are prudentially supervised. Under certain circumstances, however, based on the Money Laundering Act, investment advice may require connection to an SRO if the investment advisor also makes investments on behalf of his client. The demarcation to asset management is not always clear and requires an assessment of the contractual relationship and scope of power of attorney.
For software developers, on the other hand, from a legal point of view, the question of how the offer should be structured so that there is no activity relevant to approval or supervision is usually of interest.
Asset management vs. investment advice
An asset manager is someone who, based on an order, can dispose of their assets on a commercial basis in the name and for the account of the clients within the meaning of Art. 3 lit. c No. 1-3 FinSA. It is characteristic of asset management that the person entrusted with the assignment independently takes on the (comprehensive) care and support of the assets entrusted to them as part of an investment strategy agreed in advance. Investment decisions are usually made independently by the manager. The asset manager is given a power of attorney to invest the assets in the name and for the account of his clients.
Investment advice, on the other hand, usually (only) includes giving advice and recommendations with regard to an investment decision regarding investment transactions that relate to financial instruments within the meaning of Art. 3 lit. c No. 4 in conjunction with Art. 3 lit. a FinSA. The investment advisor therefore supports the client with his specialist knowledge, but the client usually makes the investments himself. However, one speaks of investment advice only if the advice includes a personal recommendation and not just general expectations. For a detailed delimitation, see our magazine article “Distinction between pure investment advisors and asset managers”.
Robo-Advisor as an asset manager
The services provided by a robo-advisor can then qualify as asset management and are therefore subject to an authorization requirement within the meaning of FinIA if their activities also include investment decisions regarding financial instruments within the meaning of FinIA / FinSA and their execution.
Robo-advisors who only offer investment advice but do not make and execute investment decisions are not subject to FinIA. However, as soon as the activity of the robo-advisor includes independent investment decisions for individual portfolios, which the robo-advisor also executes, authorization from FINMA is required. The activity is then also subject to the Money Laundering Act due to the power of disposal over third-party assets.
The offer of the robo-advisor regularly includes an advisory component (“Advice”). As a rule, however, it cannot be understood as an execution-only service.
Asset managers who buy or sell financial instruments that qualify as securities for their clients via their own account or custody account may also fall under the provisions for securities firms, for which a corresponding license would be required (cf. Art. 2 in conjunction with Art. 41 ff. FinIA).
Robo-advisor as an investment advisor
The service of a robo-advisor qualifies as investment advice if the service relates to financial instruments within the meaning of Art. 3 lit. c No. 4 in conjunction with Art. 3 lit. a FinSA, whereby the content of the service must contain a personal recommendation. A personal recommendation is to be accepted if the digital questionnaire asks about personal circumstances (e.g. the investment goal and the expected return) and the robo-advisor uses an algorithm based on this data to make an individual recommendation with regard to certain financial instruments to the customer's address. In contrast to the asset manager, the investment decision remains with the customer, who then independently initializes and executes the investment proposed by means of the robo-advisor.
In practice, however, there are various ways in which robo-advisor applications can be structured so that they do not fall under financial market regulation. Starting points here are, on the one hand, the transfer of investment decisions to the user and, on the other hand, the restricted use in structures exempt from regulation, such as investment clubs or investment companies within the meaning of the exception regulation in the Federal Act on Collective Investment Schemes ("KAG"), which independently (without Involvement of a third party). Such configurations, however, involve some hurdles and must be carefully considered on a case-by-case basis.
Authorization and supervision
Robo-advisors, whose service qualifies as asset management within the meaning of FinIA, have had to be approved by FINMA since the introduction of FinIA on January 1, 2020 and be subject to the ongoing supervision of a supervisory organization ("AO"). The authorization must be obtained from every person who commercially invests or manages assets for third parties on their account within the meaning of Art. 17 para. 1 FinIA. If the activity of a robo-advisor does not fall under Art. 17 para. 1 FinIA, e.g. because they are not financial instruments within the meaning of FinIA / FinSA, such robo-advisors are not subject to prudential supervision. The service, which includes the making of investments, can nevertheless be subject to the Money Laundering Act and thus require a connection to an SRO (Art. 2 Para. 3 lit. f of the Money Laundering Act, "GwG").
However, if the robo-advisor does not make any investment decisions and does not make any investments, the question arises whether such a robo-advisor has to be entered in the newly created client advisor register according to FinSA. This question is currently unanswered. However, it is necessary to join an ombudsman (Art. 77 FinSA).
Applications and duties of the FinSA
Regardless of the question of whether the (commercial) service of the robo-advisor qualifies as asset management or investment advice, the subordination under the FinIA and / or FinSA (if asset management or investment advice is about financial instruments) entails a number of rules of conduct that must be observed when setting up the Robo-Advisor. This includes, in particular, information obligations, suitability and appropriateness tests, documentation and accountability obligations as well as transparency obligations and due diligence obligations. Reliefs in this regard are only provided for institutional and possibly professional customers.
Our FinTech team is happy to be at your disposal in all matters and will actively support you in clarifying open questions in connection with the FinIA and FinSA, compliance with the associated requirements and all other questions that arise for new and existing robo-advisors can.
September 2020 | Authors: Michèle Landtwing, Admira Besic, Danilo Maric
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