SEC’s Predictive Data Analytics Rule Proposal in Focus

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Simply defined, predictive analytics in trading uses past data to predict future market movements. Predictive data analytics (PDA) isn’t new, but technological advances including the deployment of artificial intelligence have vastly improved capabilities, while also catching the eye of regulators.

Proprietary trading firms have deployed PDA to generate alpha for a long time. More recently, some firms have sought to democratize this emerging technology by providing access to intelligent market data to those who lack the resources to build in-house, including firms serving retail investors.

In July 2023, the U.S. Securities and Exchange Commission proposed new rules that would require broker-dealers and investment advisers to take certain steps to address conflicts of interest associated with their use of predictive data analytics and similar technologies to interact with investors.

The SEC proposal has met with broad opposition from the financial services industry. Just this week, U.S. Senators Bill Hegarty (R-TN) and Ted Cruz (R-TX) introduced the Protecting Innovation in Investment Act, in an attempt to stop the SEC proposal from moving forward.

SIFMA released a statement in support of the Act. “Broker-dealers and investment advisers rely on the technologies targeted by this proposal to provide critical educational tools and financial benefits to their customers, especially low- to middle-income retail investors and retirement savers,” SIFMA Executive Vice President of Advocacy Josh Wilsusen said in the statement. “This proposal would curtail access to these important technologies, harming the very investors the proposal aims to protect.” 

Investor Advisory Committee Input

The SEC’s Investor Advisory Committee has recommended that the US regulator narrow the scope of its proposed PDA rules.

The dialogue between the SEC and its industry-represented committee provides a snapshot of the current PDA landscape as trading and investment firms and technology providers await the SEC’s next communication on the topic.

The comment period for the July 2023 PDA rule ended in October and Gary Gensler, chair of the SEC, appeared before the regulator’s Investor Advisory Committee in December to discuss the feedback. 

Gensler told the committee: “We live in an historic, transformational age regarding predictive data analytics and the use of artificial intelligence. This also raises the possibilities that conflicts may arise to the extent, for example, that advisers or broker-dealers are optimizing to place their interests ahead of their investors’ interests.”

He continued that the aim of the proposed rule is to ensure that firms do not place their interests ahead of investors’ interests in their use of covered technologies. A “covered technology” is defined as any analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes. 

“This is the same standard that we apply already under Regulation Best Interest (Reg BI) to brokers when they make recommendations to retail investors or to advisers—under our interpretation of fiduciary duty under the Investment Advisers Act of 1940—when they provide investment advice,” said Gensler. “I would note that under those current rules and interpretation, brokers and advisers cannot address these conflicts of interest through disclosure alone.”

The proposed rules would also require a firm to have written policies and procedures reasonably designed to achieve compliance with the proposed rules and to make and keep books and records related to these requirements.

Committee recommendations 

The draft minutes of the meeting said the committee applauded the SEC’s efforts to address concerns around PDA and to get out in front of and head off emerging issues, including the increasing use of technologies that are transforming the securities industry, some of which could do harm to investors. 

However, the committee said it is concerned that certain aspects of the PDA proposal may have unintended consequences that negatively impacts investors, especially as the rule imposes many rigorous prescriptive requirements on an overly broad swath of technologies. 

“Efforts by firms to comply with the current formulation of “covered technologies” combined with the current formulation of “investor interactions” could have unintended adverse impacts on investors by overly curtailing access to valuable information, tools, and assistance, and impeding the adoption of new, beneficial technologies,” said the committee. 

For example, a firm’s legal advisors and technology strategists could say that the definition of covered technologies could apply to virtually any technologies used in connection with investment issues, including daily portfolio management and trading where the investment adviser has investment discretion. The definition could also likely be construed to cover basic technologies that would enable retirement plan participants to determine how much they need to save or how much money they can afford to spend annually during retirement.

In addition, the committee said the definition of “investor interaction” is also quite broad and could be interpreted to include virtually any communication or presentation of visual or other sensory data to investors by whatever means. 

“Further, the PDA Rule Proposal defines conflict of interest as using any covered technology in a way that takes into consideration an interest of the broker-dealer, the investment adviser, or the associated person,” added the committee. “This definition is unworkably broad in a practical sense as it could have the effect of defining any interest as a conflict.”

For example, the definition is not limited to those interests that are contrary to the interests of the customer or client, and has the potential to capture interests not necessarily harmful to investors and there is also no requirement that the conflicts are material. 

Therefore, the committee recommended that SEC should target its proposals on predictive data analytics and artificial intelligence that interact directly or that facilitate direct interaction with investors rather than using language which could be construed as covering virtually every technology used by broker-dealers and advisers and should be should be aligned and designed to work with Regulation Best Interest and the Adviser Fiduciary Duty Interpretation. 

Comment letters

The committee meeting followed the close of the comment period of the PDA proposal last October, and its review of the responses. 

For example, Stephen John Berger, global head of government & regulatory policy at Citadel, said in his letter that the proposal would harm investors and should be withdrawn in its entirety. In addition, Berger said that if the SEC moves forward with this rulemaking, at minimum, any new requirements under the Advisers Act should not apply to advisers of private funds. 

Berger wrote: “The Proposal’s name alone grossly misrepresents its ill-considered and over-expansive scope. Despite being advertised as narrowly focused on predictive data analytics, it would place reckless and unworkable restrictions on investment advisers’ use of any technology in the investment process writ large.”

Melissa MacGregor, deputy general counsel and corporate secretary at SIFMA and Kevin Ehrlich, associate general counsel at SIFMA Asset Management Group, said in their comment that the proposed rule fails to provide any rational basis for concluding that the existing, robust regulatory regime is insufficient to address the specific concerns raised and should not be adopted. 

“To the extent the Commission believes that there is a need to augment the existing regulatory regime, it can and should work constructively with industry to address those concerns in an appropriately targeted and evidence-based manner,” said MacGregor and Ehrlich. “The Proposed Rules do not reflect such a reasoned approach and for that reason should not be adopted.”

Danielle Nicholson Smith, managing legal counsel, and Jonathan Siegel, managing legal counsel at T. Rowe Price, said in their response that they generally supported the Asset Management Group of SIFMA, the Investment Company Institute and the Investment Adviser Association in believing that the proposal should be withdrawn and not adopted. They gave their four most important reasons as the proposal not identifying new or unique conflicts; existing regulations providing sufficient protection; the proposed rules being fundamentally flawed; and that the rules would stifle innovation.