The SEC continues to take action in investor protection and regulatory frameworks in areas of crypto assets, digital engagement practices, and ESG-related disclosures. These themes are highlighted in Chair Gensler’s testimony before Congress and the SEC’s Request for Information and Comment on digital engagement practices. Financial companies should anticipate forthcoming SEC supervision, enforcement, and rulemaking – including disclosure requirements, data protections, best execution standards, conflicts of interest, sales practices, and algorithmic bias/model risk. Similarly, other federal regulators and FINRA are currently active and expanding expectations in supervision and enforcement of investor/consumer protections.
Testimony before Congress
In testimony before the Senate Committee on Banking, Housing, and Urban Affairs, Securities and Exchange Commission (SEC) Chair Gary Gensler highlighted the following four broad themes from the agency’s Spring 2021 unified agenda: i) Market structure, ii) Predictive data analytics; iii) Issuers and issuer disclosure; and iv) Funds and investment management. Highlights of the testimony are provided below.
SEC is reviewing rules in five areas to seek opportunity to “better enhance efficiency and competition.” These areas include the:
- Treasury market – working with the Department of the Treasury, SEC will look to enhance resiliency and competition; recommendations from external groups, such as the Group of Thirty, around central clearing for cash and repo Treasuries will be considered; and firms that significantly trade in this market will be expected to register with the SEC as dealers
- Non-Treasury fixed income market – SEC will focus on greater efficiency and transparency in corporate bonds, municipal bonds, and asset-backed securities
- Equity market – SEC will look to refresh SEC rules to better reflect new technologies; key issues will include potential financial conflicts posed by payment for order flow and exchange rebates
- Security-based swaps – implementation of a series of SEC rules for security-based swap dealers and major security-based swaps dealers will begin November 1 and continue into 2022; consideration will also be given to mandating disclosure for positions in security-based swaps and related securities
- Crypto Assets market – large portions of the crypto market are operating outside of regulatory frameworks including those for investor protections, illicit activity, and financial stability. SEC efforts will follow two tracks: i) working with other financial regulators (CFTC, FRB, OCC, Treasury) to bring investor protections to crypto markets using current authorities, and ii) identifying supervisory gaps to be addressed by Congress. Overall focus will include offer and sale crypto tokens, crypto trading and lending platforms, stable value coins, exposure to crypto through investment vehicles, and custody of crypto assets.
Predictive data analytics
The SEC notes that with the advent of artificial intelligence (AI), predictive data analytics, and machine learning, trading platforms have the capabilities to tailor marketing and products to individual investors, which it suggests also prompts new questions around the potential for conflicts within brokerage, wealth management, and robo-advising. Key issues involving model risks include the possibility for optimization for revenue and data collection, embedded bias in data sets, and systemic risks arising from concentration of data sources, herding, and interconnectedness.
SEC has issued a related Request for Information and Comment specifically on “digital engagement practices,” which is outlined below.
Issuers and issues disclosure
SEC states that investors today are looking for consistent, comparable, and decision-useful disclosure around climate-risk, human capital, and cybersecurity. Staff is developing proposals for consideration on potential disclosures related to these areas. (Proposaed rules are expected by the end of this year.)
Other priorities related to issuers include disclosures around special purpose acquisition companies, tightening of the insider trading rules, and specific elements of Chinese companies listing on U.S. exchanges (such as consenting to inspections by the PCAOB, and the use of shell companies to raise capital).
Funds and investment management
A variety of potential reforms are being explored including:
- Information contained in marketing claims, especially related to ESG topics, such as “green,” “sustainable,” and “low carbon” (a recent SEC Examinations Risk Alert highlighted the need for firms to clearly and consistently articulate how they define ESG-related terms)
- Cybersecurity risk governance, such as “cyber hygiene” and “incident reporting”
- Disclosures by private funds
- Resiliency in money market funds and open-end bond funds.
Request for Information and Comment: Digital Engagement Practices
SEC published a Request for Information and Comment related to the use of “digital engagement practices” or DEPs, by broker-dealers and investment advisers. The practices/tools include both:
- Behavioral prompts, differential marketing, game-like features (commonly referred to as “gamification”), and other design elements or features designed to engage with retail investors on digital platforms (e.g., websites, portals, and applications or “apps”)
- Analytical and technological tools and methods used in connection with these DEPs, including predictive data analytics, AI, and machine learning.
As part of the SEC press release, Chair Gensler expressed concern generally for protecting “investors engaging with technologies that use DEPs." In other instances (before the Investment Advisory Committee meeting and also in Congressional testimony noted above), he expressed concern about how these new business models ensure for fairness of access and pricing, particularly in light of the possibility that data used in the analytic models could reflect historical biases that may be proxies for protected characteristics, like race and gender.
A total of 91 questions are detailed in the Request for Information and Comment, covering DEPs, the tools and methodologies behind the DEPs (e.g., analytics, models), regulatory issues associated with the DEPs and related tools and methodologies (e.g., compliance, risk management), and the use of technology in developing and providing investment advice. Questions range from the types of investors that use DEPs to cybersecurity and risk management, the use of behavioral psychology, compliance with Regulation Best Interest, and recordkeeping requirements.
Comments are requested by October 1, 2021.
The Request for Information and Comment is available here.
KPMG Regulatory Insights Regulatory Alert on the SEC Risk Alert is available here.