Rolling in the Regulations for Robo-Advisers

by Bryan Cave

Robo-advisers have surged in popularity as people seek low-cost, automated investment opportunities. In a worldwide forecast, the number of people to use robo-advisory services is estimated to reach 95.4M by 2021 compared to 5.7M estimated users in 20161. The millennial generation is an early adopter of robo-advisory services making up the largest client base in the US with 80 million investors2. The wealth industry is set to see trillions of dollars of wealth transfer from baby boomers to a new generation of digital natives, with a readiness to adopt new technologies through online channels. The use of messenger and video-calling applications such as FaceTime, WhatsApp and WeChat demonstrate the preference for more action to be taken online and the fading out of face-to-face meetings, paving the way forward for robo-advisers.

Across the APAC region digital growth has accelerated. The amount of people using the Internet is increasing 15% year-on-year, and has now passed the 1.9 billion mark. More than 1.5 billion people across APAC now use social media on a monthly basis, with 95% accessing their accounts via a mobile device3. This is the highest ratio in the world. Financial wealth management firms have tapped into this trend, and demographic niche markets are a key driving force behind the interest in robo-advisory services.

The Burnmark Digital Wealth Report issued in April 2017 compares the millennial population of various countries against an “investor’s digital readiness score”. It should be noted that Hong Kong has one of the smallest millennial populations (under 10 million), however obtained the highest digital readiness score. Baskar Prabhakara, co-founder and CEO of WeInvest expects robo-advisers to take at least 15% market share of APAC’s wealth management industry by 2025, while KMPG’s whitepaper “Robo Advising: Catching Up and Getting Ahead” published in 2015 projected a US$2.2 trillion value for robo advice – a growth rate of 68%.

With this in mind, the Securities and Futures Commission (“SFC”) issued a consultation paper “Proposed Guidelines on Online Distribution and Advisory Platforms” in May 2017, which sought the opinion and comments from members of the public with an interest and key market players on new guidelines aimed at investments undertaken online. Comments on the consultation paper are due back on 4 August 2017, at which point the SFC will introduce new guidelines under s399 of the Securities and Futures Ordinance (“SFO”).

While the SFC currently regulates and oversees offline investment transactions, there are limited regulations for online platforms offering a wide range of investment services. The consultation paper proposes guidelines for SFC-licensed or registered persons who conduct their regulated activities in providing order execution, distribution and advisory services in respect of investment products via online platforms (“Platform Operator”). Traditional offline sale processes typically see clients being guided through their investment options, with product features and associated risks explained by the intermediaries’ representative. One of the key aspects the SFC addresses in the consultation paper is for online investors to be given clear, easy to understand and unbiased literature regarding the product’s features, risks and potential returns.

The proposed guidelines will be in addition to the existing conduct requirements set out under the SFO and other ordinances in effect, the SFC proposes the following core principles:-

  • Core Principle 1 – Proper design : a Platform Operator should ensure that its online platform is properly designed;
  • Core Principle 2 – Information for clients : a Platform Operator should make clear and adequate disclosure of relevant material information on its online platform;
  • Core Principle 3 – Risk management : a Platform Operator should ensure the reliability and security (including data protection and cyber security) of the online platform;
  • Core Principle 4 – Governance, capabilities and resources : a Platform Operator should ensure there are robust governance arrangements for overseeing the operation of its online platform as well as adequate human, technology and financial resources to ensure that all operations are carried out properly;
  • Core Principle 5 – Review and monitoring : appropriate reviews of all activities conducted on the Online Platform should be performed by a Platform Operator as part of its ongoing supervision and monitoring obligation; and 
  • Core Principle 6 – Record keeping : a Platform Operator should maintain proper records in respect of its Online Platform.

Clarification of whether the Suitability Requirement will be triggered is also set out in the consultation paper, with examples provided for various situations. The Suitability Requirement is stated under paragraph 5.2 of the Code of Conduct for Persons Licensed or Registered with the Securities and Futures Commission (“Code of Conduct”) as follows:-

“Having regard to information about the client of which the licensed or registered person is or should be aware through the exercise of due diligence, the licensed or registered person should, when making a recommendation or solicitation, ensure the suitability of the recommendation or solicitation for that client is reasonable in all the circumstances.”

The consultation paper notes that the posting of factual, fair and balanced product-specific materials would not in itself amount to a solicitation or recommendation and the Suitability Requirement would therefore not be triggered. However, it should be noted that the manner of presentation and content of product-specific materials posted via the online platform must be considered as to whether a solicitation or recommendation has taken place. For example, if the platform emphasises one investment product over another, or the platform publishes product-specific “Act Now!” or “Don’t Miss Out!” banners, the Suitability Requirement would be triggered. The consultation paper concludes that the provision of investment advice via an online platform will trigger the Suitability Requirement, which will also apply to any form of robo-advice.

Robo-advice is commonly investment advice provided by Platform Operators using automated portfolio construction or model portfolios based on a client’s personal preference, attitude to investment and circumstance. This type of Platform Operator is defined in the consultation paper as a “robo-adviser”. A typical robo-adviser collects information from clients about their financial situation and future goals through an online survey, and then uses the data to offer advice and/or automatically invests client assets.

The SFC notes that there are a wide range of approaches when it comes to robo-advice, from goal-based advice (such as financial planning to purchase a property) to predefined model portfolios calibrated to a client’s risk category. The consultation paper outlines six area guidelines for robo-advisers, namely:-

  • Information for clients : Robo-advisers will be required to provide sufficient information on its online platform and services to allow investors to make an informed decision, as well as ensuring clear and adequate disclosures are made on an ongoing basis. This includes how the algorithms operate, any limitations or changes to such algorithms, information on portfolio rebalancing mechanisms and any associated risk, along with the degree of human involvement provided by the robo-adviser;
  • Client profiling : When client profiling tools or questionnaires are used to obtain information about clients as part of the know-your-client process, assurances must be made that the tools and/or questions are properly designed to obtain sufficient information on a client’s personal circumstance. Additionally, the robo-adviser must have in place proper mechanisms to identify and reconcile any inconsistences in the information provided by the client. Finally, if a risk-scoring questionnaire is used to assess the client’s attitude to risk, the robo-adviser should pay particular attention to the design of the questions and underlying scoring mechanism to ensure it accurately reflects the client’s personal circumstances;
  • System design and development : Algorithms must be in compliance with relevant conduct requirements including, where applicable, paragraph 18 (Electronic Trading) of and Schedule 7 of the Code of Conduct and any relevant guidelines. Additionally the algorithms must use objective criteria to generate investment recommendations and/or advice that matches the client’s personal circumstances against suitable investment products in a non-biased manner. Platform Operators must also maintain appropriate documentation on the design, development and any modifications made with regards to the algorithms;
  • Supervision and testing of algorithms : Algorithms should be tested before initial deployment and any subsequent changes to the algorithms should be tested before implementation. They should be reviewed by a qualified person who understands the technology, operations and the algorithm itself to generate the advice. Platform operators are required to maintain proper records, documentation and manuals concerning the scope and strategy for testing algorithms, as well as have adequate resources and measures in place to rectify any problems as well the ability to suspend the provision of advice and services as and when necessary. If a third party is used to develop or implement algorithms, the robo-adviser is required to exercise due skill, care and diligence to monitor and select a service provider;
  • Adequate resources : robo-advisers must ensure they have adequate staff who have sufficient expertise and understanding of the technology, operations and algorithms, who are closely involved in the design, deployment and ongoing supervision of the operation of such algorithms. Additionally, training or testing should be provided to all staff use the robo-advisory tools available on the platform; and
  • Rebalancing : robo-advisers should make clear to clients how the rebalancing process operates including the frequency of such rebalancing, any additional costs and any risks associated with automatic rebalancing. When any changes are made to the existing algorithm that may materially affect a client’s portfolio, the robo-adviser must inform the client clearly and promptly of such a change. In addition, policies and procedures are to be put in place that defines how the algorithm would handle a major market event.

More and more robo-advisers are looking to launch mobile applications to meet the demands of the millennial investor, whereby investors can manage their portfolios literally with the touch of a fingertip. The SFC’s consolation paper clearly outlines the need for robo-advisers to provide accurate, easily comprehensible information to investors. One of the SFC’s fundamental concerns seems to be the provision of information to an investor, going so far as giving examples of the use of a chatbox or pop-ups to highlight key information or warnings if, for instance, a change is made to the investor’s portfolio. It will be interesting to see how robo-advisers translate their comprehensive online platforms to mobile applications taking into consideration the requirements stipulated by the SFC.

Investors are demanding more from their financial advisers, expecting easy-to-use, technology-driven apps and platforms to manage their portfolios. As such, there is an opportunity for savvy robo-advisers to capture a large market share as millennials look to invest. The upcoming issuance of the Guidelines on Online Distribution and Advisory Platforms by the SFC will certainly shape how robo-advisers can expand their business operations, whilst taking into consideration the existing legislation, with particular reference to s103, s109 and s113, set out the SFO.

1. Source:

2. Source: Digital Wealth, Burnmark, April 2017

3. Source: Digital in 2017: Global Overview, we are social, 24 January 2017

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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