When asked about its stance on artificial intelligence ("AI") in financial services, ChatGPT responded with: "Ethical use of AI in the financial services industry is not just best practice, it's a moral imperative to safeguard the trust and financial well-being of individuals and society." Straight from the horse's mouth.
AI is used in financial services in a variety of ways, including algorithmic trading ( "algo trading" ). Algo trading is a widely used application of machine learning in finance, where automated computer algorithms analyse large datasets and identify patterns and signals to optimise for, predict, guide, forecast, or direct investment-related behaviours or outcomes. These algorithms are designed to analyse market data and identify trading opportunities. Algo trading has become increasingly prevalent in the financial industry due to its ability to execute trades at high speed and efficiently manage large portfolios. However, it does raise concerns about market stability, fairness, and the potential for unintended consequences, leading to regulatory oversight and ongoing discussions about its ethical use.
AI is also frequently used in financial services for:
- Portfolio management,
- Risk assessments,
- Fraud detection,
- Data analytics (like market analysis, customer insights, and personalise services) and
- Customer services.
While these applications may enhance efficiency, accuracy and customer experience, there is a growing concern about the potential risks. This includes biases and inherent conflicts of interest in using AI without implementing proper systems and procedures to ensure responsible use.
With the rapid growth in the use of AI in financial services, more regulators are proposing rules for its use. The US Securities and Exchange Commission ("SEC") has proposed new rules mandating broker-dealers and investment advisers to address conflicts of interest tied to their use of predictive data analytics ("PDA") and AI technologies when interacting with investors. This aims to ensure that companies prioritize investor interests over their own. The proposed rules explain that while these conflicts are not new, the scalability of these technologies and the potential for companies to reach a broader audience at a rapid speed could cause investor harm.
Some of the conflicts of interest mentioned in the proposed rules are:
- An investment adviser who is paid a percentage fee based on assets under management has an incentive to encourage a client to move assets into their advisory account, which could conflict with investors' interest or;
- A broker-dealer that receives transaction-based commission has an incentive to maximise the frequency of transactions, which could increase costs to the investor or expose them to other risks associated with excess trading. Similarly, companies offering proprietary products have an incentive to favour those products over other non-proprietary alternatives.
The SEC report further states that the investment advisor's increasing use of PDA-like technologies in their interactions may expose investors to unique risks. This may include a company using PDA-like technologies to automatically develop advice and recommendations that are then transmitted to investors through the company's chatbot, push notifications on its mobile app, or robo-advisory platform. If the advice or recommendation transmitted is tainted by a conflict of interest because the algorithm drifted to recommending investments more profitable to the company or because the dataset underlying the algorithm was biased toward investments more profitable to the company, the transmission of this conflicted advice and recommendations could spread rapidly to many investors.
The SEC, therefore, proposed "conflicts rules" which would generally require a company to:
- Evaluate any use of, or reasonably foreseeable potential use, by the company of technology in any investor interaction to identify any conflict of interest associated with that use or potential use;
- Determine whether any such conflict of interest places or results in placing the company's interest ahead of the interest of investors and
- Eliminate or neutralise the effect of those conflicts of interest that place the company's interest ahead of the interest of investors.
The proposed conflicts rules would require a company that has any investor interaction using covered technology to adopt, implement and maintain written policies and procedures reasonably designed to achieve compliance with the proposed conflicts rules. Included in these policies should be:
- A written description of the process for evaluating any use (or reasonably foreseeable potential use) of a covered technology in any investor interaction;
- A written description of any material features of any covered technology used in any investor interaction and of any conflicts of interest associated with that use;
- A written description of the process for determining whether any conflict of interest identified pursuant to the proposed conflicts rules results in an investor interaction that places the interest of the company or person associated with the company ahead of the interests of the investor;
- A written description of the process for determining how to eliminate or neutralise the effect of any conflicts of interest determined pursuant to the proposed conflicts rules; and
- A review and written documentation of that review, no less frequently than annually, of the adequacy of the policies and procedures established pursuant to the proposed conflicts rules and the effectiveness of their implementation as well as a review of the written descriptions established pursuant to the proposed conflicts rules.
In South Africa, we have no specific rules on the use of AI in financial services. However, according to King IV (Information Governance and Data Governance), the board is responsible for the ethical management of information technology, including information management and data protection and the need to identify and manage risks and opportunities related to information technology. This would include ensuring that the company employs technology, such as AI, responsibly.
Read our previous article here for some practical tips.
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