The SEC's New AI Rule: How You Can Use AI Innovations While Staying Compliant

Artificial intelligence (AI) is getting better and better, faster and faster, so regulatory authorities are taking proactive steps to ensure the protection of investors' interests. On July 26, 2023, the U.S. Securities and Exchange Commission (SEC) unveiled an innovative proposal designed to address potential conflicts of interest that may arise from the use of AI and predictive data analytics within brokerage and investment advisory firms.

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The SEC's Proposed AI Regulation

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At the core of the SEC's proposal lies the objective of mitigating conflicts of interest that could emerge due to the adoption of AI and predictive data analytics by broker-dealers and investment advisers. SEC Chair Gary Gensler emphasized the significance of the proposal, stating, “When providing advice or recommendations, firms have a duty to eliminate or address conflicts of interest and must not prioritize their interests over those of investors. I believe that, if adopted, these rules will safeguard investors from conflicts of interest and will require firms to uphold their obligations irrespective of the technology they employ.”

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The proposal mandates that brokerage and investment advisory firms take proactive measures to assess and mitigate conflicts of interest associated with their use of AI and predictive data analytics. This entails a comprehensive evaluation to ascertain whether the firm's interests could potentially supersede those of investors due to the deployment of this technology. If such conflicts are identified, the firms are obligated to rectify or neutralize them.

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Best Practices for Investment Advisory Firms Implementing AI

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While the SEC's proposed rule aims to establish a regulatory framework for safeguarding investor interests, investment advisory firms can embrace best practices to not only comply with the forthcoming regulations but also enhance their operational transparency and ethical standards. It is worth noting that, while currently a proposal, the growing prominence of AI in the financial sector suggests that AI-related regulations will likely come into effect in some form, making these best practices invaluable.

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The SEC recently conducted an examination aimed at identifying gaps in the compliance programs of investment advisory firms in relation to their use of AI. The following best practices were gleaned from this examination, offering a roadmap for investment advisory firms utilizing AI:

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1. Transparent Disclosure Practices: Investment advisory firms should prioritize clear and comprehensive disclosure documents that explicitly inform clients about the integration of AI and predictive data analytics in their operations. Transparency is a cornerstone that enables clients to make informed choices and fosters trust.
2. Strengthened Compliance Policies and Procedures: Firms should establish and maintain written compliance and operational policies that outline the supervision, operation, and management of AI systems. Regularly updating these policies to address technological or business practice changes is paramount.
3. Employee Training and Education: Providing ongoing compliance training to employees involved in the development, implementation, supervision, or use of AI software systems is essential. Ensuring that employees comprehend their responsibilities in adhering to ethical and legal standards can mitigate potential conflicts of interest.
4. Oversight Committees: Establishing committees dedicated to AI-related matters can facilitate effective oversight. These committees should convene regularly, maintain written records, and include representatives from various relevant departments.
5. Comprehensive Algorithmic Documentation: Firms should meticulously document detailed descriptions of all AI-based algorithmic models employed in managing client portfolios. This documentation should also encompass the methods utilized, comparison studies, and adjustments made due to data acquisition errors.
6. Transparent Data Source Management: Maintaining an up-to-date list of data sources used by AI systems, along with their acquisition methods, is imperative. Clearly outlining the procedures for both contracted and in-house data sources aids in risk management and accountability.
7. Regular Audits and Reviews: Conducting periodic audits and reviews of AI models and trading signals is vital to identify and rectify potential conflicts of interest or biases. Ensuring that any adjustments made are well-documented and transparent.
8. Ethical Considerations and Investor Impact: Evaluate the ethical implications of AI-driven decisions and their potential impact on investors. Establish a framework for assessing whether AI-driven recommendations prioritize investor interests.

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The SEC's proposed rule signifies a significant stride in aligning technological advancements with investor protection. As investment advisory firms continue to embrace AI and predictive data analytics, it is essential that they adhere to the proposed guidelines and implement best practices that prioritize investor interests. By embracing transparency and ethical practices, RIA firms can navigate the ever-evolving AI landscape in finance while safeguarding the trust and well-being of their clients.

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If you're looking to make the most of AI to drive efficiencies at your firm, Hadrius is a great place to start as we're the only AI-powered SEC and FINRA compliance program and built from the ground up for forward-thinking firms. Schedule a demo for a tour of Hadrius and how we can turn compliance into an accelerant for your firm's growth!

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