Safeguarding, AI Proposals Scrutinized by Lawmakers

Concerns about cash deposits and the definition of ‘covered technology’ dominate the criticisms of both rules.

Industry leaders in letters this week called on the Securities and Exchange Commission to fully withdraw its proposals on artificial intelligence and conflicts of interest and on the safeguarding of advisory assets.

Artificial Intelligence and Conflicts of Interest

The artificial intelligence proposal would require advisers to eliminate conflicts of interest that arise from their use of technology that uses “analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor.”

A letter from industry leaders was signed by the Investment Company Institute, the Insured Retirement Institute, the U.S. Chamber of Commerce business organization, the American Investment Council and other organizations. They describe the proposal as part of the SEC’s “continued war on technology.”

Specifically, the organizations argue that the “lack of discernible boundaries” on what technologies qualify will function “as a de facto ban on the use of technology.” The definition, they argue, is so broad as to encompass essentially every digital tool and therefore functions as a ban on conflicts of interest, as well as a wide range of technology.

The letter also argues that the SEC lacks the legal authority to require advisers to eliminate conflicts, when in all other cases they are only required to mitigate and disclose those conflicts.

The AI proposal also has opponents on Capitol Hill. At a hearing Tuesday before the Senate Committee on Banking, Housing and Urban Affairs, Senator Tim Scott, R-South Carolina, described the rule as a “power grab to regulate emerging and existing technologies” that goes beyond the SEC’s legal authority and would stifle innovation.

Senator Mike Rounds, R-South Dakota, said of the proposal that it is a “restrictive regulatory regime that will govern any analytics tool and is inconsistent with decades of legal and commission precedent regarding the handling of conflicts of interest.”

SEC Chairman Gary Gensler, who testified at the hearing, argued that artificial intelligence is different from other technologies in important respects, especially as it relates to conflicts of interest. “The nature of artificial intelligence is that it is sometimes has so many factors—millions, if not billions, of variables—that it’s looking at, that it’s very hard to explain” to investors and therefore not suitable for a mitigation-and-disclosure regime. This is because issuers would struggle to explain the technology comprehensively in disclosure documents, and investors would struggle to read them, Gensler argued.

The public comment period for the AI rule closes on October 10.

The Safeguarding Proposal

On Tuesday, 26 industry groups wrote a public letter to Gensler urging the SEC “not to adopt the [Safeguarding Advisory Client Assets’] in its current form.” The letter is signed by the Securities Industry and Financial Markets Association and the Investment Company Institute, among others.

The safeguarding proposal would require advisers to obtain assurances that their client’s assets are segregated from that of the custodian to ensure that the assets are protected in case of custodial bankruptcy.

Since the proposal makes no distinction between assets, it would apply to cash deposits at custodial banks, which is perhaps industry actors’ greatest concern about the rule. The letter cautions that this element would limit banking credit and increase the costs of credit.

Rounds said the proposal would mark “a fundamental shift from current banking practices” related to cash deposits.

The letter also criticizes the proposal for redefining discretionary trading as custody, which they argue will also increase advisory fees.

The public comment period for the safeguarding proposal closes on October 30.

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