Globalization, financialization and digitalization has led to the identification of new needs for regulating finance.
To examine this, it is necessary to analyze the regulatory interventions that arise from policymakers and to understand the impact of the oversight of the use of new technology in asset management. In particular, the “new business models, applications, processes or products with an associated material effect on financial markets and institutions and the provision of financial services” (as the Financial Stability Board stated in 2019 in “Monitoring of fintech”). It is important to remember that past research has highlighted that policymakers have generally avoided disciplinary intervention into the status of the technical structure of asset managers.
Therefore, the regulators may open the asset management industry to technological innovations, and then clarify the use of algorithms, software and any other high-tech tools or devices or autonomous tools based on machine learning and artificial intelligence. Most of the conclusions will refer to the need for regulating fintech in order to protect savings, market integrity and price stability. Indeed, as the use of algorithms makes the source and the methodology of artificial reasoning visible, the supervisors may control what programmers and coders have written in the logical sequence underlying the high-tech investment process; hence, it is possible to control how software will provide an output in respect of certain inputs. Therefore, we expect new ways of regulation and control over asset managers that apply fintech solutions to their activities.
2. Fintech firms as outsourcers of asset managers.
The juridical difference between in-house and outsourcing providing of fintech services refers to the involvement of other entities, and therefore to the role of contracts and to the decision-making power that is present in the organizational structure of the asset manager.
In this context, the contracts between the mangers and the fintech outsourcers may refer to the execution of the investment policies and the asset management itself, because of the importance of the algorithms, big data and any other specifics chosen by the outsourcers. Therefore, it is possible to question the current way the law regulates such contracts, because it has not been designed to regulate digitalization and, in particular, the possibilities due to sharing, common usage, duplicability, intermediation, etc.
Current regulation may not be suitable for an extensive use of outsourcing policies in asset management, whose content complies with the investment policies agreed with the investors (and is written in the fund rules). Indeed, the application of fintech solutions innovates the business configuration. The current rules on outsourcing appear inadequate to regulate the use of fintech solutions, as long as these solutions may influence the sound and safe management of the savings collected by asset managers.
Hence, there needs to be authorization for the provision of fintech services (as it is provided for the exercise of similar activities managing the multilateral systems that bring interests together as alternative venues for financial instruments). On the contrary, there is no evidence that justifies putting such firms outside the supervision of a public authority.
There is no justification for allowing fintech firms to seize new opportunities without following a safe process (similar to that provided to get authorization to carry out one of the reserved activities that these firms intend to replace, supplement or improve). We should recall the European Central Bank’s “Guide to assessments of fintech credit institution licence applications”, which follows a comprehensive approach to the business of banking (including the business model in which the production and delivery of banking products and services are based on technology-enabled innovation).
It is possible that the monitoring of the asset management industry cloud is leading to the extension of regulation to the fintech providers and in particular to decentralized financial technologies, artificial intelligence, big data analytics, open banking and programming interfacing (APIs). It is worth recalling that, with respect to banking, the EBA stated that the “materiality of cloud outsourcing determines whether an institution is required to adequately inform its competent authority about it”. This may suggest including in the scope of public supervision the fintech tools used in risk-taking, decision-making and record keeping. Accordingly, this may require also the compliance of the mechanisms used for organizing and running the platforms used by asset managers.
The same attention should be paid to the growing importance of the firms running the fintech platforms, and their role in the provision of varied services to support asset managers in implementing the investment policies of their investment funds., It is useful to divide platforms into those that are (i) alternative (so called non-bank financial intermediation); (ii) instrumental (aimed at improving the use of traditional services, e.g. websites comparing offers); or (iii) competing (which need a special authorization, e.g. fintech banks). This will depend on the contents of the agreements concluded between the platform’s managing firm and the asset manager, with respect to the rules on access and the functioning of such platforms, as well as the ancillary services provided by the aforesaid firm. Therefore, there needs to be specific rules to govern this way of innovating the operating model of traditional operators.
3. The use of fintech platforms by asset managers
An asset manager may use a platform in order to gain advantages from a virtual shared-resource system where individual users, acting independently, may offer or demand money or risks. This applies to platforms that allow the execution of exchanges (or the provision of services) that in the past were exclusively related to the performance of reserved activities (by credit institutions, brokerage firms, asset managers, insurance companies, etc.). Today these platforms are based on the possession of a compatible electronic instrument (a device), the use of a computer program (an application), and access to an interconnection network (even immaterial).
An asset manager that aims to use the platforms shall verify, on the one hand, the contents of the supporting infrastructure of the platforms and, on the other hand, the relevant failures. It should also take into account the management of these platforms. Any asset manager should be in a position to verify the resilience of the infrastructure (digital or traditional) behind the website, through which the transactions are carried out, and ̶ as this infrastructure is not supervised ̶ it should assess the compliance of the relevant mechanisms to the disciplinary framework. This requires the transferring of information from the fintech firm to the asset manager.
It is worth noting the systematic use of ICT tools for the execution of the investment policies in asset management (from new infrastructures, to new devices, to new block programming). In addition, they are used to automatize the execution of orders and other actions ofasset management, to access significant aggregations of information (so-called big data) by means of new software architectures (including blockchain technology). This highlights the importance of the platforms in this sector of the financial market, their effect on competition and the new conditions for performing asset management on the basis of cloud computing, big data analysis, artificial intelligence, blockchain and distributed ledger technologies.
However, the risk of abuse of the power held by the ICT service providers, the platform’s managing companies and the fintech firms must also be taken into account. It is worth recalling the approach proposed by the European Commission (through the “Financial Technology Action Plan” COM_2018, 109), which aims at encouraging new types of financial activities under a legal order able to avoid asymmetries within the capital market (between asset managers that use a traditional approach and the others that use platforms and other fintech tools). Obviously, the EU policymakers want to ensure the neutrality of the technology with respect to the protection of private interests and social utility.
From a regulatory standpoint, an asset manager has to consider that technological platforms perform a dual function: the provision of services (alternative or instrumental) and the circulation of capital (to match supply and demand). The result is a dualism between the functions of providing services and managing the market, so that the linkages can be extended to any user of the platforms. Hence, the need to control these platforms and avoid asymmetries in their use by the asset managers.
4. The development of investment policies
In asset management, the fund’s rules set out an investment policy and the legislator reserves to the managers the business of executing such a policy. As any investment policy is made by a set of purchases and sales, the human directors of the asset manager usually develop the relevant instructions, but these instructions can also be set by an algorithm, and then it can be executed by software and any machine learning tool would suggest specific changes to them.
It is worth considering that the use of such ICT tools may be direct or indirect, by the use of fintech firms as software suppliers or outsourcers, even if the power to take an investment decision remains with the board of directors of the asset manager. The automation of the investments requires that every aspect of the investment policy can be so precisely described that a machine can execute it (on the basis of the relevant inputs). This depends on the capability of the programmers to develop an algorithm able to support the performance of the relevant tasks required for the ordering of sales and purchases that leads to the result expected by the investors (in compliance with the fund’s rules). Hence, an asset manager may gain advantages also by a machine-learning system that can solve cognitive problems commonly associated with investment activities (such as gaining information, problem solving, and pattern recognition). It can also use software that supports the human resources that manage the assets of the fund.
All the above comes under an out-of-date regulatory framework, based on the UCITS Directive and the AIFMD. The most common fintech innovations drive the need for regulatory innovations that may lead to the supervision of the services related to the “digital portfolio management”, which includes algorithmic trading, digital ID verification, predictive/descriptive/ prescriptive analytics, and algorithmic trading tools.
The need for regulation creates a risk that the internal features of the relevant software may reduce competition among asset managers. Indeed, there is the possibility that that the decision-making processes may rely on the same set of data or algorithms, and this may align the output of the ICT tools. Hence, the policymaker should intervene to prevent any market failure related to such a possibility. Secondly, asset managers must consider the operational risks associated with both cyber security and cloud outsourcing, and then provide technical standards able to verify that the ICT tools have a coherent and resilient infrastructure and software. Indeed, both these considerations can lead to a concentration of market failures and risks.