Finra takes a closer look at robo-advisors

Finra takes a closer look at robo-advisors

US regulatory body Finra (Financial Industry Regulatory Authority) has waded into the growing market for robo-advisory services, warning firms of the need for sound governance and supervision of digital investment tools.

Noting that global spending on digital wealth management services is expected to increase significantly, the watchdog has issued a new report intended to highlight best practice, and to remind member firms of their obligations under Finra rules

“We trust that the report will provide information and guidance for Finra member firms and investors about key aspects of the rapidly growing arena of digital investment advice,” says Richard Ketchum, chairman and CEO. “As these services develop, firms need to ensure that the core principles of investor protection - such as understanding and responding to customers’ needs and objectives - serve as the foundation of these new tools as well.”

Although the report does not create any new legal requirements or change any existing broker-dealer regulatory obligations, it outlines regulatory principles and effective practices in five key areas:
  • Governance and supervision of algorithms, including initially assessing the methodology of digital tools and the quality and reliability of data inputs, as well as ongoing evaluation such as testing the tools to ensure they are performing as expected, and determining whether models used by a tool remain appropriate as market conditions change;
  • Customer profiling, including assessing both a customers’ risk capacity and risk willingness, and addressing contradictory or inconsistent responses in customer-provided information;
  • Governance and supervision of portfolios and conflicts of interest, including determining the risk, return and diversification characteristics of a portfolio that is suitable for a given investor profile, and mitigating - through avoidance or disclosure - conflicts that can arise through the selection of securities for a portfolio;
  • Rebalancing, including providing descriptions of how the rebalancing works and procedures that define how the tools will act in the event of a major market movement;
  • Training that enables financial professionals to understand the key assumptions and limitations of individual digital investment advice tools, and determine when use of a tool may not be appropriate for a client.

The report also suggests that investors evaluate whether their financial services firm is gathering enough information to understand their needs and risk tolerance.

"Investors should be aware that conflicts of interest can exist even with digital investment advice, and that the advice they receive depends on the investment approach and underlying assumptions used in the digital tool," states the body. "In addition, the report recommends that investors understand the fees they are paying and services they are receiving, including such features as portfolio rebalancing."

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